What is set-off?

A common provision found in commercial contracts involving payments between two parties is a right of set-off. But what is set-off and how does it arise?

Set-Off

A right of set-off enables Party A to deduct a sum of money owed to them by Party B, against any sum due to be paid by Party A to Party B.

Example: Party A owes Party B $100. Party B owes Party A $200. Set-off results in Party B owing Party A $100, while Party A's debt to Party B is extinguished.

As a matter of English law, set-off rights may arise by way of contract or by law:

Contractual set-off

Parties to a contract can expressly agree that where mutual payment obligations arise between the two parties, instead of both parties making separate payments to one another, the party who owes the largest payment need only pay the difference (the set-off amount). The extent of the set-off right can vary from contract to contract and will depend on the terms specified.

While set-off usually only applies to mutual debts (i.e. debts owing between the same parties), contractual set-off can be agreed in relation to claims which are not mutual (i.e. not owing between the same parties) or in relation to permitted types of claim that wouldn’t usually be eligible to be set-off (e.g. claims contingent on a specific event happening).

Sample Clause: A Party (Party A) may set off any matured obligation due from the other Party under the Agreement (Party B) against any matured obligation owed by Party A to Party B, regardless of the place of payment or currency of either obligation. If the obligations are in different currencies, Party A may convert either obligation at a market rate of exchange in its usual course of business for the purpose of the set-off.

Equitable set-off

Set-off can apply to closely connected claims, where it would otherwise be "manifestly unjust" for the claim to be enforced without taking account of the cross-claim (subject to any contractual exclusion that may apply).

Example: Party A has bought inventory from Party B and still owes Party B $10,000 of the purchase price. Some of the inventory purchased is, however, damaged on arrival and Party A has to pay $2,000 to repair the damaged items; this amount of $2,000 can be set-off against the $10,000.

Insolvency set-off

As a matter of English law, mandatory statutory rights of set-off arise automatically for an insolvent debtor company against its creditors. It supersedes any contractual set-off rights that may exist.

Under insolvency set-off, all sums (including contingent and unascertained liabilities) due between the insolvent party and its creditors under all mutual dealings are set-off to create a final balancing payment. In the case of liquidation, the right will take effect automatically from the date of the liquidation. In administration, the right will only take effect when the administrator gives notice of distribution to the creditors.

The rules regarding insolvency set-off are particularly complex. It is therefore wise to take specialist legal advice.

Banking set-off

Where a party has more than one account with a bank, the bank is entitled to set-off one credit balance against another debit balance. It is available to banks as a self-help remedy without the requirement for litigation.

Can set-off be excluded?

Contractual terms excluding or restricting the right of set-off (other than insolvency set-off) are enforceable as a matter of English law. The courts have held that clear, express wording is required to exclude a right to set-off.

Practical points to note

• If you are defending a claim from a counterparty, consider whether there may be a right of set-off that may be relevant.

• If the dispute arises out of a contract, check if there is a contractual provision relating to set-off (either expressly providing for and allowing set off, or seeking to exclude that right).

• If a counterparty to a contract is likely to become insolvent, review monies owed to that company and amounts owed to you so that you can be ready to validate any rights of insolvency set-off that arise.

*This note has been published to provide general information and not as legal advice.