UK: Cross-Contract Set Off - What Is The View Of The Courts?

In the mêlée of day-to-day commercial relationships, how easy is it for clients to link contracts unwittingly and thereby create a cross-contract set off? In which direction is the court moving in this area and how alert need clients be when seeking to enforce payment?

Introduction

In June 2010 the Court of Appeal handed down a unanimous Judgment in the case of Geldof Metaalconstructie NV v Simon Carves Ltd ("Geldof") [2010] EWCA Civ 667. The Leading Judgment was given by Lord Justice Rix. In the Geldof case the Court of Appeal reviewed the Judgment of His Honour Judge Raynor QC sitting as a High Court Judge in the Manchester District Registry of the Technology and Construction Court and in particular issues relating to equitable set off and cross-contractual set off provisions.

In this paper, I investigate the two questions, how easy is it for clients to link contracts unwittingly and thereby create a cross-contract set off? and which direction are the Courts moving in this area and how alert need clients be when seeking to enforce payment? Before addressing these questions I set out the background to the law of set off, the equitable set off position prior to the Geldof decision and the law as it now stands following the decision in Geldof. I then look at how the Judgment of Lord Justice Rix affects the two questions.

Background to the law of set off

Before looking at the different types of set off, lets consider why set off is important. Set off is the ability of a debtor to reduce or eliminate entirely the debtor's liability to a creditor by taking into account monies owed by the creditor to the debtor. In litigation set off operates as a defence to a claim rather than a separate stand alone counterclaim. Commercially set off can be used not only as a defence to a claim, but also, to reduce or eliminate monies owed to another party. In construction we are all used to the Section 111 of the Housing Grants Construction and Regeneration Act set off notice. Indeed today this will be the most common type of set off used in the construction industry. A ground for withholding may be an equitable set-off. There are three main categories of set off:

Legal set off - a procedural remedy which applies only in litigation. It applies where there are mutual debts which are both due and payable at commencement of the action. The amounts of debts must be readily ascertained, therefore excluding unliquidated damages claims. The debts need not be connected, that is in relation to the same contract of the same subject matter.

Equitable set off - which is the issue we are looking at in this paper, is considered below. The old leading case of Rawson v Samuel1 held that equitable set-off was available as a defence when "the title of the Plaintiff to his demand is impeached". A classic example of this is a claim for unliquidated damages in negligence being used to set off a claim for monies payable under a contract. Equitable set off can be used not only as a defence for the claim but also as a grounds to withhold payment of a debt.

Insolvency set-off - The final form of set off is insolvency set off which derives from the Insolvency Act 1986 and the Insolvency Rules 1986. This relates purely to mutual dealings of the parties where one party is insolvent. This simply assists the creditor who might be otherwise required to pay debts owed to the insolvent party to avoid paying those debts. This is a separate breed of set off and not relevant to the questions raised in this paper.

Equitable set off pre Geldof - in his Judgment, Rix LJ reviewed the law as it stood on equitable set off. As already set out above, the law of equitable set off has its roots in the case of Rawson v Samuel but as is identified by Rix LJ the modern law of equitable set off is generally considered to date from the case of Hanak v Green2 Morris LJ in his Judgment set out the law in these terms:

"The position is, therefore, that since Judicature Acts there may be (1) a set off of mutual debt; (2) in certain cases a setting up of matters of complaint which, established, reduce or even extinguish the claim; and (3) reliance is a matter of defence upon matters of equity which formally might have called for injunction or prohibition...

The cases within group (3) are those in which a Court of equity would have regarded the cross-claims as entitling defendants to be protected in one way or another against the plaintiff's claim."

Rix LJ also referred to the case of Bankes v Jarvis3 which Morris LJ identified two factors as critical that it would have been "manifestly unjust" for the claim to be enforced without regard to the cross-claim and "there was a close relationship between the dealings and transactions which gave rise to respective claims". The Learned Judge reviewed the law in detail but for our purposes, the main cases were Lord Dennings Judgment in Federal Commerce & Navigation Co Ltd v Molena Alpha Inc4 ("The Nanfri"). In this case the Court had to consider whether claims against a ship owner could be set off against time charter hire. The issue had to be decided against a background of the historical rule excluding set off against voyage charter freight and special terms in the time charter in question permitting deductions in certain circumstances. Lord Denning said:

"But one thing is clear: it is not every cross-claim which can be deducted. It is only cross-claims that arise out of the same transaction or are closely connected with it. And it is only cross-claims which go directly to impeach the plaintiff's demands, that is, so closely connected with his demands that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim."5

Lord Brandon in the case of Bank of Boston Connecticut v European Grain and Sugar Ltd6 ("The Dominique") also considered the position and stated:

"But rather that it was a cross-claim, flowing out of an inseparably connected with the dealings and transactions which also gives rise to the claim"

However, although the cases above appear to be moving away from restricting equitable set off to matters arising from the same contract, all of the cases above related to the same contract, Rawson remains good law. In the case of Dole Dried Fruit and Nut Co v Trustin Kerwood Ltd7 the Court considered a claim for equitable set off where there were two contracts one an over arching agreement and the other part of a series of sale contracts. Rix LJ summarised the case as follows:

"The plaintiff was now claiming for the price of goods sold under the latest of such sale contracts, and the defendant was seeking to set off its counterclaim for repudiation by the plaintiff of the distribution agreement. This Court held that the counterclaim could be set off and that there was thus an arguable defence to the claim for the price of goods sold."

Therefore a multi-contract set off was allowable.

Finally, we have the case of Bin Kemi v Blackburn Chemicals Limited8 a case concerning a claim by the clamant for damages for repudiation of a 1994 distribution agreement for the supply of a product called Dispelair. The defendant denied the existence of the agreement and in the alternative counterclaimed for damages for repudiation by the claimant. Under the heading of "Close Connection" Potter LJ reviewed the authorities and commented as follows:

"The Dole Fruit case illustrates the wise refusal of this Court to become bogged down in the nuances of differences between the formulation of the test propounded in The Nanfri, both in relation to the earlier criterion of "impeachment of title" disapproved by Lord Brandon in the Bank of Boston case, and in relation to the need for a "close connection" between claim and cross-claim... It seems that, insofar as there may be a difference, the Court has been content for the outcome to be governed by the notion of fairness involved in the proposition that it must be "manifestly unjust" to allow one to be enforced without regard to the other. For myself, I consider that Lord Brandon's formulation is to be preferred because on the one hand it emphasizes that the degree of closeness required is that of an "inseperable connection", while on the other it makes clear that it is not necessary that the cross-claim should arise out of the same contract; all that is required is that it should flow from the dealings and transactions which gave rise to the subject of the claim..."

What is perhaps most interesting about all of the above judgments is that they go to support the comment of Thorpe LJ in Esso Petroleum Co Ltd v Milton9 as "claims to equitable set-off ultimately depend upon the judge's assessment of the result that justice requires" What we are left with, prior to Geldof is arguably a lack of clarity on two points the role of the justice element of the Hanak test and whether or not the "inseparable connection" referred to in The Dominique was denying a right to rely on equitable set-off in a case of multiple contracts in all but the rarest of cases.

As Rix LJ identified the law needed to be clarified. That clarification came in the Geldof case.

Gelfdof Metaalconstrucie NV V Simon Carves Ltd

Before setting out the law, as formulated by Rix LJ, it is important to just give a brief overview of the facts. In the case Geldof supplied pressure vessels and storage tanks for bioethanol plants. Simon Carves Ltd ("SCL") was the lead contractor for the construction of a bioethanol plant on Teeside. SCL entered into a supply contract with Geldof for the supply of pressure vessels in July 2007, SCL then, after a separate tender process, entered into an installation contract with Geldof for storage tanks in December 2007. Therefore, the only relationship between the two contracts was the site and the parties and nothing further at this stage. At this stage it would be difficult to argue that these two contracts were in any way closely connected or to use the language of case law inseperably connected.

Relations between Geldof and SCL deteriorated and in August 2008 Geldof stopped work under the December 2007 installation contract and refused to resume work unless outstanding invoices arising both under the installation contract and the supply contract were met. Geldof maintained this position again in December 2008 and in response SCL terminated the installation contract.

It will come as no surprise to this audience that litigation then followed with Geldof seeking summary Judgment for payments of, among others, one of the invoices under the supply contract. SCL sought to set off against Geldof's claim its claim for unliquidated damages for repudiation of the installation contract. At first instance His Honour Judge Raynor QC granted the application for summary judgment, primarily on the grounds that Geldof's claim and SCL's claim lacked the necessary close inseparable connection and SCL was not entitled to set off.

SCL appealed.

On the review of the law Rix LJ determined that the law needed clarification and established a test with two elements. A functional and formal element which each element performed a different role as follows:

The formal element ensures "that the doctrine of equitable set off was based on principle and not discretion" not a view shared by Thorpe LJ); and

The functional element is required "to remind litigants and Courts that the ultimate rationality of is equity".

Rix LJ stated that the best statement for the test for equitable set off was Lord Denning's formulation in The Nanfri less any reference to impeachment of title. The formal element is the requirement of close connection a close connection that need not flow out of the same contract and the functional element is the need for equitable set-off to be deployed to avoid "manifest injustice."

Rix LJ's formulation of the test is as follows:

"cross-claims ... so closely connected with [the plaintiff's] demands that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim"

The result of the application of this test was to overturn the Judgment of HHJ Raynor QC in the lower Court. The reason being, that Geldof by making payment of the invoices under the supply contract a condition of its resuming work under the installation contract had brought the two contracts into "intimate relationship with one another". SCL then made the relationship "inseparable and irrevocable" by terminating the installation contract in reliance on Geldof's poor performance and raising demands for payment. The two contracts were therefore brought into "close and inseparable relationship with one another" thus fulfilling the formal requirement for close connection. He then determined that it would be manifestly unjust not to deploy equitable set-off in this situation.

Rix LJ confirmed that this would be enough to meet the test for equitable set-off on its own, but, then went on to note that the contracts were also connected practically because, they both related to the bioethanol plant, the vessels supplied on the supply contract were useless without proper performance and installation contract and the warranty under the supply contract was linked to practical completion of the plant. On this basis it would "not be fair" ie "manifestly unjust" to enforce payment under the supply contract when there was a claim under the installation contract.

How easy is it for clients to link contracts unwittingly and thereby create a cross-contract set off?

Setting aside the fact that many people intentionally link contracts, as was the case with Clause 24 of the SCL order, the Judgment of Rix LJ has made it clear that parties may, by their conduct, bring two unconnected contracts into close connection by linking performance of one with payments under the other. Applying the test formulated by Rix LJ in Geldof clients need to be wary that if they wish to enforce payment of an invoice they should be careful not to link it other contracts where their own performance could be disputed. In the writer's view, rather than it being an unwitting matter it would indeed as in the Judgment in Geldof gives a debtor a template for bringing otherwise separate contractual claims together and to allow for the use of equitable set off which would not otherwise be permissible.

In which direction is the Court moving in this area and how alert need clients be when seeking to enforce payment?

It is quite clear that the Courts have slightly widened the scope of equitable set off. However, this goes against the push as part of the review of the Housing Grants Construction and Regeneration Act in which there was much debate over the need to outlaw the use of cross-contractual set off clauses, like Clause 24 of the SCL contract, in order to avoid the linking of more than one construction contract.

Conclusion

In conclusion it is possible to unwittingly link two contracts but based on Geldof it is only in limited circumstances where the courts feel that it is manifestly unjust for one party to enforce a right under a contract when a claim exists for the other party under a separate contract that the courts will consider equitable set off across contracts. The courts may, on their own admission, have slightly widened the rule but as this is equity it will be applied more on a case by case basis.

Footnotes

1. [1848] CR and TH 161, 41

2. [1958] 2 QB 9

3. [1903] 1 KB 549

4. [1978] 2 QB 927

5. At 974G/975A.

6. [1989] AC 1056

7. [1990] 2 Lloyd's Rep 309

8. [2001] 2 Lloyd's Rep 93

9. [1997] 1 WLR 938, 953

To see further articles from Fenwick Elliott please go to www.fenwickelliott.com/articles-and-papers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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