Using Debt Set-Offs in Dispute Resolution

Neil Henderson

This article by Neil Henderson first appeared in Lloyd's List on 17th November 2010.

If you were to ask the average person travelling on the London Underground system as to whether it should be possible to take into account monies owed to you by a person suing you to reduce their claim against you, it is likely that that they would say ‘of course’. This is, in its broadest terms, the concept of set-off; a legal principle by which one party is not obliged to pay over sums to another party that owes them money.

In a business context, the exercise of the right of set-off is self-evidently important and enables effective dispute resolution and cashflow management. Take, by way of example, a charterer who has entered into a series of charterparties for various vessels with the same owner. Is that charterer entitled to set off or deduct sums indisputably owed under one charterparty against claims brought by the owner which relate to a different vessel under another charterparty? Does the forum of the dispute have an effect on any entitlement to make deductions?

The two principal types of set-off in English law on which this article concentrates on are legal and equitable set-off. There are others, including the principle of set-off in insolvency proceedings, but they will not be considered here.

Legal set-off

The principle of legal set-off is primarily a procedural one and has existed since the Insolvent Debtors Relief Acts of 1729 and 1735. Its current basis is found in section 49(2) of the Senior Courts Act 1981 which identifies the practical benefits of ensuring all matters in issue between parties are determined in a single set of proceedings if possible: “every court… shall so exercise its jurisdiction in every cause or matter before it as to secure that, as far as possible, all matters in dispute between the parties are completely and finally determined, and all multiplicity of legal proceedings with respect to any of those matters is avoided”.

Legal set-off allows litigating parties to set off claims so that when it comes to judgment of those claims the corresponding judgment sums will reduce the net judgment debt.

In order for a legal set-off of such cross-claims to occur the two claims must be for sums which are due and which are either liquidated (i.e. a debt) or capable of ascertainment without valuation or estimation at the time: Stein v Blake [1996] AC 243 at 251F-G. This requirement significantly limits the efficacy and applicability of the legal right of set-off.

Equitable set-off

As is equity’s wont, the shortcomings of the legal rights of set-off have been remedied to a great extent by the operation of equitable set-off. This differs from legal set-off in that it is not merely procedural and affects the substantive rights of the parties.

Equitable set-off and its development were considered at length by the Court of Appeal in Hanak v Green [1958] 2 QB 9. The Court recognised the right to raise a cross-claim as a defence to a claim, whether in diminution or extinction of that claim. The basis of such a defence was that “a court of equity would say that neither of these claims ought to be insisted upon without taking the other into account”.

The classic exposition of equitable set-off is found in The Nanfri [1978] 2 QB 927. The case involved a dispute over the payment of hire under three time charters for the vessels the Nanfri, the Benfri and the Lofri. The charterparties provided for the payment of hire twice-monthly in advance, in default of which the owners were entitled to withdraw the vessels from service. The charterparties also included certain provisions for permissible deductions from hire. Following a deduction from hire for the Nanfri, the owners ordered the masters of all three vessels to withdraw all authority of the charterers or their agents to sign bills of lading and to refuse to sign freight pre-paid bills of lading. One of the issues for determination was whether the charterers had been entitled to deduct sums from hire.

Lord Denning formulated the definitive test for when equitable set-off is available. This is where a cross-claim is “out of the same transaction or… so closely connected with [the claim] that it would be manifestly unjust to allow [the claimant] to enforce payment without taking into account the cross-claim”. This entitled the charterers to deduct certain sums from hire without the consent of the owners.

The principle of equitable set-off is not a settled one and was recently considered by the Court of Appeal in Geldoff Metallconstructie NV v Simon Carves Ltd [2010] EWCA Civ 667. There Lord Justice Kay undertook a thorough review of the authorities and concluded that the best restatement of the test was that formulated by Lord Denning in The Nanfri.

Can there be set-off between separate contracts?

Returning to the question posed at the beginning of this article, is it possible to set-off sums owing between different contracts? The Court of Appeal considered this in Bim Kemi v Blackburn Chemicals [2001] 2 Lloyd's Rep 93. The issue before the Court was the degree of connection which had to be shown between a claim for damages for breach of a contract, and a cross claim for damages for a breach of a different contract between the same parties, for the latter claim to be the subject of a set-off.

Lord Justice Potter considered that the authorities demonstrated that it was not necessary that the cross-claim should arise out of the same contract. All that was required was that the cross-claim should arise from the dealings and transactions which gave rise to the subject of the claim.

Ignoring for the moment the forum for the resolution of the dispute, does the principle recognised in Bim Kemi enable a party to set off sums owing between different charterparties? The answer depends upon the specific circumstances of the relationship between the contracting parties, but it is likely that there would be no right to exercise equitable set-off. This is because the two charterparties will typically be distinct contracts even if there is an ongoing commercial relationship between the parties. Set-off might be possible where there is an initial umbrella agreement between the parties to enter into a number of different charterparties, or if one charterparty was in substitute of another (for instance if the original vessel had to put in for an extended period of dry-docking).

Set-off in arbitration

Of course the ability to set off, whether on an equitable or legal basis is complicated further by the dispute resolution mechanism being arbitration.

The Bim Kemi decision was in the context of litigation before a court. Submission to arbitration is a contractual dispute mechanism agreed by the parties. The scope and jurisdiction of the arbitral tribunal is defined by the parties or in default of express agreement the provisions of the Arbitration Act 1996. Only those parties to the arbitration agreement can be parties to the arbitration. Likewise only those contracts which fall within the scope of the arbitration clause can be the subject of arbitration and hence be taken into account in relation to any reliance on set-off.

By way of illustration: two contracting parties enter into two charterparties; the final hire statements for the respective charterparties record one balance in owners’ favour and one balance in charterers’; in the absence of express agreement to arbitrate the two claims together, the parties will not be entitled to set off one final balance in diminution or extinction of the claim for the other.

The exception of set-off against freight

No article on set-off would be complete without a quick mention of the inability to set-off against freight. There is a long-settled rule of law that freight is payable in full without deduction. Even if cargo is short-delivered, or delivered damaged, there can be no deduction on that account from freight. Any cross-claim must be left to be decided later by the courts or arbitration: see The Brede [1974] Q.B. 233 and The Aries [1977] 1 W.L.R. 185. This puts the contractual carrier in a strong position to negotiate in any dispute since the claim for freight can be determined summarily without taking into account any cross-claims.

Conclusion: express contractual rights of set-off

In view of the potential limitations of set-off discussed above, trading entities would be well advised to at least consider the inclusion of an express right of set-off in their contractual documentation.

An example of such a clause can be found in the recently-decided Geldof Metaalconstructie (see above). The clause was in the following terms: “Purchaser, without waiver or limitation of any rights or remedies of Purchaser or Owner, shall be entitled from time to time to set off against the Purchase Order Price any amounts lawfully due from the Supplier to the Purchaser whether under this Purchase Order or otherwise”. The Court of Appeal considered this wide enough to encompass claims under other contracts.

Neil Henderson is a commercial and shipping barrister whose practice includes all aspects of shipping and maritime work, international trade, and contracts for the sale and carriage of goods.