Introduction:
In construction contracts, the “right to set off” allows general contractors or owners to withhold payments from subcontractors for a variety of reasons, such as covering claims, penalties or damages. While this mechanism can protect contractors from unfulfilled obligations, it poses significant risks for subcontractors, particularly when set-off clauses are overly broad or loosely defined. These provisions can lead to cash flow disruptions, inflated liabilities and unfair financial burdens on subcontractors. This guide highlights the potential risks associated with set-off clauses and outlines practical steps subcontractors can take to mitigate these risks through negotiation, legal review and proactive planning.
For example, if a subcontractor damages materials or causes delays that result in penalties or additional expenses for the contractor, the contractor may “set off” these costs against the payments owed to the subcontractor. Set-off rights are usually outlined in the contract’s terms, and their application can vary based on local laws and the specific contract.
Key points regarding set-offs:
- They allow the deduction of amounts from payments owed to the subcontractor.
- They are often linked to claims for damages, delays or breaches of contract.
- Contract provisions and legal frameworks typically govern when and how set-offs can occur.
Red Flags in Set-Off Clauses
Here is an example of a set-off clause that should raise concerns for subcontractors:
“Company may withhold and set-off against amounts due and payable to Subcontractor under this Subcontract or any other subcontract or agreement that may be entered into between the Parties, all damages, back charges, expenses, fees and any other amounts that Company, the Owner and or/any third party (including any agent, employee supplier or subcontractor or Subcontractor) may incur or has incurred, including but limited to (i) the estimated cost to remedy Subcontractors defective work; (ii) third-party claims filed or reasonable evidence indicating the probable filing of such claims; (iii) Subcontractor’s failure to make payments for labor, materials, supplies or equipment; (iv) personal injuries or property damage caused by Subcontractor and/or its subcontractors or any person employed directly or indirectly by Subcontractor or its subcontractors; (v) reasonable evidence that the Work or Project does not or will not comply with the work schedule; (vi) the cost to complete warranty or punch lists items not completed or corrected by Subcontractor or any agent, employee and any subcontractor, material supplier or laborer or Liens or claims relating to the monetary disputes or controversy between Subcontractor and any subcontractor, material supplier or laborer or liens or claims relating to the project; (viii) any dispute or controversy between Company and excess of Subcontractor’s insurance coverage; (x) the cost of obtaining the required insurance and//or subcontractors, suppliers or any of their agents or employees in the performance of the Work; plus a markup for Company’s overhead and profit at the greater of a a)$750.00 or b)fifteen percent (15%). As a long as such withholding and set-off exercised by Company in good faith, Subcontractor hereby waives any claims against Company for any consequential damages following from such withholding or set-off, even if it is later determined that such withholding or set-off was improper.”
The clause has multiple broad conditions that allow withholding, including:
- The estimated cost to remedy the subcontractor’s defective work.
- Third-party claims or evidence indicating the probable filing of such claims.
- The subcontractor’s failure to make payments for labor, materials, supplies or equipment.
- Personal injuries or property damage caused by the subcontractor or its subcontractors.
- Evidence suggesting that the project won’t comply with the agreed-upon schedule.
Additionally, the clause allows for a markup of $750 or 15% for the company’s overhead and profit on any withheld amounts. Furthermore, it contains a waiver of claims for consequential damages, even if it is later determined that the set-off was improper.
Risks for Subcontractors
From the subcontractor’s perspective, this set-off clause presents several risks:
- Broad Withholding Rights: The company can withhold payments for a wide range of reasons, including speculative third-party claims or potential project delays. This could severely disrupt the subcontractor’s cash flow.
- Liability for Defective Work: Payments can be withheld for the estimated cost of fixing defective work, which could be subjective and inflated, straining the subcontractor financially.
- Third-Party Claims: The clause allows withholding for third-party claims, even before the validity of those claims is determined, which increases the subcontractor’s risk exposure.
- Responsibility for Others’ Actions: Subcontractors may be held financially responsible for damages caused by their own subcontractors or suppliers, which increases their liability even for issues beyond their direct control.
- Failure to Meet Schedules: The company can withhold payments based on “reasonable evidence” of potential delays, even if actual delays have not occurred yet.
- Uncapped Markup on Costs: The company can apply a significant markup on withheld amounts, inflating the financial burden on the subcontractor.
- Waiver of Consequential Damages: The subcontractor waives the right to claim damages resulting from improper withholding, which limits recourse and could lead to significant financial losses.
What Should Subcontractors Do?
If you encounter a set-off clause like this, there are several actions you can take to mitigate the risks:
- Negotiate the Clause:
- Narrow the Scope: Request more specific and limited reasons for withholding payments to avoid unnecessary deductions.
- Limit Withholding to Actual Costs: Ensure that any withheld amounts are based on documented actual costs, not estimates.
- Cap the Markup: Negotiate a cap or reduce the markup on withheld amounts to avoid excessive deductions.
- Remove the Waiver of Consequential Damages: Protect your right to claim compensation if the set-off is improper.
- Clarify “Good Faith”: Define what constitutes “good faith” in withholding payments to make it easier to contest improper withholdings.
- Seek Legal Review: Have a legal expert review the contract to identify and address potential liabilities and suggest alternative language to better protect your interests.
- Request Notification Requirements: Ensure the contract includes a detailed written notification process before any withholding occurs, giving you a chance to address issues before payments are deducted.
- Negotiate Alternative Dispute Resolution (ADR): Include provisions for mediation or arbitration to resolve disputes quickly, avoiding costly and lengthy litigation.
- Clarify Third-Party Liability: Ensure that you are only liable for third-party claims directly related to your work, not for unrelated claims.
- Ensure Adequate Insurance: Confirm that your insurance coverage is sufficient to cover potential claims, and that the insurance requirements in the contract are reasonable.
- Monitor Cash Flow: Regularly monitor your financial position and maintain proper documentation to protect against unexpected withholdings.
- Document Everything: Keep detailed records of all project-related communications, payments and issues to safeguard against improper set-offs.
- Prepare Contingency Plans: In case of improper withholding, have contingency plans, such as credit lines or reserve funds, to ensure smooth operations.
Conclusion
Set-off clauses in construction contracts can significantly impact a subcontractor’s financial stability, especially when the provisions are overly broad or vague. To safeguard against improper withholdings and financial strain, subcontractors must take an active role in negotiating the terms of these clauses, ensuring they are fair and specific. Seeking legal advice, clarifying liabilities and preparing for disputes through documentation and alternative dispute resolution methods are essential strategies for protecting your business. By addressing these issues early, subcontractors can avoid unexpected financial pressures and ensure smoother project execution, free from the challenges of unfair set-offs.