Equitable set-off

Introduction

On 11 June 2010 the Court of Appeal handed down judgment in the case of Geldof Metaalconstructie NV v. Simon Carves Ltd. The judgment is important, because it draws together the previous authorities on the application of the doctrine of equitable set-off. Although decided in respect of a construction contract, it is of universal application to all cases where the doctrine can apply.

Background

The background facts that led to the appeal by Carves were these:

• Carves were engaged by Ensus in October 2006 to construct a new bioethanol plant at Wilton on Teesside.
• Thereafter, in or about July 2007 Carves entered into a contract with Geldof for the supply only of storage vessels (“Supply Contract”), and the goods were eventually delivered to site in November 2007.
• In or about December 2007 Carves then entered into a separate sub-contract with Geldof based upon the IChemE Yellow Book 3rd Edition for the design and installation of site built tanks (“Installation Contract”).
• It was a common point between the parties that the two contracts were independent of each other and that the only linking factors were that they were between the same parties in relation to the same site and main contract.
• Geldof commenced work on site on or about March 2008 and the parties fell into dispute in December 2008, culminating with Geldof issuing an alleged Notice of Suspension on 23 December 2008 for the non payment by Carves of sums due under both the Supply Contract and the Installation Contract.
• Geldof’s notice stated that it would not return to site unless all the sums due to it under both contracts had been paid.
• Carves responded by serving a Default Notice on 30 December 2008, alleging various breaches of the Installation Contract by Geldof and giving it 14 days in which to rectify those breaches. Geldof responded by letter denying that it was in breach and confirming that it required payment of all the sums stated in its notice, before it would return to site to complete its works under the Installation Contract.
• On 13 January 2009 Carves issued a Termination Notice pursuant to clause 43.2 of the Installation Contract, on the ground that Geldof had failed to make good the alleged breaches.
• Carves also argued later, that in the alternative Geldof had repudiated the Installation Contract by unlawfully suspending work and demanding sums due under the Supply Contract, as a condition precedent to it returning to site to complete its works under the Installation Contract and that Carves’ Termination Notice of 13 January 2009 served as confirmation of Carves’ acceptance of that repudiation.

The action

On 23 April 2009 Geldof issued proceedings, but only in respect of sums due under the Supply Contract.

Carves responded saying it had a contractual right of set-off pursuant to clause 24 of the Supply Contract and/or in the alternative and equitable right of set-off, for the rectification of defects and the additional costs of completing the works under the Installation Contract, consequential upon Geldof’s repudiation/ Carves determination of Geldof’s employment. Clause 24 said:

“[Carves] without waiver or limitation of any rights or remedies of [Carves] shall be entitled from time to time to set off against the Purchase Order Price any sums lawfully due from [Geldof] to [Carves] whether under this Purchase Order or otherwise.”

Manchester TCC heard an application for summary judgment on 29 September 2009. Geldof argued that Carves could not rely clause 24 because that wording was not sufficiently wide to encompass unliquidated claims for damages that had not be adjudicated upon[1] and Carves had no right to a claim of equitable set-off because there was insufficient proximity between the Supply and Installation contracts. For its part, Carves argued that as regards clause 24, to give logical meaning to the provision it must be interpreted as intended to expand Carves’ rights at common law and as such, it was wide enough to catch Carves’ claims for unliquidated damages, insofar as those claims were ones that were legitimate heads of claim recognisable at law. As regards its alternative claim for equitable set-off, Carves argued that there was sufficient proximity and connection between the two contracts, because they related to claims between the same parties in respect of the same site and project. Moreover, Geldof had itself placed that question beyond doubt by linking the two in its Notice of Suspension, given its demand for payment due under both contracts as a condition precedent to its return to site to complete the works under the Installation Contract.

HH Judge Raynor QC gave judgment for Geldof in the sum of €1,329,437.55. On the question of clause 24, the learned judge held that it was not wide enough to encompass claims for unliquidated damages that had not been adjudicated upon. In respect of Carves’ alternative claim for a right of equitable set-off, he held that there was insufficient proximity between the contracts for the doctrine to apply.

The appeal

In a unanimous decision, the Court of Appeal allowed the appeal and gave judgment in Carves’ favour on both grounds of appeal, the leading speech being given by Rix LJ, with whom Maurice Kay LJ (Vice President of the Court of Appeal Civil Division) and Patten LJ concurred.

On the question of clause 24, the court held that:

“The ultimate question is therefore one of construction: does the phrase “all amounts lawfully due” mean amounts which have been adjudicated or agreed to be due, or does it mean amounts which are claimed to be due and which are recognised or recognisable at law? It seems to me that either is possible as a matter of language, but that business sense and the intended width of the clause points to the latter conclusion……….Therefore, for this reason too [Carves] is in my judgment entitled to set off its counterclaim, even if I am wrong to think it fell within the scope of equitable set-off.”

Whilst the point was important in the context of this appeal and therefore to Carves, the court’s decision on clause 24 is of less general application than the decision on equitable set-off. It does nevertheless confirm that a legitimate, but as yet unliquidated, counterclaim is capable of defeating an application for summary judgment under such a clause.

On the question of equitable set-off, the previous authorities had tried to clarify the proximity test in a number of ways. Thus

• in Hanak v Green it was likened to being a “…close relationship between the dealings and transactions which gave rise to the respective claims”,
• in The Nanfri it was referred to as being claims that were “closely connected……[s]o closely connected with [the Claimant’s] demands that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim” ,
• in The Dominique the court spoke of a cross-claim “flowing out of and inseparably connected with the dealings and transactions which also give rise to the claim” .
• Bim Kemi adopted the test in The Dominique.

Consequently, with each authority the definitions of what constituted the necessary proximity for equitable set-off confused matters as to what the applicable test actually was and for example, what constitutes claims that are “closely connected”.

At first instance the court took the view that test formulated in The Dominique and adopted in Bim Kemi, meant that where a cross-claim arises under a separate and otherwise seemingly unrelated contract (i.e. where there is no actual link between the two) there could be no “inseparable connection” between “the dealings and transactions” and therefore relief by way of equitable set-off was not available. However, as the Court of Appeal recognised, to apply the test in such a strict way was to ignore Lord Denning’s “manifestly unjust” explanation of the test as expressed in The Nanfri and the fact that the doctrine was originally formulated as an ‘equitable relief’ to assist a party in circumstances where it could not find relief at common law. Rix LJ concluded the following:

“Although the test for equitable set-off plainly therefore involves considerations of both the closeness of the connection between claim and counter-claim, and of the justice of the case, I do not think that one should speak in terms of a formal element in the test and a functional element. The importance of the formal element is to ensure that the doctrine of equitable set-off is based on principle and not discretion. The importance of the functional element is to remind litigants and courts that the ultimate rationality of the regime is equity. The two elements cannot ultimately be divorced from each other……….That emphasises the importance of the two elements identified in Hank v Green; it defines the necessity of a close connection by reference to the rationality of justice and the avoidance of injustice,; and its general formulation, “without taking into account”, avoids any traps of quasi-statutory language which otherwise might seem to require that the cross-claim must arise out of the same dealings as the claim, as distinct from vice versa.”

So what does that mean? It means that the courts should apply the test pragmatically, in that whilst there must be a “close connection” between claim and counterclaim, that connection need only be such that it would be “manifestly unjust” to allow one without considering the other. In other words, it is an equitable relief that cannot be rigidly defined as to the circumstances that will give rise to relief to its application and therefore the court must consider each case on its own merits.

In this case, based upon the facts, Carves was successful, because the Court of Appeal held that it would have been “manifestly unjust” to allow Geldof to obtain summary judgment on its claim under the Supply Contract, without taking into accounts Carves’ counterclaim under the Installation Contract. Future cases will of course turn on their own merits, but at least there is now scope to argue against the rigid separation of contracts.

* Howard Cornes of Hill Dickinson LLP represented Simon Carves Ltd.

[1] In this sense ‘adjudicated upon’ is taken to mean having been the subject of an independent determination, rather than having been the subject of an adjudication pursuant to either a contractual provision, or one arising under the Housing Grants Construction and Regeneration Act 1966.