Introduction

In Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667, the English Court of Appeal examined the law of equitable set-off. After considering existing authority on the topic, Rix LJ, on behalf of the Court, laid out the applicable test to determine when parties have the right to rely on equitable set-off.

The Court held that the test for set-off consists of a formal requirement of close connection between the claim and cross-claim, as well as a functional requirement where it would be unjust to enforce the claim without taking the cross-claim into account. This is to ensure that the test is based on principle and not mere discretion, and also to highlight that the basis of the set-off regime is equity.

The case involved a claim based on the Defendant’s failure to pay for equipment under a supply contract. The Defendant, relying on a counterclaim for damages for the Plaintiff’s repudiation of an installation contract, was held to have established a right to set-off. The Court found that by demanding payment under the supply contract as a condition for continuing work under the installation contract, the Plaintiff had itself linked the two contracts. Furthermore, the two contracts – although formally separate – had many practical links.

This judgment provides a helpful analysis of the relevant authorities on the topic of set-off, and synthesizes them into a clearer and more consistent test.

Brief Facts

  1. The Defendant, Simon Carves Ltd (“SCL”), was the main contractor of a bioethanol plant, and needed to purchase pressure vessels and install storage tanks. Geldof Metaalconstructie (“Geldof”) offered to supply both these requirements.
  2. The supply contract was concluded on 3 July 2007. This contract provided for a “Right to Offset”, whereby SCL could set off against the purchase price “any amounts lawfully due” (“the Set-Off Clause”).
  3. The installation contract was separately tendered for and concluded on 21 December 2007. There was also evidence that it was normal industry practice for the installation of vessels and tanks to be dealt with separately.
  4. SCL later alleged that Geldof had breached the installation contract by failing to proceed regularly and diligently. At the same time, SCL also failed to make payment due to Geldof under the supply contract.
  5. Geldof then wrote to SCL, making it clear that it would not restart works under the installation contract unless payment had been made under the supply contract. SCL took this to be a repudiation of the installation contract, and terminated it for that reason.
  6. Geldof subsequently began proceedings against SCL for the price of the equipment under the supply contract.

Issues

SCL sought to counterclaim for damages for Geldof’s alleged repudiation of the installation contract (“the Counterclaim”). The Court thus had to decide whether SCL was entitled to set off the Counterclaim against Geldof’s claim under the supply contract.

The Court considered:

  1. The right to set-off under common law equity; and
  2. The contractual right to set-off under the supply contract’s Set-Off Clause.

Holdings Of The Court Of Appeal

It was held that SCL was indeed entitled to set off the Counterclaim, both under common law and under the Set-Off Clause in the supply contract.

The Law Of Equitable Set-Off

The Court approved of Lord Denning’s restatement of the principle in Federal Commerce & Navigation Co Ltd v Molena Alpha Inc [1978] 2 QB 927. It was there held that cross-claims could only be set off where they are “so closely connected [with the claim] that it would be manifestly unjust to allow [the claim] without taking into account the cross-claim.”

The Court summarized this test for equitable set-off as containing two elements:

  1. There is a formal requirement of a close connection between the claim and the cross-claim. This is to ensure that the doctrine is based on principle and not mere discretion.
  2. There is also a functional requirement whereby it must be unjust to enforce the claim without taking into account the cross-claim. This is to remind all parties that the ultimate rationality of the regime is equity.
  3. The Court emphasized that it is not a two-stage test, but a test with two elements that cannot be divorced from each other.

Under the formal requirement of close connection, it is unclear just how close the connection must be. The Court recognized that one possible formulation was the “inseparable connection” test (as in Government of Newfoundland v Newfoundland Railway Co. (1888) 13 App. Cas. 199), whereby the crossclaim should flow out of and be inseparably connected with the dealings and transactions which give rise to the claim.

However, it was held that the “inseparable connection” test is not the only formulation of the close connection test, and is of limited applicability where separate contracts are concerned. Therefore, it cannot be used to exclude a set-off where another formulation of the close connection requirement would have allowed it.

Application Of The Test

The main issue here was the fact that the Counterclaim was based on the installation contract, while Geldof’s claim was based on the supply contract. Despite the fact that they were separate contracts, concluded at different times, separately tendered, and independent of one another in their origins, the Court held that they were sufficiently connected to pass the test for equitable set-off.

The formal element:

  1. By insisting on payment under the supply contract as a pre-condition of returning to work on the installation contract, Geldof had itself brought the two contracts into intimate relationship with one another.
  2. This relationship was made inseparable when SCL terminated the installation contract in reliance of Geldof’s alleged poor performance and its insistence on prior payment.

The functional element:

  1. The two contracts also contained many practical links; the construction of the bioethanol plant and the effective use of the vessels supplied under the supply contract relied heavily on the proper performance of the installation contract.
  2. Therefore, it would not be fair to allow Geldof to enforce payment under the supply contract where SCL’s responsibilities as the plant’s main contractor were prejudiced by Geldof’s repudiation of its obligations under the installation contract.

Contractual Set-Off

In any event, the Court was prepared to find that the Set-Off Clause in the supply contract allowed SCL to set off its Counterclaim against the payments due.

The Set-Off Clause allowed SCL to set off “any amounts lawfully due”, and this was found to include not only amounts which have been adjudicated or agreed to be due, but also amounts which are claimed to be due and which are recognized at law. Therefore, even if SCL’s Counterclaim did not fall within the scope of equitable set-off, it was covered by the Set-Off Clause.

Concluding Words

This judgment highlights the fact that set-off is primarily a tool of equity, and that the concerns of fairness and justice thus play a large role. The Court refused to peg the test for set-off as high as requiring an “inseparable connection”, and instead introduced the functional element of injustice into the test.

In any event, parties are free to provide for contractual set-off in their contracts, which may apply even for counterclaims based on separate contracts, as long as the set-off clauses are wide enough to provide for such situations. Parties who wish to do so should thus ensure that their set-off clauses are properly worded so as to include a right to set-off which goes beyond the function of common law equitable set-off.