Set-off: Understanding Mutual Claims and Compensation
In business and finance, parties often owe each other money or have reciprocal obligations. Set-off is a legal mechanism that allows these parties to reduce their mutual liabilities by netting them against each other, so that only the balance remains payable. Essentially, it is a right to deduct one debt from another, potentially reducing or eliminating the obligation entirely. Unlike a security interest, set-off is a personal right that may arise from contract terms or from statutory and common law rules.
1. The Nature of Set-off
Set-off occurs when two parties have financial claims against each other. For example, imagine a supplier owes a retailer $10,000 for raw materials, while the retailer owes the supplier $6,000 for services rendered. Through set-off, the retailer can deduct the $6,000 from the $10,000, so only $4,000 remains payable.
The right of set-off is not automatic in all circumstances—it depends on the nature of the claims, their timing, and whether they are liquidated (i.e., precisely calculable). Courts evaluate each case based on its specific facts to determine if set-off can apply.
2. Types of Set-off
There are several types of set-off recognized in law:
a) Legal Set-off
Legal set-off allows a defendant to counterclaim in a court action brought by a claimant. The requirements are:
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Both claims must be certain and liquidated.
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Both claims must be due and payable at the start of the legal action.
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The claims do not need to arise from the same transaction but must involve the same parties.
Example: A software developer sues a client for $50,000 for services provided. The client owes the developer $20,000 for prior expenses the developer agreed to cover. The client can raise a legal set-off of $20,000 against the claim.
b) Equitable Set-off
Equitable set-off applies when claims are closely connected such that enforcing one without accounting for the other would be unfair. Unlike legal set-off, it does not require ongoing litigation.
Example: A construction company and a subcontractor enter into multiple agreements. The subcontractor fails to complete certain works, reducing the value of the project. The construction company can use equitable set-off to reduce payment owed for completed portions, reflecting damages caused by the subcontractor.
c) Banker’s Set-off (Right of Combination)
Banks can offset debts and credits across a customer’s accounts. For instance, if a client has a $5,000 overdraft and $2,000 in a savings account, the bank can set-off the $2,000 against the overdraft, leaving a net debt of $3,000.
This is a self-help remedy, meaning the bank can exercise it without going to court, but it typically applies only to running or current accounts.
d) Insolvency Set-off
In insolvency or liquidation, statutory set-off automatically applies. It ensures that all mutual debts and credits between a creditor and an insolvent company are offset as of the start of the liquidation. Only the net balance is claimed or paid.
Example: Company A goes into liquidation. It owes Supplier B $15,000, while Supplier B owes Company A $10,000. Under insolvency set-off, Supplier B can claim only the net $5,000.
Key points:
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Automatic by law.
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Applies to both present and future debts, with appropriate adjustments for value.
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Parties must act in the same capacity; claims must be mutual.
e) Administrator’s Set-off
In administration, set-off works similarly to insolvency set-off but only becomes effective when the administrator announces a distribution to creditors.
Example: A tech startup enters administration. The administrator gives notice of a payout. Only at this point can mutual debts between creditors and the company be set off.
3. Excluding or Restricting Set-off
Parties can contractually limit or exclude the right of set-off. Such clauses are enforceable if they are clear and unambiguous.
Example: In a commercial supply agreement, the contract states: “Neither party may offset any sums due under this contract against any other claim without express written consent.” Courts will generally uphold this clause, provided the intention is clearly stated.
This is particularly important in financial instruments, such as standby letters of credit, where the issuer may want to prevent any automatic deduction by the beneficiary.
Key Takeaways
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Set-off allows parties with reciprocal debts to net their obligations.
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There are multiple forms: legal, equitable, banker’s, insolvency, and administrator’s set-off.
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Legal and equitable set-offs differ mainly in timing and the connection between claims.
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Banks and insolvency situations have statutory rights of set-off.
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Parties can restrict or exclude set-off through clear contractual terms.
Understanding set-off is essential for businesses managing mutual claims, contracts, and financial transactions. It helps ensure that debts are properly accounted for and reduces the risk of overpayment or legal disputes.
What is the basic idea of set-off?
It allows mutual debts between parties to be netted so that only the balance remains payable.
It allows creditors to seize a debtor’s assets automatically.
Which type of set-off applies automatically during liquidation of a company?
What is a key requirement for legal set-off?
Both claims must be certain, liquidated, and due at the start of the action.
The claims must arise from the same contract only.
How does equitable set-off differ from legal set-off?
It applies when claims are closely connected and fairness requires adjustment, even outside litigation.
It applies only if claims are unrelated but liquidated.
Which type of set-off allows a bank to combine credits and debts across a customer’s accounts?
Banker’s set-off (Right of Combination)
Can parties contractually exclude the right of set-off?
Yes, if the clause is clear and unambiguous.
No, set-off cannot be limited by contract.
