At the tail end of a global recession, businesses are now faced with a challenging economic climate which rears its ugly head in the form of the green-eyed debt dragon. Some businesses are struggling to meet the burdens imposed on them by their ever-more demanding creditors. This has resulted in a rush of debt recovery claims via the courts, businesses being brought to an end, and negotiations between businesses and their creditors as to how to manage their obligations. In some cases it may be that the creditor also owes the business money, in which case, there may be grounds for some of the debt owed by the business to the creditor to be ‘set-off’. But what does ‘set off’ really involve? Contrary to common belief, there’s more to it than meets the eye…
The basic idea behind set-off is that two parties have financial liabilities to one another. For example, a business owes money to its supplier under a supply contract and the supplier, at the same time, owes money to the business in respect of a refund for goods supplied. In this situation, if the parties have a right to exercise set off, they will be able to deduct the lesser liability from the other so that only the balance remains due.
An Automatic Right?
The thing about set-off is that it is not an automatic right afforded to every debtor that has a cross-claim against its creditor. Furthermore, a cross-claim is not necessarily always going to be a set-off. There is a common misconception that, under commercial arrangements, the parties will have a right to set-off unless their contract specifically provides otherwise and that any liabilities, of any origin, can be set-off. However, this is not the case; there are different categories of set-off that have different pre-requisites and there are specific mechanisms that must be used when drafting commercial agreements to ensure that the right to set-off can be legally exercised.
Different Categories of Set-Off
There are 5 different categories of set off :
- Contractual Set-Off : This right to set off is granted to the parties by a term expressly written into a contract;
- Legal Set-Off: This right to set-off occurs only as a defence to civil proceedings and can only be exercised when a court action is pending. The defence allows the debtor to set-off liabilities which do not necessarily need to arise directly from the claim at hand.
- Equitable Set-Off: This right to set-off is non-contractual and exercisable by parties outside of civil proceedings. It only allows the debtor to set off liabilities that are closely related to the main transaction or that arise from a single-trading relationship between the parties.
- Insolvency Set-Off:This is a form of set-off that applies under the laws of insolvency which overrides contractual rights to set-off; and
- Banker’s Set-Off:This is a right to set-off that is exercisable by banks over customer bank accounts.
What Does this Mean For You?
Before entering into a contract, parties should ask themselves whether they want to be able to exercise the right to set-off. Many contracts expressly prohibit set-off, which, has the effect of restricting the parties to non-contractual set-off which is governed by the principles of equity.
Being restricted to a non-contractual set-off means that the right to set-off will not always available in respect unrelated liabilities or liabilities that are not closely connected to the main transaction – especially those that arise in the absence of court proceedings. Therefore, if you want to be able to exercise the right to set off, having a contractual right to do so is vitally important ; it not only allows you to set-off unrelated liabilities (to the extent legally permissible), but it also provides you with a defence to non-payment in civil claim against you. The defence to non-payment is two-fold; it prevents you from otherwise having committed a breach of contract by failing to pay as you agreed and it also prevents the creditor from entering a summary judgment against you where the debt claim is undisputed.
If you want to secure a contractual right to set-off you should ensure that a provision is drafted into the contract to grant you that right. There are specific rules as to the way set-off clauses need to be drafted so as to be enforceable and not only do the parties need to ensure that a right is to set-off is included within the contract, but that such right is drafted in a way that makes it legally enforceable.
If you wish to discuss any of the issues raised in this article or you would like assistance with the drafting of commercial agreements, please contact Amanda Bonnick for further information.
The information provided in this article is for general information purposes only and does not constitute legal or other professional advice and cannot be relied upon as such. Any law quoted in this article is correct as at 10 May 2012. Appropriate legal advice should be sought for specific circumstances before any action is taken. Copyright © Murrell Associates Limited 2012.