How to simplify settlements on the line General Contractor – Subcontractor? Set-off of claims.

In a situation where the General Contractor (GC) and the Subcontractor (SC) are at the same time mutual debtors and creditors, it is natural that settlements can be made by offsetting claims (set-off of receivables). Making a set-off is treated as equivalent in effect to making a payment.

In the article, we will look at the basic issues related to offsetting from the perspective of the General Contractor:

• advantages of this method of settlement;
• the most important requirements for effective set-off;
• the problem of maturity of claims;
• analysis of the factual and legal basis for the set-off of claims;
• risks and challenges arising from set-off.

Benefits of offsetting

Undoubtedly, the offset mechanism allows to simplify the payment process. As a model, instead of two transfers – after offsetting – it is enough to make one transaction of lesser value.

The set-off of mutual receivables is carried out by a one-sided statement made to the other party (and often even against the stance of the other party), which is important during the realization of a construction contract.

Consequently, the possibility of offsetting – in addition to the function of simplifying settlements – also makes it possible to satisfy GC’s claim when SC does not intend to pay its debts. For example, when the General Contractor has a claim against the Subcontractor for reimbursement of the costs of substitute subcontracting, GC can independently enforce the amount due by offsetting against the payment of the VAT invoice to SC.

Finally, the risk of a set-off mobilizes the SC to properly perform the contract. Indeed, a disloyal SC must face the risk that GC will independently reduce the remuneration due to it by deducting contractual penalties or the value of damages without the need to involve a court or a bailiff.

Set-off requirements – maturity

In order for the set-off to be effective, it is necessary for GC’s claim to be brought to maturity.

Therefore, in the case of GC’s pending claims against SC for contractual penalties, damages or costs of substitute workmanship – before offsetting, GC should send SC a demand for payment, which will set a deadline for payment.

It is worth remembering an important exception for practice, which authorizes GC to make an immediate offset. If the SC has become insolvent, the GC can demand performance regardless of the designated payment date (Article 458 of the Civil Code). This means that GC can then call on SC for payment and set-off almost simultaneously. 

It should be emphasized that, contrary to the literal wording of Article 498 § 1 of the Civil Code, the maturity requirement does not apply to SC’s claim (a passive claim).

This means that GC can set off when the due date for payment to SC has not yet occurred. Rather, it should be assumed that GC is entitled to set-off even before SC delivers the invoice, as long as GC can determine the amount of payment (e.g., based on partial work takeover reports).

In other words, for an effective set-off on statutory grounds, it is necessary that GC’s claim is due, not SC’s claim.

As a final note, it is worth noting that contracting parties may contractually regulate that the maturity of the claim is not a condition for set-off at all. Indeed, the parties are entitled to modify the basic principles of the set-off mechanism on their own. However, the abandonment of the maturity condition must be clearly expressed by both parties.

Requirements for set-off – factual and legal basis of the claim

In addition to the issue of maturity, the factual and legal basis of GC’s claims is of primary importance for effective set-off.

On the grounds of statutory set-off, it is not required that GC’s and SC’s claims arise from the same contract. Consequently, GC may, for example, present a contractual penalty for deduction and set it off against a fee receivable for SC’s performance of another investment.

Before offsetting, GC should carefully analyze the basis of its claims and collect the documentation required to prove them (e.g., photos of faulty work, costs of substitute subcontractor).

Based on the aforementioned analysis, the offsetting statement should indicate the claim to which it is entitled and the amount of the claim. It is important that the claim due to GC be described as accurately as possible to avoid later challenges to the correctness of the offset.

Nevertheless, the set-off may refer to claims in dispute. In other words, the position of the SC, which disputes the legitimacy of, for example, accrued contractual penalties, is not relevant to the effectiveness of the set-off. This is because the set-off is triggered by one-sided action. The described feature affects the importance of the instrument in question in construction contracts.

Offsetting – risks and challenges

However, there are also some complications associated with the offset mechanism.

While the claims covered by the set-off may be subject to dispute, GC must expect a course of events in which its claims are challenged by SC. This is because the subcontractor is entitled to challenge in court the validity of the claims and the setoff made on the basis of them. In an unfavorable scenario, the offset may be judicially declared invalid.

In such a situation, GC – in addition to payment of the remuneration due to SC, ineffectively or invalidly deducted earlier – will be obliged to pay late interest.

The simplest way to minimize the above-mentioned risks is to first conduct a thorough analysis of the factual and legal basis for the claims to be offset and to properly document them.

GC should also bear in mind that making a set-off in the context of court proceedings is subject to certain limitations (Article 203[1] of the Code of Civil Procedure). To put it in simple terms – it is easier to challenge the effectiveness of a set-off of claims that has been made in the course of litigation. To protect yourself from the described risk, it is worthwhile to present the claim for set-off even before the dispute is brought to the courtroom.

Finally, it should not be overlooked that offsetting is, in some ways, a double-edged weapon. By deciding to make settlements in the form of a set-off, GC simultaneously accepts the claim raised by SC. Indeed, the set-off has the effect of an acknowledgment of debt.

Summary

The set-off mechanism – along with the transfer of receivables – is a practical instrument for making settlements between entities involved in the construction process. It facilitates the turnover of capital and secures the interests of counterparties. When deciding to make a set-off, the General Contractor should be aware of the risks associated with this settlement mechanism. This will allow the Contractor to adequately protect itself against complex disputes with the Subcontractor.