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What is a Set-Off Clause in Commercial Contracts?

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In commercial contracts, certain clauses can significantly affect the dynamics of a commercial relationship. If you are a service provider, understanding legal set-off clauses is crucial to allowing your business to confidently navigate contracts. Set-off clauses provide the other party, usually your clients, with extra rights that can make a big difference in the outcome of commercial agreements. This article aims to clarify what constitutes a set-off clause, how it influences commercial contracts and what you should consider regarding its implications. 

What is a Set-Off Clause?

A set-off clause is a small but impactful provision that your company can include within a commercial contract. These clauses allow clients to deduct any owed amounts from their payments to the service provider. It essentially enables both parties to offset their financial claims, removing what is owed from the amounts due under the agreement. 

You will usually find a set-off clause near the payment clause. However, it may not always be called a ‘set-off’ clause. Occasionally, it is referred to as ‘deductions’, ‘customer entitlements’ or ‘back charges’. 

The Impact of a Set-Off Clause

The presence of a set-off clause in your commercial contract allows your client to deduct money from payments owed to the service provider, such as your business. In turn, this clause will impact the money receivable. This deduction can exist in specific circumstances, which include instances where: 

  • the service provider owes a debt to their client; or 
  • the client has incurred a loss and requires compensation. 

This deduction may be fair and reasonable or potentially unfair to service providers. For instance, if your business makes an obvious error resulting in a loss to a client, a set-off clause may provide a reasonable outcome.

An Example

Consider a scenario where your business has been working on a large-scale project with a client. You have just completed the scope, and the client seems satisfied. Your business relies on their payment to sustain ongoing operations, having allocated funds for delivery, materials, and employee wages

Assuming full payment, you invoice the client accordingly, only to receive a fraction of the expected amount. They claim deductions based on a perceived defect in your work and insist on offsetting the costs—40% of your invoice—for rectifying this alleged defect. 

This action stems from the broad, one-sided right of set-off in your signed commercial contract. Such a situation might seem unfair from your perspective, highlighting the importance of understanding these clauses and safeguarding your business before entering a commercial contract. 

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How to Handle a Set-Off Clause

For service providers, effectively managing a set-off clause in your contract begins with reading it carefully before giving consent. It is highly recommended to consult a legal expert to review this clause to unveil its potential impacts on your business, such as inhibiting your right to claim under insurance policies.

The primary goal when assessing or modifying a set-off clause is to narrow the scope of the set-off ability as much as possible. Ensuring prompt and full payment is a primary goal for service providers. But this goal can be hampered by a set-off clause written too broadly.

Considerations

It is important to understand that even though changing a set-off clause in a contract can be beneficial, doing so does not entirely remove the inherent set-off right. Clients may still have this right under equitable principles, particularly if a calculation could create a new amount after consideration of the parties’ grievances. It is up to the courts to decide whether the right to set-off is valid, meaning not everyone has access to an equitable set-off right. 

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Avoiding the consequences of a contractual set-off right is more difficult when one exists.

Therefore, the best course of action is to proactively amend a set-off clause during contract negotiations. Negotiating with clients to limit or eliminate their set-off rights is reasonable. Service providers can protect their interests and preserve fair client relations by limiting this right within reasonable bounds. 

You should consider: 

  • whether the scope of the set-off clause includes debts due or a broader range of claims; 
  • the impact on payments, insurance and liability; and
  • whether the clause gives way to a unilateral set-off, applicable to just one party, or a mutual set-off, involving both parties.

Key Takeaways 

A set-off clause gives your client the legal right to offset or subtract any amounts owed by you from the amount they owe you. Many businesses overlook this to their detriment, as such a clause may prevent you from making insurance claims. It is key to carefully read your commercial contracts before signing to protect your business regarding set-off clauses. 

If you need help navigating a set-off clause, LegalVision’s experienced contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0800 005 570 or visit our membership page.

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