Cecily Zamora
Set-off, also known as set off, is a legal mechanism that allows parties in a contract, who are both creditors and debtors to each other, to offset their mutual debts. This means that instead of paying the full amount, the party will only be liable to pay the remaining balance. Set-off can be incorporated into a contract through a set-off clause or it can arise by law in certain circumstances. The right of set-off can be a powerful tool in commercial contracts, but it is important to carefully review and understand the implications as it may significantly impact financial risk and asset accessibility.
| Characteristics | Values |
|---|---|
| Definition | Set-off is a legal mechanism that allows parties (each being a creditor and a debtor) to offset their debts. |
| Types | Legal set-off, equitable set-off, contractual set-off, insolvency set-off, banker's set-off, and statutory set-off. |
| Application | Set-off can be applied to contracts, loan agreements, and banking relationships. |
| Requirements | The debts must be monetary and mutual. |
| Effect | The parties only need to pay the remaining balance after offsetting their debts. |
| Benefits | Set-off can be used as a defence to a claim and helps avoid insolvency. |
| Considerations | Set-off clauses may impact a provider's right to claim insurance and receive full payment on time. |
| Limitations | Set-off may not apply to certain accounts, protected funds, or credit card accounts. It is also subject to bankruptcy law limitations. |
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What You'll Learn
Set-off clauses in commercial contracts
For example, if Party A owes Party B $100 for services performed by Party B, and Party B has simultaneously caused a loss to Party A to the value of $50, Party A can use the set-off clause to apply the $50 against the $100 owed to Party B. As a result, Party A will pay the net amount of $50 to Party B.
In the context of commercial contracts, the most relevant types of set-off are contractual set-off and equitable set-off. Contractual set-off is where the right of set-off is explicitly included in the contract. Equitable set-off, on the other hand, is a self-help remedy that applies where a contract does not contain any express set-off provisions either allowing or prohibiting it.
To ensure the right to set-off monies is as limited as possible, it is important to carefully review set-off clauses before signing a contract. While amending a set-off clause at the contractual level can help limit its scope, it is important to note that this does not eliminate a set-off right altogether. Clients may still maintain this right in the law of equity, which is a different area of law to contract law.
To avoid the uncertainty and restricted applicability associated with common law set-off, parties may wish to include a contractual provision specifying whether set-off is to apply, the mechanism of application, and the situations where the right of set-off would be triggered. Conversely, parties can also elect to exclude the right of set-off by including a contractual provision to this effect.
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Contractual set-off
For example, if Party A owes Party B $100 for services performed by Party B, and Party B has simultaneously caused a loss to Party A to the value of $50, Party A can use the set-off clause in the contract to apply the $50 against the $100 owed to Party B. Consequently, Party A only needs to pay Party B a net amount of $50.
It is important to note that the debts to be set off must be monetary and mutual. Additionally, set-off clauses may impact a service provider's ability to claim under their insurance and receive payment in full and on time. Therefore, it is advisable to have a lawyer review such clauses before signing a contract.
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Equitable set-off
Set-off is a common law right that allows parties, each of whom is a creditor and a debtor, to set off their debts. Where the right of set-off applies, the parties can net their payment obligations and will be liable to pay only the remaining balance. The debts to be set off must be monetary and mutual.
Contractual set-off and equitable set-off are the most commonly relied-on types of set-off. While contractual set-off rights are included as a provision in a contract, 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. Equitable set-off is a self-help remedy that is more difficult to use in practice as its applicability depends on the satisfaction of particular criteria.
The test for establishing an equitable right to set-off is set out in Geldof Metaalconstructie NV -v- Simon Carves Ltd (2010). 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: there must be a close connection between the claim and the sum of money that is being set off; and it must be manifestly unjust to allow a party to enforce the claim without taking the set off into account.
It is generally easier for an equitable claim to succeed if the set-off arises under the same contract, but this is not a prerequisite. 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 an assessment is likely to be assessed on a case-by-case basis by the courts.
Including contractual rights to set-off can aid parties in including more situations where the right of set-off can apply or, conversely, 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.
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Common law set-off
Set-off, also referred to as 'set off', is a legal mechanism that allows two or more gross claims to be netted. This means that the gross claims of mutual debt are replaced by a single net claim. In other words, a set-off is the right of a debtor to balance mutual debts with a creditor.
The law of set-off is of paramount importance in international affairs, as creditors are often also debtors to the same counterparty. Set-off was originally introduced to prevent the unfair imprisonment of a debtor who was owed money by their creditor.
In the context of commercial contracts, the most relevant types of set-off are contractual set-off and equitable set-off. A contractual set-off is recognised as an incident of party autonomy, and a banker's right of combination is considered an implied term. Contractual set-offs are often used when there is an ongoing business relationship between the parties.
Equitable set-off is a self-help remedy that becomes relevant when a contract does not contain any express set-off provisions, either allowing or prohibiting it. The leading case confirming the principles and conditions that equitable set-off requires in order to be recognised by law is Geldof Metaalconstructie NV- v- Simon Carves Ltd.
To avoid the uncertainty and restricted applicability associated with common law set-off, parties may include a contractual provision specifying that set-off is to apply, the mechanism of application, and the situations where the right of set-off would be triggered.
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Set-off in loan agreements
Set-off clauses are commonly used in loan agreements between lenders, such as banks, and their borrowers. In a loan agreement, a set-off clause allows the lender to seize the borrower's assets or deposits if they default on the loan. This ensures that the lender receives a greater percentage of the amount owed to them than they would otherwise.
For example, consider a scenario where Party A owes $100 to Party B for services performed. Simultaneously, Party B has caused a loss to Party A, and the claim is worth $50. In this case, Party A can utilise the set-off clause and apply the $50 they are owed against the $100 they owe to Party B. Consequently, Party A would only need to pay a net amount of $50 to Party B.
It is important to note that set-off clauses may result in the loss of assets that borrowers could have retained through other means of debt settlement, such as bankruptcy. Therefore, borrowers should carefully review set-off clauses in loan agreements before signing.
In addition to loan agreements, set-off clauses can also be used in supplier agreements between a manufacturer and a buyer. This type of clause can replace a letter of credit from a bank, giving the supplier access to the buyer's deposit accounts or other assets if the buyer fails to pay.
There are various types of set-off, including legal set-off, insolvency set-off, banker's set-off, contractual set-off, and equitable set-off. Legal set-off, also known as statutory or independent set-off, arises when both the claim and counterclaim in a court action are liquidated sums or ascertained with certainty. Equitable set-off, on the other hand, occurs outside of litigation when two mutual claims arise from the same or closely related matter, and it would be unjust to enforce one claim without considering the other.
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Frequently asked questions
Set-off, also known as netting or offset, is a legal mechanism that allows parties in a contract who are both creditors and debtors to each other to offset their payment obligations. In other words, it allows one party to deduct or offset their debts or liabilities against the monies owed by the other party, with only the remaining balance being payable.
There are various types of set-offs, including legal set-off, equitable set-off, contractual set-off, insolvency set-off, and banker's set-off. The most common types used in commercial contracts are contractual set-off and equitable set-off.
A set-off clause is a provision in a contract that allows one or both parties to apply any debts they are owed against any payments due to the other party. It gives the client extra rights, such as the right to deduct money from payments if the service provider owes them a debt or has caused a loss.
A set-off may be automatic if it is contractually agreed upon. Otherwise, creditors often require legal authority or court approval to exercise their right of set-off.
To protect yourself from set-off clauses, carefully review contracts before signing, maintain separate banking relationships, and seek legal advice to understand your risk exposure. Amending a set-off clause in a contract does not eliminate the other party's right to set-off, which may still be insisted upon in certain circumstances.
