Set-off in IT Contracts

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The right to set off is a commonly misunderstood boiler plate provision in IT contracts. In fact even the courts have previously stated that set-off has no “uniform meaning and is a ready source of confusion”1.

A right of set-off arises where two parties owe each other money and they agree to offset the smaller claim against the other so only the remaining sum is due. This means that the parties are only required to make one payment rather than two separate payments.

Set-off is not an automatic right and there are different categories of set-off that parties may rely on. This note considers contractual and equitable rights of set-off which are the main rights of set-off applicable to IT contracts (if the parties enter into litigation then the courts may apply legal set-off to set-off liquidated debts when awarding costs, although this is outside of the scope of this note).

Contractual Set-Off

The parties to a contract can expressly include a right to set-off in the terms of that contract. Such a right may apply where both parties owe each other money under the same contract. For example, the customer may be able to set-off service credits or the cost due to delay or rectifying defective works following poor performance by the supplier against the service charges it owes the supplier.

In addition, a contractual set-off clause can also be drafted to allow set-off across contracts where the customer and supplier are party to a number of different contracts at the same time. For example, the customer and the supplier enter into a contract for (1) the supply of software and (2) a separate contract for the supply of support services. If the software is faulty and the contract includes a right of set-off, the customer will be entitled to set-off the amount of damages owed to it under the software supply contract from the support service contract.

If you are including a right to set-off in a contract it is important to ensure that the scope of the set-off is drafted clearly.

Equitable Set-Off

Equitable set-off is a type of non-contractual set-off. In order for a party to rely on equitable set-off, the cross-claim must “be so closely connected with the claimant’s claim that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim”2. This test can be satisfied by any of the following:

  • a trading relationship between the parties;
  • where the parties have attempted to negotiate a single settlement for multiple claims3; and/or
  • the parties’ conduct when performing the contracts.

In Geldof Metaalconstructie NV v Simon Carves Ltd [2010] the courts held that this test was satisfied due to the parties’ conduct because Geldof, who was a subcontractor working on a building site, insisted that payment by the main contractor under a supply contract was a pre-condition to performing work under a separate installation contract. This pre-condition formed the close connection between the supply contract and the installation contract.

Given that the test for equitable set-off could yield uncertain results, parties that may need to rely on set-off should instead include a clearly drafted contractual set-off provision.

Excluding Set-Off

Parties are free to exclude contractual and equitable set-off in a contract provided that they use clear and unambiguous language to do so4.

IT suppliers will often look to exclude a customer’s right of set-off as it can be used as a defence for withholding payment following a period of poor performance under the contract. In other words, by excluding set-off the supplier will ensure that any service credits or damages for poor performance are treated separately from the customer’s obligation to pay. Where suppliers want to exclude set-off they should also ensure that the rights of equitable set-off are also expressly excluded.

If a supplier is contracting on its standard terms and conditions it must be careful when excluding set-off because it may fall foul of the Unfair Contract Terms Act 1977 (“UCTA”). UCTA only applies in business to business contracts where one party is contracting on the other party’s standard terms and conditions. As the supplier is restricting the customer’s right to a remedy it must comply with the ‘reasonableness’ test to do so otherwise it risks the courts finding it is an unlawful provision.

Conclusion

Set-off is usually included as a boiler plate provision in a contract and therefore its importance can often be overlooked. The decision whether to include a right to contractual set off or to expressly exclude set-off from a contract must take into account the commercial relationship between the parties. However you wish to approach set-off in a contract, the clarity of the drafting is key.

For further information or assistance regarding the drafting of set-off provisions or negotiation of IT contracts, please contact Luke Russell or Justin Harrington, contact details below.

1 Fearns (t/a Autopaint International) v Anglo-Dutch Paint & Chemical Co Ltd [2010] EWHC 2366
2 Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667
3 Addax Bank BSC v Wellesley Partners LLP [2010] EWHC 1904
4 Modern Engineering (Bristol) Ltd v Gilbert-Ash (Northern) Ltd [1974] AC 689