Knowing how much money you owe and are owed is critical when considering disputes with other parties. You need to consider whether a right of set-off exists between you and the other party.

Where this right exists, and the other party has failed to perform its obligations and caused you loss, you might be able to withhold payment on a related contract. If you are already involved in a dispute, set-off may be a defence to a claim that has been brought against you. Equally, if you are involved with an insolvent company, automatic set-off will apply, and may allow you to set-off debts against sums owed to you.

Here is our guide to set-off, when it might arise and some practical considerations when you are negotiating and considering existing contracts.

What is set-off and when can it arise?

Set-off occurs where a debtor has a cross-claim against a creditor; the set-off amount will reduce or extinguish the creditor's claim. Set-off can arise in a number of situations:

1. As a defence to court proceedings (legal set-off)

Legal set-off only arises as a defence to court proceedings. It is available where the claim and counterclaim are both either liquidated or ascertainable with certainty and are both due and payable. The counterclaim must be "procedurally actionable" i.e. it must be capable of being litigated in the English court (and not, for example, be subject to an arbitration clause).

The two claims do not have to arise from the same transaction or closely connected transactions. However, legal set-off can be specifically excluded by contract.

2. Where parties are contracting on a number of closely related contracts (equitable set-off)

Equitable set-off is available to a debtor before litigation arises, where the cross-claim arises from the same transaction (or a closely related transaction) as the debt owed.

However, disputes can arise over whether the claim and cross claim are close enough to enable a party to rely on the doctrine of equitable set-off. Although each case will be decided on its own particular facts, a relevant factor that will be considered is whether it would be unjust to enforce the claim without taking into account the cross-claim. Therefore, proximity of the claims and justice are both essential elements for the doctrine to apply.

A debtor can simply deduct the amount of the mutual cross-claim from the debt owed and tender the balance of the debt.

However, caution should be exercised, as if there is no right of set-off (or the right to set-off has been excluded) then refusal to perform your obligations on a separate contract may amount to a repudiatory breach.

Equitable set-off can be specifically excluded from contracts.

3. Where you hold a number of accounts with any bank (banker's set-off)

This is used where a customer has more than one account at the bank, at least one of which is in debit and one of which is in credit. The bank can set-off any debt owed against any deposits held. This remedy can be automatically exercised without formality.

4. Where the right to set-off is specifically provided for under contract (contractual set-off)

If payments are due from both parties to a transaction they may agree that, instead of both parties making separate payments, the party due to make the larger payment should pay the difference between the two amounts due.

It is usual, in commercial contracts, for the boilerplate provisions to either permit or prohibit set-off. Note that if the right is not prohibited though, then it usually exists.

5. Where there is an insolvency situation

The rules of insolvency set-off are mandatory and cannot be varied by contract. Consequently, insolvency set-off supersedes any contractual rights of set-off that exist between a creditor and an insolvent debtor.

Insolvency set-off applies immediately and automatically upon:

  • a company being wound up;
  • the administrator of a company giving notice of his intention to distribute assets to creditors; or
  • an individual being made bankrupt.

Where a creditor proves they are owed a debt in a liquidation, administration or bankruptcy, an account must be taken of the mutual rights of the parties. The sums due from one party must be set-off against the sums due from the other.

However, automatic set-off will not apply if at the time the debt was incurred the creditor had notice of:

  • a resolution or petition to wind-up;
  • an application for an administration order or of notice of intention to appoint an administrator; or
  • a pending bankruptcy petition.

All claims, including future, contingent and unliquidated sums, must be brought into account.

Insolvency set-off applies on the date of the winding-up order. Assets are notionally treated as being realised and distributed simultaneously on that date.

Insolvency set-off in an administration does not come into effect unless and until the administrator gives notice of an intended distribution to creditors.

Insolvency set-off is good news for a creditor; it always benefits a creditor who also owes a debt to the insolvent company. Instead of having to prove with other creditors for the whole of the debt (e.g. where you may only recover 10p in the pound), you can set-off "pound for pound" what is owed to the company and prove for, or pay, only the balance.

Practical steps

  • Each of these rights (except for insolvency set-off) may be modified by agreement between the debtor and creditor, by either excluding or restricting rights of set-off, or by providing for a contractual right to set-off cross-claims that would not otherwise be taken into account.
  • If you intend obligations in separate contracts to be conditional upon one another, the safest approach will always be to include clear drafting for this conditionality.
  • Equally, where rights of set-off are not intended to operate, it is advisable to document this fact clearly in the contract.
  • The word "set-off" should be included in any such clause: for example it has been held that a lease term which stated rent was to be paid "without any deduction" was insufficient to exclude a tenant's right of equitable set-off (Connaught Restaurants Ltd v Indoor Leisure Ltd). It is usual to prohibit any "withholding, deduction or set off".
  • Remember that if you are contracting with consumers or with parties on standard terms, a clause excluding the right of set-off constitutes a limitation of liability because it restricts a remedy otherwise available to the innocent party. Therefore, the set-off clause will be subject to the reasonableness test in the Unfair Contract Terms Act 1977.
  • In an insolvency situation, where you are a creditor, remember that if any debt is owed to you by the company, set-off will operate automatically, (provided you did not have notice of the insolvency) and you can set-off sums owed pound for pound.