Where contracting parties document a transaction in two separate but related contracts, can failure to perform under one contract justify the other party withholding payment under the other contract?  

In the recent Scottish case of Inveresk PLC v Tullis Russell Papermakers Limited, Inveresk and Tullis Russell entered into an Asset Purchase Agreement in terms of which Inveresk sold to Tullis Russell assets related to the manufacture of certain brands of paper. At the same time, the parties also entered into a Services Agreement, under which Inveresk agreed to assist in the manufacturing of the products for a period following completion of the transaction.  

Inveresk sued Tullis for £909,395 of "Additional Consideration" under the Asset Purchase Agreement. Tullis tried to resist payment on the basis that it was entitled to set the sums off against sums which it was suing for separately under the Service Agreement.  

The remedy which Tullis was trying to exercise is known in Scots law as "retention". The right to retention is based on the principle of “mutuality of obligations”, i.e. that neither party need perform his obligations if the other is not performing its corresponding obligations.  

In finding against Tullis, the opinion of the Inner House of the Court of Session delivered by Lord Clarke made it very clear that choosing to divide a transaction into separate contracts will create a "strong presumption, at the very least" in law that the obligations contained in those two separate agreements are intended to operate independently of one another, meaning that the remedy of retention cannot be exercised. The inclusion of "entire agreement" clauses in both contracts also supported this presumption.  

In English law, the right to “equitable set-off” arises where there is an "inseparable connection" between the claim and counter claim, such that it would be manifestly unjust to enforce one without taking the other into account (Bim Kemi AB v Blackburn Chemicals Limited [2001] Ewca CIV). Under English law the fact that claim and counterclaim arise under separate agreements does not prevent equitable set-off from operating.  

Where the parties intend obligations in separate contracts to be conditional upon one another, the safest approach under both English and Scots law will always be to include clear drafting for this conditionality. Likewise, where rights of set-off are not intended to operate, it is advisable for the parties to document this fact clearly in the contract.