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Poor old “set-off”! Thought by many of us to be such an obvious or even obscure concept, we rarely give it a second thought, let alone investigate it in any detail at all. Yet perhaps set-off is not as straightforward and therefore as boring as one might think?! We seek in this article to:

1. Provide a concise explanation of the right of set-off and the differing bases for that;
2. Identify why a right of set-off can be of potential concern to those that seek to ensure their professional indemnity insurance does not fail to indemnify them; and
3. Describe the ways they might best ensure that does not transpire.

Firstly, what is set-off?

In technical, legal terms, set-off is a defence to a claim for a debt.

Summarised: a debtor (D) and a creditor (C) can balance their mutual debts and perform a “reconciliation” of the amount owed. In simple terms then, D deducts (or “sets off”) amounts C owes to it and the net amount is what D owes to C (or C owes D as the case may be).

A very simple example of how this might occur in the construction industry is a Consultant has completed services for which it claims $10,000. Their client, has previously overpaid them $2,000 (based on later assessment, that’s not disputed, that certain services were incomplete) , so “sets-off” one amount against the other and pays Consultant (a consolidated payment of) $8,000.

Equity

At its most fundamental the right of set-off arises from Equity. But what is Equity?

For those unaware, the concept of Equity is something that arose in the Courts of Chancery as early as the 14^th and 15^th centuries in England. There developed a particular set of “Equitable” remedies and procedures. Those remedies were often created so persons for whom legal remedies (in the Courts of Common Law) were inadequate in some way, might seek to avail themselves of an alternative. These courts and this area of “law” was concerned primarily with ensuring fairness or, just as often, avoiding an unfairness. Note however it has long been (as far back as 1870) that “Equity” and “Common Law” remedies and procedures are “merged” within the modern courts of Australia.

• The basis for set-off in Equity

In relation to equitable set-off, the relatively recent judgements of Hawes v Dean [2014] NSWCA 380 and Smith v Acquire Asia Pacific Philippines Inc [2016] NSWSC 1084 provide guidance as to specifics. To be clear, the equitable right of set-off does not simply exist as a right of which anyone may automatically avail themselves.

Instead, the equitable basis for the right to set-off requires (among other things, but fundamentally)  “that there be a connection between adverse parties’ claims which would make it unconscionable for one party to insist on its legal right without first accommodating the other party’s countervailing legal rights”.

Whilst this aspect is not the only requirement which those who seek to rely on the right in Equity might have to satisfy, for our purposes here, we shall limit our observations to that as the most important.

(There is, for example, case law that equity will sometimes allow set-off otherwise than between the same parties where there is a particularly compelling factor that makes reliance on separate rights unconscionable).

In short, the starting point is that, if your consultancy agreement says nothing to the contrary, then you and your client probably have equitable rights to set-off claims, so long as there is a sufficient connection between the claims.

• With a basis under statute (Legislation)

Although the specific details need not concern us here, we note, for completeness in discussing the bases of a right of set-off, that there does exist certain legislation which also provides for such a right. Sale of Goods Act (NSW) s54, Civil Procedure Act 2005 (NSW), Bankruptcy Act 1966 (Cth) and the Corporations Act 2001 (Cth) are just some examples.

• The basis in Law (Contract)

Whilst the right to set-off does not exist per se in common law, it is “well recognized that parties to a contract may, by the express terms of their contract or by necessary implication from those terms, exclude any right of equitable set-off”. Similarly, parties can agree in contract to allow “set-off” of amounts they owe to each other before the final amount is paid.

Consider a set-off clause “typical” of the kind we might see in consultancy agreements:

• The Principal may set-off against any amount that the Principal owes the Consultant, any amount the Consultant owes the Principal whether actually, contingently or prospectively under or in connection with this Agreement or otherwise.

Note that such a clause has two elements:

1. It creates the contractual right to set-off: “The Principal may set-off against any amount that the Principal owes the Consultant, any amount the Consultant owes the Principal..”; and
2. It expressly removes the requirement that there be a connection (as would otherwise have to be shown to avail oneself of the defense in Equity as we discussed) between the debts by use of the words: “…whether actually, contingently or prospectively under or in connection with this Agreement or otherwise.

Primary insurance concern

As insurance advisors, we note for clients for whom when we review contracts, set-off clauses in a contract may interfere with your insurer’s subrogation rights. As such, they may enliven a waiver of rights exclusion.

If a third party, say a sub-consultant engaged by the Consultant or perhaps an injured bystander, were to make a claim against the Consultant, its insurer may seek to defend that claim in part by seeking contribution from the Consultant’s client (the Principal). However the presence of a right to set-off arising from a clause akin to the example clause we described above, could give the Principal the ability to avoid making that contribution – where the Principal claims it can set-off that contribution, in whole or in part, against other amounts it is owed by the Consultant.

Thus by agreeing to the clause, the Consultant has effectively waived rights of the insurer in subrogation and thus the insurer might then avoid indemnifying the Consultant to some extent.

Recommended Solution

We therefore advise clients who face a clause of this kind to take action to avoid or minimise the possible insurance risk described above. Deleting such a clause entirely is obviously the best solution. However where that is not a palatable option, we always urge restricting the contractual set-off right. This might be achieved by replacing, for example, the words “any amount” with “professional fees” to reduce the risk.

Commercial Implications …not all set-off clauses are equal!

Usually the primary concern for consultants is that a set-off (or indeed any!) clause may impede their ability to get paid.

The risk may exist that a less than scrupulous or aggrieved client seeks to utilise a contractual right of set-off to their advantage, by raising exaggerated or unfounded allegations of design deficiencies to avoid paying fee claims. Broadly drafted set-off clauses make it easier for them to do so, and can be difficult for a consultant to resist.

Of course, the best alternative is to replace a client’s set-off clause with an express extinguishment of set-off rights. As an example, words like:  “No withholding, deductions or set-offs shall be made from the Consultant’s fees for any reason unless the Consultant has been found to be legally liable for such amounts.” However, if a set-off right is insisted upon by a client, the amendment of a set-off right to this standard should usually be sought.

In the commercial sense, some set-off clauses are of a higher risk than others and a close review of the exact wording of the set-off clause will always be prudent. It will be a higher risk where the right exists for a client to set-off amounts merely “claimed” or amounts that “may” be owing, and/ or claims unrelated to the current project. On the other hand, a set-off right is likely to be a lower risk for a consultant where the client can only set- off debts proven to be owing, and only debts connected to the current project.

One final note: if facing a set-off claim where a substantial amount of your fees are at stake, consultants may wish to seek legal advice on the possibility of pursuing a claim under security of payment legislation to bypass the set-off claim.

Peter Aston

Risk Manager