Remedies for breach of contract

This final part of a four part series on practical contract law considers remedies for breach of contract.
Samantha Cotton, PLC

Many commercial agreements contain express provisions for remedies. For example, in a contract for the sale of goods, the buyer may be entitled to require the seller to make good or replace defective items. There may be a presumption (which may be expressed in the contract) that all the terms which are to govern their contractual relationship have been included by the parties in express written form in the contract itself. In doing so they intended to displace any rights and remedies provided by law (such as the buyer's right to terminate the contract for fundamental breach) which are not specified in the contract.

The purpose of a cumulative remedies clause is to ensure that the parties' rights specifically provided for in the agreement are in addition to their rights provided by the general law (see inset box "Cumulative remedies clause"). Any particular remedy that a party envisages it may need should be specifically preserved in the contract.

Damages

Unlike the equitable remedies of specific performance and injunction (see "Specific performance" and "Injunctions" below) damages for loss in a breach of contract claim are available as of right.

An innocent party may claim damages from the party in breach in respect of all breaches of contract. The damages may be nominal or substantial. Nominal damages are awarded where the innocent party has suffered no loss as a result of the other's breach and substantial damages are awarded as monetary compensation for loss suffered as a result of the other party's breach.

For an innocent party to obtain substantial damages he must show that he has suffered loss as a result of the breach (remoteness) and the amount of his loss (measure). It is up to the party in breach to argue that the innocent party has failed to mitigate his loss.

Remoteness of loss

The innocent party may only recover damages for loss suffered as a result of the breach provided it is not too remote. The aim of damages is to put him in the position he would have been had the contract been properly performed.

The principles of remoteness are given in Hadley v Baxendale ([1854] 9 Exch. 341) and provide that the following losses are recoverable:

  • All loss which flows naturally from the breach.
  • All loss which was in the contemplation of the parties at the time the contract was made as a probable results of the breach.

If the loss does not fall within the above categories, then it will be too remote and will not be recoverable.

The rule in Hadley v Baxendale has been interpreted to mean that only loss which is within the reasonable contemplation of the parties may be recovered (The Heron II [1969] 1 AC 350).

(Note that when dealing with specific types of contract there may be legislation that covers remedies under that particular type of contract. For example, in a sale of goods contract, a party may be able to recover special damages (for example, from unusual loss arising from special circumstances known the contract breaker (section 54, Sale of Goods Act 1979) (SGA).)

Measure of damages

This is the method for calculating the damages to which the innocent party is entitled. It covers loss of bargain or expectation loss. The usual aim of the court is to put the innocent party in the position he would have been in had the contract been properly performed (Robinson v Harman [1848] 18 LJ Ex 202). The two usual methods of assessing this are difference in value or cost of cure. The court will generally use the more appropriate.

Sometimes reliance loss may be sought where loss of expectation is difficult to prove. The aim of reliance loss is to put the innocent party into the position he would have been in had the contract never been made, that is, an indemnity for his out of pocket expenses incurred in reliance on the contract (Anglia TV v Reed [1972] 1 QB 60).

There are many other types of loss that have been claimed by innocent parties. Damages for disappointment or mental distress are not generally awarded (Addis v Gramophone Co. Ltd [1909] AC 488) unless the contract is, for example, a holiday contract (Jarvis v Swans Tours Ltd [1973] 1 QB 233).

Mitigation

An innocent party cannot recover for loss that he could have avoided by taking reasonable steps. This is sometimes expressed as the duty to mitigate. This does not apply to actions for the price of goods delivered. Such an action is an action for an agreed sum and not an action for damages.

Although there is no duty to mitigate before actual breach occurs the innocent party should not aggravate his loss. It is for the defendant to prove that the plaintiff has failed to mitigate his loss (Pilkington v Wood [1953] Ch 770).

Advance payments

If a party in breach has made advanced payments under the contract his ability to recover that money depends upon whether that payment constitutes a deposit (that is, a guarantee by him of due performance) or merely a payment of the whole or part of the price in advance.

If it is a deposit (this depends on the intentions of the parties) the general rule is that it cannot be recovered and it will be set off against any damages awarded to the innocent party. Care should always be taken with deposits so that they do not amount to penalties (see "Penalty clauses" below). However it may be possible to recover a deposit if the party has a lien over it (for example, Chattey and Another v Farndale Holding Inc., The Times, 17th October, 1996).

If the advance payment is not a deposit, the party in breach may recover it, subject to any claim for damages by the innocent party in respect of the breach.

An innocent party may only recover an advance payment if there has been a total failure of consideration. This is a quasi-contractual remedy. If there is only a partial failure of consideration, this remedy is not available (Rowland v Divall [1923] 2 KB 500).

Penalty clauses and liquidated damages

It is common for the parties to expressly state in the contract that if the contract is breached, a specified sum will be payable or that goods will be forfeited. Clauses covering these areas are known as liquidated or agreed damages clauses. They frequently appear in commercial contracts, whether individually negotiated or on a party's standard business terms and, most commonly, in relation to late rather than defective performance, particularly in the fields of construction and engineering and supply or sale of goods. Occasionally, they appear in lease agreements imposed by a key or anchor tenant who, for example, needs to be trading from the demised premises by a certain deadline. Such clauses do not usually appear in contracts of employment.

The purposes of such clauses are to make recovery of damages easier, avoiding the problems of proving actual loss; to avoid arguments as to the remoteness of certain types of consequential or indirect losses; and to assure the other party of their intention to be bound by the contract.

The normal rules applicable to the determination of whether a clause operates as liquidated damages or a penalty apply irrespective of the type of contract in question. A distinction must be drawn between clauses which purport to impose a penalty on the defaulting party and clauses which levy liquidated damages from that party. Penalty clauses are generally not enforceable, whereas liquidated damages clauses are.

Penalty or liquidated damages?

For a liquidated damages clause to be valid the specified sum must be a genuine pre-estimate of the anticipated loss which the claimant would be likely to suffer in the event of a breach of the obligation in question. If the loss is difficult to quantify a "best guess" procedure should be operated, keeping a record of the calculations underlying any elements of the determined figure. Provided the selected figure is not vastly in excess of the greatest loss which could be suffered, the clause is likely to be enforceable. The essence of a penalty is that the money specified is in terrorem of the defaulting party, in other words, it is intended to apply undue force to the other party to perform his side of the contract.

The use of the words "penalty" or "liquidated damages" are not conclusive. It is necessary to examine whether the amount specified is in fact a penalty or liquidated damages. It is for the party in breach to show that the sum is a penalty (Robophone Facilities Ltd v Blank [1966] 3 All ER 128).

The leading case of Dunlop Pneumatic Tyres establishes the tests to distinguish penalties from liquidated damages:

  • A clause will be construed as a penalty clause if the sum specified is "extravagant and unconscionable" in comparison with the greatest loss that could possibly have been proved as a result of the breach.
  • It is likely to be a penalty if the breach of contract consists of not paying a sum of money and the sum stipulated as damages is greater than the sum which ought to have been paid.
  • There is a presumption that if the same sum is stated to apply to different types of breach of contract, some of which are serious and others not, it is likely to be a penalty clause.
  • It is not a bar to the operation of a liquidated damages clause that a precise pre-estimation is impossible.

(Dunlop Pneumatic Tyre Co Limited v New Garage & Motor Co Limited [1915] A.C 79)

There is no public policy issue in relation to the upper limit of damages to which parties can contract to be liable. The Unfair Contract Terms Act 1977 will in certain circumstances impose a test of reasonableness in relation to exclusion clauses (which purport to limit or exclude liability) but this is unlikely to apply to a genuine liquidated damages clause. If the clause specifies a sum which is more than a genuine pre-estimate (and therefore a penalty) the clause will be unenforceable. The courts will not benefit the party claiming damages by imposing a lower substitute figure.

To claim on a genuine liquidated damages clause, the claimant merely has to show breach of contract, whether or not there has been any actual loss and regardless of the extent of any loss.

It is not entirely clear whether a liquidated damages clause is intended to be a mutually binding limitation on the amount of damages payable. It is likely that it is intended to be mutually binding in the field of building and engineering contracts. A Court of Appeal case held that where "£nil" was inserted as the amount of liquidated damages, then general damages for breach of contract were not recoverable in the alternative (Temloc v Errill Properties, 1987 39 BLR.30). A contract can, however, expressly provide for the party seeking to impose the clause to have a choice whether to operate it or not. Certain charterparty cases suggest that the claimant may have a choice either to sue under the liquidated damages clause or to ignore it and claim general damages without limitation although these cases are probably limited to that area of law.

If, however, the clause is invalidated because it is a penalty clause or due to acts of the claimant (such as requiring the other party to perform additional work without a contractual mechanism to grant that party further time to perform the contract) or breach of contract by the claimant, then the limit specified in the unworkable clause will operate as a limitation on the amount of damages which can be claimed (although in the case of a penalty the limit is unlikely to be reached because by its nature, it will be higher than the loss could ever be).

As regards enforcement, many contracts will specify that the damages can be deducted from subsequent sums due. This is particularly the case for building contracts where interim payments to the contractor are usual. Many contracts will also provide for the claimant to be able to recover liquidated damages as if they were a debt due by the other party. If possible, when drafting a penalty clause, you should try to ensure that you can deduct or recover damages in these ways as they are a more effective way of ensuring that you will be able to recover the money due.

Otherwise the usual rules of enforcement would apply and a claim form would be issued in the normal manner (without, of course, having to prove actual loss).

Note that it will be a defence to a claim for liquidated damages that the claimant has prevented the other party from completing his obligations either by the claimant's own breach of contract or by other acts of prevention in circumstances where there is no provision in the contract to make an allowance or give a time extension to the party from whom damages are claimed for these circumstances.

It is important to observe all relevant procedural requirements in the contract such as notice periods and provisions requiring the liquidated damages to be assessed and deducted within certain time periods, otherwise the defendant will not be required to pay the damages.

Specific performance

This is an equitable remedy granted at the court's discretion.

Specific performance is a decree by the court to compel a party to perform his contractual obligations. It is usually only ordered where damages are not an adequate remedy (for example where the subject matter of the contract is unique for example, Chinese vases in Falcke v Gray ([1859] 4 Drew 651) but not if a replacement of the subject matter could be obtained even after a long delay (Societe des Industries Metallurgiques SA v Bronx Engineering Co Ltd [1975] 1 Lloyds Rep 465).

It is a general rule that specific performance will not be ordered if the contract requires performance or constant supervision over a period of time and the obligations in the contract are not clearly defined. For example, specific performance of a covenant to keep a shop open during normal business hours was refused by the House of Lords in Co-op Insurance v Argyll Stores ([1997] 3 All ER 297) on the grounds that enforcement of a covenant to carry on a business would require constant supervision of the courts with the court resorting to criminal punishment for contempt of court if the order was not complied with. However, a recent case has reversed this rule in relation to a tenant's repair covenants (Rainbow Estates Limited v Tokenhold Limited and another [1998] New Property Cases 33). The judge in this case concluded that the old law of refusing specific performance if it would involve constant supervision was no longer good or (at least) that there were exceptions. It may be that only in the most exceptional circumstances (such as in this case) specific performance will be available to the landlords; however the arguments advanced indicate that it should be available in other situations. Specific performance was ordered requiring tenants to spend £300,000 on repairs to the flats. Factors militating in favour of this remedy were that the landlord had no right of entry to repair in default of the tenant; that the lease had no forfeiture clause and that the building was listed so that repair as distinct from redevelopment was the most appropriate outcome.

Specific performance is often ordered in relation to building contracts because the contract deals with results rather than the carrying on of an activity over a period of time and it usually defines the work to be completed with certainty (Jeune v Queens Cross Properties Ltd [1973] 3 All ER 97).

Specific performance is not available for contracts requiring personal services such as employment contracts because such an order would restrict an individual's freedom (Chappell v Times Newspapers Ltd [1975] 1 WLR 482).

The court has broad discretion to award specific performance and in exercising this discretion it takes into account factors such as:

  • Delay in asking for the order (Lazard Brothers & Co Ltd v Fairfield Properties co (Mayfair) Ltd [1977] 121 SJ 793).
  • Whether the person seeking performance is prepared to perform his side of the contract (Chappell v Times Newspapers Ltd [1975] 1 WLR 482).
  • Whether the person against whom the order is sought would suffer hardship in performing (Patel v Ali [1984] 1 All ER 978).
  • The difference between the benefit the order would give to one party and the cost of performance to the other (Tito v Waddell (No 2) [1977] Ch 106).
  • Whether any third party rights would be affected.
  • Whether the contract lacks adequate consideration (the rule "equity will not assist a volunteer" applies so that specific performance will not be ordered if the contract is for nominal consideration even if it is under seal (Jeffrys v Jeffrys [1841] 1 Cr & Ph 138)).

Injunction

Like specific performance, an injunction is an equitable remedy and therefore only granted at the discretion of the court. It is awarded in circumstances where damages would not be an adequate remedy to compensate the claimant because the claimant needs to restrain the defendant from starting or continuing a breach of a negative contractual undertaking (prohibitory injunction) or needs to compel performance of a positive contractual obligation (mandatory injunction).

In exercising its discretion the court will consider the same factors as above for specific performance and will use the balance of convenience test (weighing the benefit to the injured party and the detriment to the other party). An injunction will not be granted if its effect would be to compel a party to do something which he could not have been ordered to do by a decree of specific performance (Lumley v Wagner [1852] 1 DM & G 604).

In urgent cases a plaintiff may be able to obtain an interim injunction to restrain an act. Special types of injunction may be granted to preserve property and assets pending trial (Mareva injunctions and Anton Piller orders).

Quasi contract: other remedies

Quasi-contract creates obligations at common law, distinct from obligations under a contract. It is an area of law in its own right.

Quasi-contractual remedies are sometimes available either as an alternative to a remedy for breach of contract or where there is no remedy for breach of contract. For example, a claim for quantum meruit (a reasonable remuneration for work done of goods supplied under a contract which is later discovered to be void).

Limitation of actions

An innocent party will lose his right to bring a claim for breach of contract if he delays for a certain length of time.

The Limitation Act 1980 provides statutory limitation periods. Theses do not apply to equitable remedies, however, in practice, equity usually applies the statutory rules.

The Limitation Act 1980 distinguishes between simple contracts and deeds. It provides the following limitation periods:

  • For simple contracts, six years from when the cause of action accrued.
  • For deeds, twelve years from when the cause of action accrued.

If there has been fraud or mistake, the limitation period does not begin to run until the innocent party has discovered this or should have discovered this. There is a three year time limit in respect of damages for personal injuries arising from breach of contract.

In acquisition agreements (which may be deeds) the seller may want a shorter limitation period (commonly six years from the date of the contract) This shorter period relates to the Inland Revenue's time limit for making tax assessments. Alternatively, the seller may want an even shorter period in relation to non-tax matters (perhaps to link in with the audit of the target company).

Self-help remedies

Rather than bringing an action for breach of contract, parties can make use on some self-help remedies such as retention of title clauses, enforcement of security, withholding payments and set off and rights against the goods themselves.

Retention of title

A seller can avoid the problems of having to sue a buyer in event of the buyer's default under the agreement by inserting a retention of title clause into the contract.

A retention of title clause (sometimes referred to as a Romalpa clause, after the first leading case on the subject, Aluminium Industrie Vaasen BV v Romalpa Aluminium Ltd [1976] 1 WLR 676) aims to give the supplier of goods priority over secured and unsecured creditors of the buyer if the buyer fails to pay for the goods because it is insolvent, or for some other reason which may be specified in the clause.

In a basic retention of title clause the supplier reserves ownership of the goods supplied to the buyer until the buyer has paid for those particular goods. When drafting, it is important to ensure that legal and beneficial title are retained: the reservation of equitable or beneficial title alone will not do (Re Bond Worth [1979] 3 AER 919). The clause should be supplemented by standard clauses containing:

  • A right for the supplier to enter the buyer's premises in order to repossess the goods (so that the supplier will not commit a trespass when doing so).
  • An obligation on the part of the buyer to store the supplier's goods separately from goods belonging to third parties, to mark them as the supplier's property and to allow the supplier access to the buyer's premises to verify that this has been done. This will enable the supplier to identify its own goods if a repossession of the goods becomes necessary.
  • A list of insolvency related events which will trigger the supplier's right to demand payment for the goods (if not already due) and to repossess them.

In addition, although not a standard clause, if the goods supplied might be attached to the buyer's premises (for example, in the case of heavy plant or machinery), it is worth including a provision prohibiting the buyer from annexing them to such premises without the supplier's consent. If goods do become annexed to the buyer's premises, the consent of the owner of those premises will be necessary if the supplier is to be entitled to repossess them in the event of non-payment by the buyer.

This basic clause is often backed up by certain other standard clauses such as clauses for all monies, proceeds of sale and mixed goods:

All monies clause

In this of clause, the supplier reserves ownership of the goods supplied until the buyer has paid not only for those particular goods, but also for any other goods supplied by the supplier to the buyer, and has repaid all other moneys owed to the supplier, regardless of how such indebtedness arose.

A limitation upon the practical effectiveness of this clause is that the supplier retains title to goods only until those specific goods have been paid for. The buyer will therefore obtain title to those goods upon paying for them even if other goods received from the supplier have not been paid for. The effect of the all monies clause is that all of the goods supplied, whether paid for or not, belong to the supplier until the buyer has settled all invoices. In practice, the clause therefore avoids the need to relate specific goods at the buyer's warehouse with specific unpaid invoices.

It has been suggested that an all monies clause creates a charge by the buyer in favour of the supplier, which would be void against a liquidator or administrator and any creditor of the buyer unless registered at Companies House in accordance with the Companies Act 1985. The House of Lords, on appeal from a Scottish decision, has held that such a clause does not create a charge, but the decision, while of strong persuasive authority, is not binding on the English courts (Armour v Thyssen Edelstahlwerke AG, PLC, 1990, I(5), 51).

It is therefore advisable to incorporate the all monies clause in a separate sub-clause from the basic retention of title clauses so that it could be severed from them if it were ever held invalid by a court for lack of registration as a charge. Although possible in theory, the registration by a supplier of all its sales contracts at Companies House in case they contain retention of title clauses which create charges is, for a number of practical reasons, unlikely to be a realistic option.

Proceeds of sale clause

This is where the goods supplied are to be sold on by the buyer and the supplier seeks rights in the proceeds of sale in order to satisfy the purchase price of the goods.

A clause giving the supplier rights over the sale proceeds of goods resold by the buyer was held to be valid in the Romalpa case, on the basis that there was, on the facts before the court, a fiduciary relationship between the buyer and the supplier, and the buyer as a fiduciary was under a duty to account for the sale proceeds to the supplier as beneficiary. Since the Romalpa decision, the courts have distinguished the facts of the cases before them from the facts in the Romalpa case, and have in a series of cases held that clauses of this kind create a charge by the buyer in favour of the supplier which will be void if not registered at Companies House.

As a result, it is now extremely difficult, if not impossible, to draft a proceeds of sale clause without its being construed as a charge over the goods which will, therefore, be unenforceable unless registered as such. One of the main difficulties in practice is that, in order to rely on the equitable remedy of tracing, the supplier must create a fiduciary relationship with the buyer and, in order to achieve that, the buyer must resell the goods as the supplier's agent. This would mean the buyer's customers holding the supplier directly liable for any defects in the goods, which is unlikely to be desirable from the supplier's point of view. If, on the other hand, the authority of the buyer as agent is cut down, so that it cannot create privity of contract between the supplier and the buyer's customers, the result is that there is unlikely to be a true agency.

The inclusion of a proceeds of sale clause in standard terms is inadvisable without specialist advice or a thorough review of the latest relevant case law. It has been argued that if a court were to hold that the proceeds of sale clause created a charge which was invalid for non-registration, it might also decide that the invalidity of the proceeds of sale clause extended to the basic retention of title and all monies provisions, with the result that they too would be rendered invalid for non-registration. It is considered more likely that, if the proceeds of sale clause is contained in a separate clause or sub-clause and the standard terms contain a severance provision, the court will sever the proceeds of sale clause leaving the remaining provisions unaffected, but the need for caution in this area is clear.

Mixed goods clause

This is useful where the goods supplied have been mixed or combined in a manufacturing process with other goods owned by the buyer or third parties. In this clause the supplier seeks rights of ownership in any new product resulting from the manufacturing process.

The supplier may be selling goods for use in a manufacturing process, rather than for resale in their original condition (if, for example, it is a supplier of components rather than finished products). The case law distinguishes between:

  • Goods which maintain their identity (and which, if attached to other goods, can be separated without causing damage). Such goods will continue to belong to the supplier where there is a basic form of retention of title clause as described above, so no additional provisions are necessary.
  • Goods which lose their identity in the manufacturing process; for example, the sale of resin which is used in the manufacture of chipboard. The resulting new product (the chipboard) will belong to the buyer and the courts have held that if a retention of title clause purports to reserve rights in the new goods to the supplier, the clause will create a charge which will be ineffective if not registered (Borden (UK) Limited v Scottish Timber Products [1979] 3 AER 961).

It is clear from the case law, therefore, that the use of a mixed goods clause will achieve nothing for the supplier; on the contrary, it may do harm if (following the same argument as described above in the case of a proceeds of sale clause), its invalidity also rendered the basic and all monies clauses invalid for non-registration as charges. Suppliers of products which are quickly consumed within a manufacturing process should therefore consider alternative means of securing their purchase price, such as credit insurance.

Limitations on effectiveness

The following actual or potential limitations upon the effectiveness of retention of title clauses should be borne in mind:

  • If the buyer is a company against which an application for an administration order has been made, no steps may be taken without the consent of the court (which in practice is unlikely to be forthcoming) to repossess goods supplied pursuant to a retention of title clause until the hearing of the application and, if an administration order is made, while the order remains in force (section 11, Insolvency Act 1986).
  • The retention of title clause must be properly incorporated in the contract between the supplier and the buyer in order to be enforceable as a contract term. A retention of title clause is not, however, so unusual that special notice needs to be given of it (John Snow & Company Limited v DBG Woodcroft & Company Limited [1985] BCLC 54).
  • Retention of title will be of little or no practical benefit where the goods supplied are perishable or have a low scrap value.
  • Retention of title is an area which generates a rapidly changing body of case law. Particular clauses are liable to be rendered ineffective by a court decision at any time, so a review of retention of title clauses is a particularly important aspect of the overall review of standard terms which suppliers should be carrying out on a regular basis.

Decisions of the courts have severely restricted the effectiveness of complex mixed goods and proceeds of sale clauses. The most that a well drafted retention of title clause is likely to achieve for a supplier is:

  • The right to enter the buyer's premises without trespassing.
  • The ability to recover goods stored at the buyer's premises which can be identified as the supplier's, possibly to the extent of all sums owed by the buyer to the supplier.
  • A possible action for damages for conversion against a receiver or liquidator personally who sells goods which were identifiably the supplier's.

A retention of title clause should be regarded as an adjunct to a proper credit control system, not as a substitute for it. Where the supplier has doubts as to the financial standing of the buyer, the supplier should consider:

  • Reducing the period of credit allowed to the buyer, or the amount of credit, or both.
  • Taking alternative forms of security, such as a bank guarantee or letter of credit.
  • Obtaining credit insurance. This has become more readily available in recent years, with a greater choice of tailor-made products on offer. The existence of a satisfactory set of standard terms of business is likely to be a precondition to obtaining such insurance.

Risk and insurance

The risk in the goods will pass at the same time as title to them passes unless otherwise agreed (section 20, SGA). In standard terms of sale risk is usually stated to pass at the time of delivery of the goods. This is on the basis that the supplier will not wish to remain responsible for loss or damage to the goods up to the time when title passes, given that the effect of the basic retention of title clause is that title does not pass until the buyer has paid for the goods. The result is that if the goods are destroyed after delivery the buyer will remain liable for the price.

To guard against the risk of the buyer being unable to pay, the supplier should include a provision requiring the buyer upon delivery to insure the goods with a reputable insurance company (the supplier may reserve a right of pre-approval) and to ensure that the supplier's interest in the goods is noted on the policy.

Taking security

If a lender has loaned money to a person and taken security to support the loan, this enables the lender to appoint a receiver to enforce his security if the person defaults on the loan. Security can take the form of a fixed charge over specific assets or a floating charge over the whole of part of an undertaking.

Withholding payment and set-off

Where a debtor has a cross-claim against a creditor, a right of set-off enables him to reduce or extinguish the creditor's claim by the amount of his cross-claim. There are four types of set-off (the first three of which may be extended by contract):

  • Legal set-off. Legal set-off is a procedural remedy which evolved from the Statutes of set-off and a number of 18th and 19th century cases (see also Bennett v White [1910] 2QB 643 CA). It can only be resorted to as a defence to a court action and, unlike other types of set-off, is not available as a "self-help" remedy. Legal set-off is also only available where the two claims are liquidated or ascertainable with certainty and are both due and payable at the commencement of the action. However, unlike equitable set-off, the two claims do not have to arise from the same transaction or closely connected transactions.
  • Equitable set-off. This is available to a debtor outside the context of litigation where his cross-claim arises from the same transaction (or a closely related transaction) as the debt owed. Either and probably both of the claims may be for an unliquidated sum, such as a claim for damages (Hanak v Green [1958] 2 All ER 141 CA and McCreagh v Judd [1923] WN 174 DC). As it is a self-help remedy, a debtor can, without formality, simply deduct the amount of his mutual cross-claim from the debt he owes and tender the balance of the debt (if any) to the creditor. However, as with legal set-off, the sums in question must be due and payable or, in the case of unliquidated damages must be a reasonable assessment of the loss made in good faith (The Nanfri [1978] Lloyd's Rep 132 CA).
  • Banker's set-off. Banker's set-off arises in a situation where a customer has more than one account with his bank, at least one of which is in debit and one of which is in credit. It is also known as the right to combine accounts. Banker's set-off is arguably of wider commercial application and could be available in any situation where one party has two or more accounts with another, for example between principals and their agents or between a supplier and his customer, but the position has not been explicitly judicially determined. A debtor can only invoke banker's set-off if the two accounts are current or running accounts, that is, where the balance on the account, whether it be positive or negative, is payable on demand or on reasonably short notice (Re Willis, Percival & Co ex parte Morier [1879] 12 ChD 491 CA). As with equitable set-off, the remedy is one of self-help and can be automatically exercised without formality.
  • Insolvency set-off. While each of the above categories of set-off may be varied by contract, either by extending or restricting a party's rights under the general law, the rules of insolvency set-off are mandatory and may not be varied by contract (Halesown Presswork and Assemblies Ltd v Westminster Bank [1972] AC 785). Contractual rights of set-off do not survive the liquidation or bankruptcy of either the creditor or the debtor.

Any creditor proving in a liquidation or bankruptcy must deduct from his claim the amount of any liabilities incurred:

  • Prior to the company or individual going into liquidation or bankruptcy.
  • At any time when the creditor had notice of either a resolution or a petition to wind up the company or bankrupt the individual.

All liabilities, including future, contingent and unliquidated sums must be brought into account (Rule 4.90, Insolvency Rules 1986 for company liquidations; section 323, Insolvency Act 1986 for bankruptcies).

Since any attempt to vary these rules by contract will be void, parties would need to use indirect means to avoid their application. They could, for example, enter into an agreement which provides that one or both of them should not prove in any liquidation or bankruptcy of the other or that any such claims will be subordinated to those of other creditors.

Rights of set-off are frequently varied by the terms of a contract. For example, in a commercial contract, a buyer may want the ability to set-off claims for debts or claims under other contracts against payments that he owes for goods or services under that contract.

Purpose of exclusion of set-off clause

Commercial agreements frequently restrict rights of set-off. For example, a seller may wish to ensure that a buyer is prevented from setting off amounts owed to it or claims regarding alleged defects in the seller's performance against the sums due to be paid by it to the seller under the agreement. An exclusion of set-off rights is particularly common in an agreement which provides for payments over a period of time. A borrowers' right of set-off will invariably be excluded in loan and security documentation.

While such a clause does not survive the insolvency of either party, the Court of Appeal has confirmed that such a clause is enforceable and not contrary to public policy (Coca-Cola Financial Corporation v Finsat International, The Times, 1st May, 1996). However, as against a party contracting on its standard terms or with a consumer, the clause constitutes a limitation of liability which will be subject to the reasonableness test set out in the Unfair Contract Terms Act 1977 (Stewart Gill v Horatio Myer Co [1992] 2 All ER 257).

SGA and rights against goods

The SGA provides for the consequences of disputes arising in contracts for the sale of goods. For example, if a seller delivers a quantity of goods less than he contracted to sell, the buyer can either:

  • Reject the goods and sue for any loss occasioned by the breach, and if the price had been paid, recover the price; or
  • Retain the goods, pay for them at the contract rate, recover such part of the price for the undelivered quantity and claim damages for the breach.

There are restrictions on the buyer's right to reject the goods. First, at common law, if the shortfall is de minimis, he will not be allowed to reject the goods. Second, section 30(2A) provides that a buyer who does not deal as a consumer may not reject the goods if the shortfall is so slight that it would be unreasonable for him to do so.

If a the buyer is in breach of a term of a sale of goods contract, for example in relation to the payment terms, the unpaid seller has rights against the goods themselves in addition to rights against the buyer. These rights may prove useful on the buyer's insolvency. If some or all of the price of the goods is outstanding the seller will be an unpaid seller (section 38(1), SGA). This gives the seller the right to:

  • Retain the goods. This can be done if the seller is still in possession of the goods and the buyer has not been given a period of credit, or the credit period has expired or the buyer is insolvent. The seller can retain the goods until the buyer pays for them (the seller's lien). The seller loses his lien when the goods are delivered to an independent carrier or the buyer lawfully takes possession of them.
  • Stop the goods in transit. If the buyer is insolvent the unpaid seller may stop the goods in transit and retain them until the buyer pays for them (section 44). Sections 45 and 46 provide rules as the duration of transit and how to effect stoppage.
  • Resell the goods. Section 48(3) allows the seller to resell the perishable goods if he notifies the buyer of his intention to sell and the buyer does not pay within a reasonable time. The seller may claim damages from the buyer for loss on the resale (section 48(3)).

Samantha Cotton is a PLC trainer.

Cumulative remedies clause

"The rights and remedies provided by this Agreement are cumulative and (subject as otherwise provided in this Agreement) are not exclusive of any rights and remedies provided by law."

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