Right to set-off: Contractual v Equitable set off

What is set off?

Where two parties have financial claims against each other, rights of set-off allow one party to deduct or "off-set" their debts or liabilities against monies owed by the other party and only pay the remaining balance. The liabilities to be set off must be monetary and mutual. Where the right to set-off applies, it may be used as a defence to a claim. However set-off is not the same as a counterclaim – the right of set-off can be used as a defence against a claim but a counterclaim is a separate claim that can be pursued even if all rights to set-off is expressly excluded. In such circumstances, the other party may still pursue its counterclaim but cannot rely on set-off to delay payment.

There are various types of set-off but the mostly commonly relied on are contractual and equitable rights of set-off.

Contractual rights to set-off

The law creates various rights of set-off but such rights do not cover every type of claim. Common law or equitable set-off also only applies when specific criteria are met. The nature and extent of the parties' set off rights are often therefore included as a provision to a contract, to avoid any uncertainty or restricted applicability and to ensure the parameters of the right to set off are clear.

Some common features of contractual set-off rights include:

• The circumstances that trigger the right to set-off and when it can be applied (e.g. if undisputed sums are to be paid despite the existence of other disputes);
• Any limitations on the right of set-off (e.g. if it applies only to claims directly arising due to breach of the contract, if it applies to both liquidated and unliquidated amounts and to present and future claims);
• Exclusion of one or both parties' right to set off under the contract or entirely (i.e. to also exclude equitable rights of set-off, but this can only be done by clear and unequivocal words).

Contractual set-off clauses can extend or reduce equitable rights of set-off (save that a party cannot vary or amend the rules of set-off that apply in insolvency; any attempt to do so will be void).

Equitable rights to set-off

Equitable set-off is a remedy that may be available to parties in certain circumstances where the contract does not contain any express provisions regarding the application of set-off.  It is more difficult to use in practice as its applicability is dependent on the satisfaction of particular criteria.

The test for establishing an equitable right to set-off is set out in the decision of Geldof Metaalconstructie NV -v- Simon Carves Ltd (2010) EWCA Civ 667 (Geldof Metaalconstructie NV) The test is premised on the principle of fairness. In order for a party to assert an equitable right to set-off, the following requirements must be met:

• the existence of a "close connection" between the claim and the sum of money that is being set off;
• it must be "manifestly unjust" to allow a party to enforce the claim without taking the set off into account.

The above test has been applied in recent Irish case law (Feniton Property Finance DAC v McCool [2022] IECA 217 and Castletown Foundation Ltd v Magan [2022] IECA 218 (Castletown)). Both cases cited this to be the applicable test for an equitable set-off claim, noting that the claim must meet both requirements. The Judge in Castletown also stated that another important feature when considering whether a claim gives rise to set off will depend on "how the parties have chosen to arrange their own legal and commercial relations" and noted that if the parties have agreed there will be no set-off, the court should give effect to that choice. This reiterates the need for clear drafting to reflect the intention of the parties with regard to the applicability and scope of any rights to set-off.

It is generally easier for an equitable claim to succeed if the set-off arises under the same contract (but this is not a pre-requisite). Indeed, in the case of Geldof Metaalconstructie NV, the contractor was entitled to avail of a set-off against a claim brought against it by a subcontractor under a separate contract. It is also important to note that equitable set-off is not limited to liquidated amounts – if the liabilities have not yet been ascertained, a reasonable assessment of the loss may be made in good faith. Such assessment is likely to be assessed on a case-by-case basis by the courts.

Drafting set off clauses

Including contractual rights to set-off can aid parties to include more situations where the right of set-off can apply or, in contrast, restrict the applicability or extent of the rights of set-off. It also provides more certainty to the parties by removing the need to meet the requisite criteria for equitable rights of set off. A useful measure to include in a set-off clause, particularly where the parties have ongoing relationships, is a right of cross contractual set-off. This avoids the need to rely on principles of equity and avoids uncertainty.

It is also worth noting that the question of whether set-off can or cannot be applied may be a matter of interpretation by the courts. In the recent case of FK Construction Limited v ISG Retail Ltd [2023] EWHC 1042 (TCC), the Technology and Construction Court (TCC) was asked to set-off an award in favour of one party in an adjudication regarding a separate project against other adjudication awards between the same two parties. The court rejected the argument for set-off, which reaffirms that courts continue to support the enforcement of valid adjudication awards and will only decline to do so in very limited circumstances. In this case, set-off was not one such circumstance. It seems likely that any argument as to whether an adjudication award on one project can be set-off against an adjudication award on a different project between the same parties will be challenging and ultimately, a matter determined by the courts on a case by case basis.

For further information in relation to this topic or any related matter, please contact Conor Owens, Partner or Siobhan Kearney, Senior Associate or any member of A&L Goodbody's Construction & Engineering team.

Date published: 6 June 2023