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All about the set-off

Dennis Brand sets out what is involved in a 'set-off'

ANALYSIS, MEP

Dennis Brand from Traprain Consultants sets out what is involved in a ‘set-off’.

Ask almost anyone what ‘set-off‘ (sometimes called ‘contra-charging’) means, and they will quickly provide an answer to the effect that set-off is where the amount of a claim is deducted from another lia-bility, following which only the net sum is paid. Ask the supplementary question as to whether there is more than one type of set-off, and not so many answers will be forthcoming, and certainly not with such speed; however, more of that later.

In construction and engineering contracts, where set-off is to be applied within the same contract, it is usually allowable if the claim and liability are both liquidated sums – that is, defined amounts. Such contracts usually provide for set-off in any event, although may require notice to be served. Some contracts, particularly those being industry-standard forms, will include provision for set-off and describe the provision as such, whereas others will include provisions which clearly amount to set-off, but without mentioning the term.

Where set-off is to be applied as between different contracts, this generally can only be done if the contracts contain clear provision for it. However, this is not so unusual where the same parties have entered into more than one contract between them, as in the case of supply contracts. What is more unusual, however, is where set-off is allowable between different parties to different contracts – for example, where at least one of the parties, and possibly both, to a contract are corporate entities and part of larger groups.

Provision can be made in the contract that, where there is a claim from another member of the same group in respect of another contract, one party may set-off against the other the amount due (or claimed) by that other member of the same group. This may be considered somewhat unfair, as the party who is having the set-off applied against it has no real opportunity to challenge the set-off until it has been applied. However, set-off in such circumstances can only occur if such provision is expressed in the clearest terms.

Set-off, however, is important where it may be difficult to pursue the other party by legal action, or if they are at risk of becoming insolvent. Let us return to the subject of types of set-off. There are four basic types: legal set-off, equitable set-off, banker’s set-off and insolvency set-off.

Legal set-off can only be used as a defence to court proceedings, and the claims in respect of which set-off is to be applied must be defined or liquidated sums, which can be proved. It is important that the claims be both due and owing at the time when the claim is made. It is important also that the claims or debts be between the same parties and that they are held in the same capacity.

Unlike the examples discussed above in respect of construction and engineering contracts, legal set-off claims do not have to result from the same or even closely related transactions. It is important, however, to keep in mind that contra-claims which are not defined or liquidated sums but estimates when the set-off is proposed can only be confirmed following a court judgment or arbitration award, and cannot of themselves be accepted as valid claims for set-off.

Equitable set-off is different from legal set-off in that it does not need court proceedings to make it an available option for the debtor; moreover, contra-claims must be as a result of related, if not the same, transactions. Unlike legal set-off, claims can be for undefined or unliquidated sums – for example, damages. The sums concerned must, at the time of the set-off being applied, be due and owing. If for an undefined or unliquidated sum, the amount must be a reasonable assessment and made in good faith.

Banker’s set-off is where the customer of a bank has more than one current account or loan account with the same bank, not necessarily the same branch, and one of the accounts is behind in terms of repayment of the debt. The bank may in such circumstances transfer funds from the customer’s account which is in credit to pay the account which is in debt. Although banker’s set-off does not require either a judgment of a court or arbitration award before it can be applied, many banks will inform customers by including such set-off provision in the literature which customers are required to sign when applying to open a bank account.

Insolvency set-off is available in certain jurisdictions where there is an established insolvency law and procedure, as in the UK. Insolvency set-off cannot be varied by terms written into a contract. There are very limited circumstances where set-off is permissible in a bankruptcy or liquidation, because set-off in such circumstances goes against the rule in insolvency that unsecured creditors must be treated equally in respect of their claims.

Insolvency set-off aside, it is acceptable to include a clause within a contract which limits or even excludes the right to set-off between the parties. If drafted properly, such clauses are enforceable and are not considered as being contrary to public policy. However, that being said, such clauses must be drafted properly if they are to be enforced.

Note, however, that the right to apply set-off is variable in different countries, and it is better to establish such a right in the contract itself. Again, remember that each company is a separate ‘person’, and set-off rights generally only run within a particular contract and between the same parties. If you want something more extensive, it needs to be stated clearly (and may be difficult to enforce in practice).

Dennis.Brand@traprain.com

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