Ken Tracey examines the issues surrounding set-off in construction contracts

Set-off is a means of avoiding overpayment used by a party when they consider they have a counterclaim against another. However, it is frequently used to postpone payment by notifying spurious or inflated charges in order to improve the cashflow and profit of the party that is paying.

Typically, set-off against subcontractors would include the rectification of defective work, delay costs, rectification of damage and any service, materials or plant provided by the main contractor beyond their contractual obligations.

The right to set off counterclaims is rooted in common law and provisions are routinely included in construction contracts. In the event that there is not a contractual provision, the Scheme for Construction Contracts 1998 would apply.

Payment may therefore be reduced by set-off, provided that the main contractor/ employer complies with the terms of the contract or the scheme. A withholding notice must be issued by the paying party, a specified number of days before the final date for payment. It must state the grounds for withholding payment and the amount to be withheld against each item. It does not require the amounts to be quantified, which is regrettable as the sums often include an enhancement to improve cashflow, giving rise to dispute.

Having established that a party has the right to set-off, providing that they comply with the conditions of contract (or the legislation) it is important to avoid onerous conditions of set-off.

Cross-contract set-off

Set-off is generally only permitted within the contract where the payment is made, but conditions are often included to allow sums to be set off against payment due on another contract with the same client. This is known as cross-contract set-off and is only permitted if agreed by the parties. Often a party will agree by default, having failed to scrutinise the conditions.

The practice is obviously detrimental to a contractor’s cashflow, and encourages poor performance and disputes.

It is often imposed without the contractual right.

Future estimated costs

A withholding notice does not require amounts to be quantified, which is regrettable as the sums often include an enhancement to improve cashflow, giving rise to dispute

In standard forms, set-off is generally allowed against costs already incurred by the paying party – prolongation due to a subcontractor’s delays, for example. This would exclude an estimate of liquidated damages relating to those delays that a main contractor may be liable to pay to the employer at some future date.

The facility to allow a contractor to set off sums that they may be liable for as opposed to those where the liability has been established, is often incorporated into main contractors’ own terms and conditions. Inevitably, sums deducted may be held for a considerable period, until such times as the Final Certificate is issued on the main contract before some form of payment is made. To avoid this, contract conditions must be scrutinised to ensure only costs already incurred may be set off.

Alleged damage

Good business practices should reduce the opportunities for the other party to impose set off. A strict regime of waste removal from the working areas and early attention to defects and damage will help. Photographs of completed work and the formal acceptance of finished work by the contractor will provide a contemporary record of the condition and quality of work as delivered by the subcontractor.

Accusations of damage should be backed by evidence, and efforts made to reach an agreed settlement. A broad-brush approach of charging all subcontractors proportionally merely because they have worked at some time in an area where damage has occurred should be contested.

Alleged delays

To contest set-off, it must be proven that the subcontractor has not delayed progress. If the delay costs set off are inappropriate, yet the main contract works are delayed, it is likely that the subcontractor is entitled to an extension of time.

Notices of delay and applications for extension of time should have been submitted in accordance with the contract. The subcontractors’ entitlement to an extension of time may then be established, along with any direct loss and/or expense, thereby negating the proposed set-off.

Ken Tracey is commercial adviser at the ECA