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Set-off - the principle that governs who pays what to whom when two parties owe each other money - has long been a source of confusion. The Court of Appeal has recently provided some much-needed guidance on the issue.

There are four main types of set-off:

• Banker鈥檚 set-off. Where there are two or more bank accounts, one in credit and one overdrawn, the bank will use the credit in one account to reduce the overdraft in the other.
• Insolvency set-off. When one party becomes insolvent owing another money, the amount the solvent party has to claim in the insolvency is automatically reduced by any money that it owes the insolvent party.
• Legal set-off. This applies only where both of the amounts owed are debts that are due and payable (as opposed to claims in damages where the amount due may yet to be ascertained) and is limited to claims within England and Wales.
• Equitable set-off. Arguably the most relevant to the construction and engineering industries and, helpfully, the subject of the recent guidance.

It is not uncommon for clients to use consultants or contractors on more than one project and for a number of projects to be running at the same time. Imagine that the contractor is in delay on one project but has a claim for loss and expense under another. Can the client use the liquidated damages it鈥檚 entitled to under the contract that鈥檚 late to reduce (or defeat entirely) the claim for loss and expense under the other one?

If it can, then it has to use equitable set-off rather than legal set-off because this is how the law allows parties to set off damages claims as opposed to debts. This makes equitable set-off a potentially useful legal weapon, and the recent case of Geldof Metaalconstructie NV vs Simon Carves Ltd has shed some light on when it can be used.

Simon Carves Ltd (SCL) was the contractor for a bioethanol plant. Geldof successfully tendered for two subcontracts: one for the supply of pressure vessels, the other for the installation of storage tanks. The supply contract was awarded six months before the installation one. Geldof linked the two contracts together by demanding payment of invoices under the supply contract as a condition of continuing with performance of the installation contract.

Geldof delivered the pressure vessels to site on 7 November 2008 but SCL did not pay the 拢1.7m invoice that accompanied the delivery. In fact, Geldof claimed that a number of invoices were due under both contracts, but this was the relevant one as far as equitable set-off was concerned. SCL argued that Geldof was in breach of the installation contract because of delays. Geldof refused to return to the site following the Christmas break of 2008 because of the unpaid invoices, which SCL treated as an unlawful repudiation of the installation contract.

Geldof brought a claim for the price of goods under the supply contract. SCL tried to set off its 拢5.3m damages claim under the installation contract against the unpaid 拢1.7m invoice. Geldof obtained summary judgment in the Technology and Construction Court that SCL could not rely on equitable set-off and SCL appealed.

The Court of Appeal noted that previous cases had caused some confusion. In a unanimous judgment, it decided that the law as stated in two judgments - Hanak vs Green and The Nanfri - was to be preferred. Equitable set-off is allowed where 鈥渢he cross-claims [are] so closely connected with the [claimant鈥檚] demands that it would be manifestly unjust to allow it to enforce payment without taking into account the cross-claim鈥�. There are two distinct requirements - a formal requirement of close connection and a functional requirement that it would be unjust to enforce the one claim without taking account of the other.

The Court of Appeal allowed SCL鈥檚 appeal. Even though the cross-claims arose out of two contracts that were concluded at different times, Geldof had brought them into an 鈥渋ntimate relationship with each other鈥� by making the payment of invoices under the supply contract a precondition of completing work under the installation contract. Also, the facts that both contracts related to the bioethanol plant and that the pressure vessels supplied were of no use to SCL unless the installation contract was properly performed made it manifestly unjust to enforce payment under one without reference to the other.

Stuart Pemble is a partner in, and Susie Wilson a solicitor at, Mills & Reeve