Set-off and Abatement – General Principles

CMG Events - Construction Law Conference

6 December 2017

JOHN M E LYDEN, FSCSI, FRICS, FCInstCES, MRIN, MCIArb, MEWI,

Construction Contract Consultant,

Arbitrator, Chartered Quantity Surveyor, Conciliator, Mediator,

Member of the Minister’s Panel of Adjudicators under the Construction

Contracts Act

3 Castle Court, Currabinny Road, Carrigaline, County Cork, P43 EA46

Email: johnlyden@eircom.net

Set-off page 1 of 33

Introduction

Where work is defective, a key question is whether the employer can set off

the cost of rectifying defects against sums otherwise due to the contractor. If a

contractor is insolvent, this is often a very important issue. This question needs

to be considered under the following separate grounds for set off:

1.set off at common law

2.set off under the RIAI Contract

3.set off under the Public Works Contract

4.set off in equity

5.set off under the insolvency rules

Set off at common law

The law of set off in Ireland, at common law, under the RIAI Contract, and in

equity, was reviewed in some depth by Mr Justice Clarke in Moohan v S & R

Motors (Donegal) Ltd [2008] 3 IR 650.

Set-off page 2

At paragraph [19] 5.5, Clarke J endorsed the analysis of Murphy J in Hegarty

& Sons Ltd v Royal Liver Friendly Society [1985] IR 524, as follows:

“It is ... worthy of note that Kelly J [in Powderly v McDonagh [2006]

IEHC 20, unreported, 31 January 2006] described the analysis conducted

by Murphy J in Hegarty ... as “perhaps the best analysis of the position” I

agree.” [emphasis added]

Murphy J in Hegarty stated that the propositions to be gleaned from the

decision of the House of Lords in Modern Engineering v Gilbert-Ash [1974]

AC 689 could be summarised as follows:

“[page 528] (2) One starts with the presumption that each party to a

building contract is entitled to all those remedies for its breach as would

arise by operation of law including the remedy of setting up a breach of

warranty in diminution or extinction of the price of materials supplied

or work executed under the contract. ...

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(4) Whether the parties have in fact curtailed or restricted the common law

or equitable right of set off depends upon the construction of the

agreement between them ...” [emphasis added]

The parties can agree to exclude a set-off. In Caterpillar (NI) Ltd v John Holt

& Company (Liverpool) Ltd [2013] EWCA Civ 1232, [2014] BLR 103 at 111,

Longmore LJ said in upholding the relevant clause:

“Construction of the “No set-off clause”; the Construction Issue

34. As will be recalled this clause provides:

“Buyer shall not apply any set-off to the price of Seller’s products without

prior written agreement by the Seller.”

35. Mr Cogley submitted that no price was ‘due’ if there was what he

called a ‘transactional’ or ‘equitable’ set-off. …

36. He then submitted that any clause purporting to exclude a right

otherwise legally available must be expressed in clear words.

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But it is difficult to think of clearer words than that a party ‘shall not apply

any set-off’. … But that takes one straight back to the concept of

transactional or equitable set-off and would imply that only legal set-offs

were within the clause. That would be a most surprising result; indeed the

average businessman who was told that a clause of this kind applied to

legal set-offs but not equitable set-offs would hardly be able to contain his

disbelief.”

Set off under the RIAI Contract

In looking at this issue, in a passage that echoes the dicta of Murphy J in

Hegarty (see indented paragraph (4) above; Clarke J in Moohan v S & R

Motors (Donegal) Ltd [2008] 3 IR 650 said at paragraph [20] 5.6:

“It seems to me, therefore, that the overall test is as to whether, as a matter

of construction of the contract taken as a whole, it can properly be said

that the parties agreed that there can be no set off”

Set-off page 5

In Hegarty & Sons Ltd v Royal Liver Friendly Society [1985] IR 524, Murphy

J said:

“[pages 530 and 531] ... I take the view that the terms of the [RIAI

Contract] are not inconsistent with the rights of set off and counterclaim

and that accordingly the employer … is entitled to set up its claim by

way of defence to the liquidated demand of the builders ...” [emphasis

added]

In Moohan, Clarke J said at paragraph [21] 5.7:

“I am not satisfied that the balance of the authorities favours the view that

the current standard form RIAI template does give rise to an agreement to

exclude a set off”

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Set off under the Public Works Contract

The Public Works Contract (PWC) contemplates that the employer may set

off sums due from the contractor under the present contract or any other

contract. PWC clauses 10.9.1 and 10.9.2 provide that the employer or the

employer’s representative (ER) may give notice to the contractor of reductions

in the contract sum or claims against the contractor and that the ER shall

determine the matter in accordance with the contract.

PWC clause 10.9.3 provides:

“The Employer may deduct from any amount due to the Contractor

(1) any amount determined by the Employer’s Representative to be due,

or likely to become due, from the Contractor to the Employer under

the Contract and

(2) any amount due from the Contractor to the Employer under any

contract” [emphasis added]

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PWC clause 10.9.4 states that the procedure in clause 10.9 shall apply until the

Defects Certificate “but this does not limit the Employer’s rights after then”.

PWC clause 11.1.3 provides that the employer may deduct damages for delay

from interim payments.

PWC clause 11.5.3(3) provides that the employer may deduct damages for

defects, that the contractor has not rectified, from the final payment.

Set off in equity

At paragraph [21] 5.7, in Moohan v S & R Motors (Donegal) Ltd [2008] 3 IR

650, Clarke J said:

“The default position is that a party is entitled to a set off in equity in

relation to any cross claim arising out of the same contract. Thus if a

builder is owed money on foot of a construction contract, the employer is

prima facie entitled to a set off in equity, in principle, in respect of any

defective works” [emphasis added]

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Whether set off is confined to the same contract?

From the above case law, it is clear that the employer can set off the costs of

rectifying defects against sums due to the contractor arising out of the same

contract based on:

1.set off at common law;

2.set off under the RIAI Contract (see also clause 33(c)(iv) noted below) or

under the Public Works Contract; and

3.set off in equity

But that begs the question:

“Can defects on Contract A be set off against sums due to the contractor

on Contract B?”

Clause 10.9.3 of the Public Works Contract provides that the employer can set

off against amounts due to the contractor under the present contract “any

amount due from the Contractor to the Employer under any contract”

Set-off page 9

However, the RIAI Contract does not contain any express right to set off

between two different contracts. Nor does the common law right of set off (as

discussed above) allow set off between two different contracts.

In regard to set off in equity, the answer to the question posed above is a

qualified yes but there must be a close connection between the two contracts.

The law on this subject is complex and, at times, inconsistent to say the least.

Judges and legal commentators refer to ‘one contract’ cases and to ‘two

contract’ (set off between Contract A and Contract B) cases.

In Moohan, Clarke J at paragraph [21] 5.7, spoke about setting off cross claims

“arising out of the same contract”. In Dole Dried Fruit and Nut Co v Trustin

Kerwood Ltd [1990] 2 Lloyd’s Rep 309 at 311, Lloyd LJ said:

Set-off page 10

“[the cases] establish that the mere existence of a cross-claim is

insufficient. The claim and cross-claim must arise out of the same

contract or transaction, and must also be so inseparably connected that the

one ought not to be enforced without taking into account the other”

[emphasis added]

That statement from an experienced judge in the Court of Appeal in England

would seem to exclude set off between different contracts.

However, in several cases a more liberal policy has been adopted by the

courts. In Federal Commence Ltd v Molena Alpha Inc [1978] 1 QB 927 (“The

Nanfri”), Lord Denning said at page 974:

“... 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” [emphasis added]

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In fact, set off has been allowed in a number of two contract cases, such as:

Bankes v Jarvis [1903] 1 KB 549 (Contract A: agreement to purchase the

practice of a veterinary surgeon; Contract B resale of the practice back to the

original vendor)

Hanak v Green [1958] 2 QB 9 (Contract A: building contract; Contract B:

work done on a quantum meruit basis outside of the contract)

Dole Dried Fruit and Nut Co v Trustin Kerwood Ltd [1990] 2 Lloyd’s Rep

309 (Contract A: sale of goods; Contract B: distributorship agreement)

Bim Kemi v Blackburn Chemicals Limited [2001] 2 Lloyd’s Rep 93 (Contract

A: distribution agreement in 1994 for the supply of a product called

‘Dispelair’; Contract B: licensing agreement in 1984 relating to other

products)

Geldof Metallconstructie NV v Simon Carves Ltd [2010] BLR 401 (Contract

A: supply only of equipment to a construction site; Contract B: installation

only of storage tanks, at the same site but totally separate from the

equipment)

Set-off page 12

In Bim Kemi, Potter LJ said at paragraph 30:

“it is clear that the principle ... applied in the Dole Fruit case is apt to

cover a situation where there are claims and cross-claims for damages in

respect of different but closely connected contracts ...” [emphasis

added]

The various one contract and two contract cases were reviewed in depth by

Rix LJ in Geldof. The court’s findings were summarised by David Friedman

QC: Set-off -Avoiding the Confusion (2011) 27 Const LJ 494 at 503, as

follows:

“The cross-claim does not have to arise from the same contract, or

transaction as the claim, nor from the dealings and transactions which gave

rise to the claim. It is sufficient if it is closely connected with the

transaction which gave rise to the claim” [emphasis added - citing

paragraph 36 of Geldof]

Set-off page 13

In Geldof, Rix LJ said at paragraph 43:

“(ii) There is clearly a formal requirement of close connection. All the

modern cases state that ... Morris LJ in Hanak v Green spoke of a “close

relationship between the dealings and transactions which gave rise to the

respective claims” ... The Dominique adapted the Newfoundland Railway

test and spoke of a cross-claim “flowing out of and inseparably connected

with the dealings and transactions which also give rise to the claim” ...

(iii) ... In this connection, Modern Engineering (Bristol) Ltd v Gilbert-Ash

(Northern) Ltd [1974] AC 689 emphasises that an equitable set-off for

defective work is not easily excluded even in building contracts where

sums are payable under an architect’s certificate ...

(iv) There is also clearly a functional requirement whereby it needs to be

unjust to enforce the claim without taking into account the cross-claim.

This functional requirement is emphasised in all the modern cases ...

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(vi) For all these reasons, I would underline Lord Denning’s test ...

namely: “cross-claims ... so closely connected with [the plaintiff’s]

demand that it would be manifestly unjust to allow him to enforce

payment without taking into account the cross-claim”” [emphasis

added]

The principles, enunciated by Rix LJ in Geldof, were followed in Bibby

Factors Northwest Ltd v HFD Ltd [2015] EWCA Civ 1908. Morleys Ltd (the

supplier) supplied goods to HFD Ltd (the customer) under an agreement

whereby, at the end of each calendar year, the customer was entitled to a rebate

from the supplier calculated as 10% of the price payable for the goods supplied

in that year. There was also a payment discount of 2.5%.

Set-off page 15

Morleys were in financial difficulties and went into administration in July

2013. 13 years earlier, back in March 2000, the supplier entered into a

factoring agreement with Bibby (the factor) whereby the factor advanced

working capital to the supplier in exchange for the supplier assigning all of its

debts to the factor. Customers of the supplier were informed of this assignment

of the supplier’s debts by a sticker affixed to the supplier’s invoices and, in

some cases only, a letter sent by the factor to certain customers.

The factor contended that it was entitled to full payment from the customer of

all sums due from the customer to the supplier but without giving any credit

for the 10% rebate or the 2.5% payment discount. Clarke LJ held that the

customer was entitled to set-off in equity the rebate from sums, otherwise due

to the supplier, payable to the factor on foot of the factoring arrangement. The

court said:

Set-off page 16

“[para 47] Bibby contends that in deciding whether there was sufficient

connection between the claims for debt and the cross claim for rebate it

was necessary to take into account “the justice of the case; … and that, if

that is taken into account, the link between claim and cross claim is not

sufficient to justify a set off. …

[para 48] I disagree. The relevant exercise is not a general decision as to

the justice of the case. The question is whether the connection between the

claim by the Supplier and the cross claim by the Customer is so close that

it would be unjust to allow the Supplier (and hence Bibby) to maintain the

one without giving credit to the Customer for the other. The putative

victim of such injustice is the debtor. On that question the answer is, in my

view, plainly in the affirmative. …”

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Requirement that party setting off in equity must act equitably

But, as with all remedies in equity, the maxim “he who seeks equity must do

equity” must be followed. Biehler: Equity and the Law of Trusts in Ireland,

sixth edition 2016, at page 19, states in regard to this maxim:

“Equity will only grant relief on terms which ensure that a defendant is

treated fairly and to obtain equitable relief, a plaintiff must be prepared to

act in an honourable manner”

In Moohan v S & R Motors (Donegal) Ltd [2008] 3 IR 650, Clark J said at

paragraph [22] 5.8:

“that set off arises in equity and is ... subject to [the defendants]

themselves having done equity” [emphasis added]

Set-off page 18

In discussing the relevant factors in regard to equitable set off, Clarke J in

Moohan, at paragraph [11] 4.4, cited the dicta of Kingsmill Moore J in

Prendergast v Biddle, unreported, Supreme Court, 31 July 1957, at page 25:

“It seems to me that a judge in exercising his discretion may take into

account the apparent strength of the counterclaim and the answer

suggested to it, the conduct of the parties and the promptitude with

which they have asserted their claims, the nature of their claims and also

the financial position of the parties. If, for instance, the defendant could

show that the plaintiff was in embarrassed circumstances it might be

considered a reason why the plaintiff should not be allowed to get

judgment ... on his claim until after the counterclaim had been heard ...”

[emphasis added]

Set-off page 19

In the Moohan decision, at paragraph [12] 4.5, Clarke J said:

“a court in determining whether a set off in equity may be available, so as

to provide a defence to the claim itself, also has to have regard to the fact

that the set off is equitable in nature and, it follows, a defendant

seeking to assert such a set off must himself do equity” [emphasis

added]

Set off under the insolvency rules

Apart from set off in equity; where the contractor is in liquidation, the

employer may be able to set off its counterclaims under the insolvency rules.

The Companies Act 1963, section 284, provides that:

“In the winding up of an insolvent company the same rules shall prevail

and be observed relating to the respective rights of secured and unsecured

creditors and to debts provable ... and contingent liabilities as are in force

for the time being under the law of bankruptcy ...”

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The key provision is to be found in the Bankruptcy Act 1988, Schedule 1,

paragraph 17(1), as follows:

“... where there are mutual credits or debts as between a bankrupt and any

person claiming as a creditor, one debt or demand may be set off against

the other and only the balance found owning shall be recoverable on

one side or the other” [emphasis added]

Keane: Company Law, fourth edition 2007, at paragraph 36.134, states:

“All debts may be set off under the section, but there must be ‘mutuality’.

Thus, a trustee cannot set off a debt owed by him personally to the

company against a debt owed by the company to him as trustee. An

unsecured debt may be set off against a secured debt under the section”

[emphasis added]

Set-off page 21

Clause 35(f)(2)(i) of the RIAI Contract provides that retention money is held

upon trust by the employer for the contractor “subject to the right of the

Employer to have recourse thereto … for payment of any amount which he is

entitled under the provisions of this Contract to deduct from any sum due …

to the Contractor” [emphasis added]

However, where an architect’s certificate has expressly identified retention

money for a nominated sub-contractor, that money is held in trust for the

nominated sub-contractor and the employer cannot set off against that

retention money:

Murphy Brothers (Dublin) Ltd v Morris, unreported, Kenny J, 6 October

1975

Rohan Construction Ltd v Antigen Ltd [1989] ILRM 783 at 785

Set-off page 22

Sanfey and Holohan: Bankruptcy Law and Practice in Ireland, second edition

2010, at paragraph 13-08, state:

“If mutuality does exist, then set off can be pleaded in the bankruptcy. It is

not necessary that the debts arose as a result of a contractual relationship ...

Any debt which is “capable of being proved in bankruptcy can be the

subject of set off”. It is unclear as to whether one can contract out of the

right to set off, but in England it has been held that one cannot do so”

One difference between Ireland and England is that, in the UK legislation, the

words “shall be set off” are used as opposed to the words “may be set off” in

the Irish Act.

Some commentators suggest that parties, in Ireland, can contract out of the

insolvency set off procedure. For example, Johnson and Werlen: Set-off Law

and Practice, an International Handbook, at paragraph 17.27 state:

Set-off page 23

“These are similar to the rules in many other common law jurisdictions but

note that credits and debts may be set-off not shall be set-off. The optional

nature of set-off in Ireland gives greater flexibility in the event that a

company’s banks wish to facilitate a work out of the company out of its

insolvency”

However, there is no suggestion in the RIAI Contract that the parties wish to

contract out of the insolvency set off procedure. In fact, the wording of RIAI

clause 33(c)(iv), which is applicable where the contractor’s employment is

determined on the grounds, inter alia, of insolvency, suggests a clear intention

to set off, as follows:

Set-off page 24

“the Architect shall certify the amount of expenses properly incurred by

the Employer and if such amount added to the money paid to the

Contractor before such determination exceeds the total amount which

would have been payable on due completion the difference shall be a

debt payable to the Employer by the Contractor and if the said amount

added to the said money be less than the said total amount the difference

shall be a debt payable to the Contractor by the Employer” [emphasis

added]

But, as noted above, the RIAI Contract does not confer any right for a party to

set off between two different contracts. However, the insolvency rules do

allow set off between different contracts. Forde: Bankruptcy Law in Ireland,

1990, page 145, states:

“Mutuality: What can be set off in a bankruptcy are ‘mutual credits or

debts’ between the bankrupt and his creditor.

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Mutuality in this context does not require that the debts arise at the same

time nor that they should be connected in any way or that they should be

of the same nature. Debts arising at different times in unconnected

transactions ... can be mutual debts. The focus instead is on the parties

to the debts and the relationship between each other, not on the nature of

the claims being asserted. If the debts are between the same parties and

in the same capacity, they are mutual debts which can be set off in a

bankruptcy. This identity must be between those who are beneficially

entitled to the debt. It is the beneficial owner of a debt who may set off

that debt against an obligation he owes the debtor. ... The debts or claims

in question need not have arisen out of contract; ‘any mutual demands

capable of being proved in bankruptcy can be the subject matter of set

off whether or not arising out of contract’” [emphasis in bold added]

Set-off page 26

However, it should be noted that this right of set off only pertains to respective

rights which exist as at the date of insolvency. Forde: Bankruptcy Law in

Ireland, 1990, page 145, states:

“Since they can be proved, contingent claims can give rise to a set off,

provided that the debt or claim in question came into existence prior to

the bankruptcy commencing” [emphasis added]

Set-off concerning building defects where contractor is insolvent

In White Cedar Developments Ltd v Cordil Construction Ltd [2012] IEHC

525, Laffoy J, 7 December 2012, the contract incorporated the Public Works

Contract for Building Works designed by the Contractor, version 1.5 published

on 4 November 2009 (hereafter ‘PWC’). Certain of the contractor’s claims

were referred to conciliation under clause 13.1 of the PWC.

Set-off page 27

On 28 October 2011, the conciliator made a recommendation in respect of the

contractor’s claims to the effect that the employer should pay the contractor

the sum of Euro 700,649 (exclusive of VAT). Neither party dissented from that

recommendation within the period of 42 days as provided for in clause 13.1.9

of the PWC.

The conciliator first met both parties on 5 May 2011. On 26 May 2011, ACC

Bank PLC appointed receivers in respect of all of the assets of the contractor.

On 18 July 2011, the employer by letter to the contractor and the receivers

invoked the termination provisions under clause 12.1.1 of the PWC. Whilst the

employer did not contest the conciliator’s recommendation, it argued that:

1.it had no liability to pay any part of the sum of Euro 700,649 until the works

were completed by a replacement contractor, and

2.it could then set off, against the said sum, any amounts incurred by the

employer in having the works completed.

Set-off page 28

By letter dated 19 October 2012 (nearly a year after the issue of the

conciliator’s recommendation), the receivers demanded that the employer pay

the sum of Euro 700,649 and threatened to seek the winding up of the

employer company under section 214 of the Companies Act 1963.

Laffoy J [paras 29 and 30] held that the presentation of a petition to wind up

the employer would, in the circumstances, be an abuse of the procedure under

the Companies Act. In regard to a set-off against the sum of Euro 700,649

otherwise due to the contractor; Laffoy J said [para 18]:

“the [employer] is entitled to set off against that sum the termination

amount as determined in accordance with Clause 12.2.9 ... Obviously, in

determining the termination value, the Employer’s Representative would

have to factor in the sum which the Conciliator recommended is to be paid

by the [employer] to the [contractor].

Set-off page 29

Thirdly, the termination amount does not fall to be determined by the

Employer’s Representative until the Works have been completed”

Abatement

Albeit that it is a different remedy, in a strict legal sense; abatement is closely

related to set-off. Its essence is stated by the editors of Construction Law

Reports, at 163 Con LR 118, thus:

“Where a claim is made for work, services or goods, the defence of

abatement may entitle the other party to reduce or extinguish the claim by

showing that the work, services or goods provided were worth less than

the value claimed by reason of defective performance: Mondel v Steel

(1841) 8 M&W 858, Gilbert-Ash (Northern) Ltd v Modern Engineering

(Bristol) Ltd [1973] 3 All ER 95, [1974] AC 689 (HL).”

Set-off page 30

In Multiplex Constructions (UK) Ltd v Cleveland Bridge UK Ltd [2006]

EWHC 1341 (TCC), (2006) 107 Con LR 1, Jackson J said:

“[para 652] Although there is not a complete harmony of approach to be

discerned from this line of cases, I derive seven legal principles from the

authorities cited:

(i) In a contract for the provision of labour and materials, where

performance has been defective, the employer is entitled at common law to

maintain a defence of abatement.

(ii) The measure of abatement is the amount by which the product of the

contractor’s endeavours has been diminished in value as a result of that

defective performance.

(iii) The method of assessing diminution in value will depend upon the

facts and circumstances of each case.

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(iv) In some cases, diminution in value may be determined by comparing

the current market value of that which has been constructed with the

market value which it ought to have had. In other cases, diminution in

value may be determined by reference to the cost of remedial works. In the

latter situation, however, the cost of remedial works does not become the

measure of abatement. It is merely a factor which may be used either in

isolation or in conjunction with other factors for determining diminution in

value.

(v) The measure of abatement can never exceed the sum which would

otherwise be due to the contractor as payment.

(vi) Abatement is not available as a defence to a claim for payment in

respect of professional services.

(vii) Claims for delay, disruption or damage caused to anything other than

that which the contractor has constructed cannot feature in a defence of

abatement.”

Set-off page 32

Principle (vi) was considered by the court in William Clark Partnership Ltd v

Dock St PCT Ltd [2015] EWHC 2923 (TCC), (2015) 163 Con LR 117, in

which Judge Davies said:

“[para 5.8] The starting point for my consideration must be the decision of

Jackson J in Multiplex. In that case Jackson J reviewed every authority

relied upon by the parties in relation to abatement ([640]-[651]) and then

set out the seven legal principles to be derived from the authorities (at

[652]), including principle (vi), that abatement is not available as a defence

to a claim for payment in respect of professional services.

Although some have questioned the continuing validity of the distinction

between professionals and non-professionals, the Court of Appeal

(including Jackson LJ) has in Robinson v PE Jones (Contractors) Ltd

[2011] EWCA Civ 9, (2011) 134 Con LR 26, albeit in a different context,

affirmed that the distinction still holds good.

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In the circumstances I am not prepared to doubt the correctness of the

principle stated by Jackson J, even if invited to do so.”