Construction disputes – A contractor’s tale: Defeated Before You Set-off?

Prolonged construction disputes, particularly those involving more than two parties, can have a devastating effect on both profits and cash flow.

Using set-off on construction claims, as a means to reduce the financial impact of unresolved disputes can be an extremely effective strategy; however, it is one which does carry risk and must therefore be employed carefully.

A classic example of a construction dispute stand-off occurs where an employer refuses to pay a contractor because of an allegation that works carried out by a sub-contractor are defective.  This situation can prove to be a real headache for the ‘innocent’ contractor, who becomes ‘piggy in the middle’ between the employer and sub-contractor; especially where the main contract and sub-contract do not contain identical provisions regarding set-off and the withholding of monies.

The primary advice to contractors therefore, is to ensure that any relevant contractual terms set out within the main contract, in relation to set off or withholding monies, are incorporated and / or repeated, in appropriate terms, within the sub-contract.  The advice to sub-contractors is, where possible, the contractor’s rights to set-off or withhold monies should be expressly excluded or restricted to the maximum extent possible.

Equitable Set-Off

In situations where it is not possible to exercise an express contractual set off, it may be possible to establish an equitable set-off.  The Court of Appeal in the case of Geldof Metaalconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667 approved Lord Denning’s test in The “Nanfri”:

“…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 his cross-claim…”

Common Law Set-Off / Abatement

Another distinct form of set-off is common law set-off or abatement.  In Cleveland Bridge v Multiplex [2006] EWHC 1341 (TCC), Jackson J. distilled the legal principles of abatement as follows:

1. 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.
2. 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 the defective performance.
3. The method of assessing diminution in value will depend upon the facts and circumstances of each case.
4. 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.
5. The measure of abatement can never exceed the sum which would otherwise be due to the contractor as payment.
6. Abatement is not available as a defence to a claim for payment in respect of professional services.
7. Claims for delay, disruption or damage caused to anything other than that which the contractor has constructed cannot feature in a defence of abatement.

Restrictions on Rights of Set-Off

Whilst set-off can operate extremely effectively to reduce or extinguish the liability of a party to pay sums which might otherwise be due; the principle should not generally be used as a basis to challenge the enforcement of an adjudicator’s decision, as such arguments will normally be doomed to failure.

The Housing Grants, Construction and Regeneration Act 1996 (HGCRA), followed by the Local Democracy, Economic Development & Construction Act 2009 (LDEDCA), placed restrictions on the ability of a paying party to withhold payment of sums due under a construction contract.

Under the new LDEDCA regime, if a party wishes to pay less than the notified sum, he must provide a notice to that effect specifying the sum he considers to be due and the basis upon which that sum is calculated.  Such a notice must be given no later than the prescribed period before the final date for payment (7 days before final date, 10 days after due date, unless alternative periods have been agreed).

Despite the statutory provisions in force there have been numerous attempts to use set-off as a basis to avoid the enforcement of adjudicator’s decision; however, the courts have resisted these efforts robustly and established a general ‘rule against set-off’ in VHE Construction PLC v RBSTB Trust Co Ltd [2000] 70 Con LR 51 (upheld by the Court of Appeal in Levolux At v Ferson Contractors [2003] 86 Con LR 98).