December 11, 2006

Set-Off in Construction Contracts

Whenever a dispute arises on a construction project, the parties invariably claim a right of set-off. To what extent are such claims permissible?

Set-off is a familiar concept in the construction industry: it allows a debt owed by one person or company to another to be reduced, or offset, by the amount of a debt owed in return. However, there are limitations on when such a legal set-off will be allowed. The debts must be mutual, and they must be for sums of money that can be established with certainty as a matter of arithmetic, or what the court refers to as “liquidated” sums. In situations where the requirements for a legal set-off are not met, parties may be able to rely on the doctrine of equitable set-off, which does not require that the debts be mutual, nor that the debts be for liquidated sums.

The right to an equitable set-off arises when a defendant’s cross-claim is so clearly connected with a plaintiff’s demand that it would be unjust to allow the plaintiff to enforce his demand without taking into account the defendant’s cross-claim. In the construction industry, this often arises when a contractor (or subcontractor) seeks to enforce a demand for payment, and the owner (or contractor) sets off against that demand its own claim, generally for delay or for construction deficiencies.

A well-known B.C. case involving equitable set-off in the construction industry is Swagger Construction Ltd v. University of British Columbia. In that case, UBC hired Swagger Construction to build the Forest Sciences Centre. At substantial completion, Swagger brought an action for payment with respect to the 33rd Progress Certificate. The Court allowed UBC to set off against this payment its own claim in damages against Swagger, for delay and for the cost of correcting deficiencies and completing the work.

In reaching its decision, the Court ruled that one party to a construction contract has the right to defend, by way of equitable set-off, against the claims of the other party. The Court further noted that this would generally constitute a claim for contract monies on the one hand, and a claim for damages for poor workmanship or delay, on the other.

The right of equitable set-off exists as part of a construction contract unless it is specifically excluded by the parties. However, the recent Ontario case of Armenia Rugs/Tapis Ltd. v. Axor Construction Canada Inc. demonstrates that the right of equitable set-off has limits. Specifically, a contractor is not entitled to set-off, against progress payments owed to a subcontractor, amounts claimed as damages against the contractor by a third party.

The facts of the Axor case are as follows. Axor Construction was the general contractor hired by Public Works Canada to construct additions to the RCMP building in Ottawa. Armenia Rugs was one of Axor’s subcontractors, hired to install ceramic tiles on the exterior, and part of the interior, of the addition. Armenia worked on the job site for approximately two and a half months without being paid any progress payments, at which point it gave notice that it was terminating the contract and sued for payment.

While Armenia and Axor were attempting to resolve this dispute, the Labourer’s International Union gave notice to Axor that it was claiming $40,000 in damages, alleging that one of Armenia’s subtrades, Best of Best Tiles, had hired non-union labourers. Armenia’s contract with Axor required it to employ only unionized labourers, and required it to “indemnify and hold harmless Axor from any claims against it for damages, losses, and expenses, etc. arising out of the performance of the subcontractor’s work.” Axor informed Armenia that it was going to set off the amount of $40,000 against any progress payment made to Armenia, until the claim by the Labourer’s Union was resolved.

The court found that Axor was not entitled to set-off the amount of $40,000, and to withhold payment of this sum from Armenia’s progress payments. The Court provided several reasons for its decision.

First, the $40,000 damages claimed by the Labourer’s Union was an arbitrary amount, unsupported by reliable objective evidence. In fact, the Union’s claim was eventually settled for only $5,000. The court found that it would not be fair or reasonable to allow a third party such as the Union to determine arbitrarily what amounts could be held back from a subcontractor. Second, it was not clear whether the Union’s claim against Axor had any merit.

No evidence had been produced to show that the Union’s claim had any chance of success. Finally, the claim for damages was made by a third party, and was not a claim for construction deficiencies or damages for delay involving the two parties to the contract, Axor and Armenia.

The Court found that it would be “manifestly unfair” to allow a general contractor to withhold, from a progress payment to a subcontractor, the full amount of any claim for damages made by a third party, where the merits of the third party damage claim had not been established, and where the amount withheld had not been determined based on reliable objective evidence.

Owners and contractors generally have a right to equitable set-off. Ultimately however, the nature of the claim and the wording of the contract will determine to what extent a right of set-off will be allowed by the courts.

Christopher Hirst and Norman Streu are partners within the construction and engineering practice of the Vancouver law firm, Alexander Holburn Beaudin & Lang LLP. Norm Streu is also past chair of the Vancouver Regional Construction Association. This column was prepared with the assistance of Megan Nodwell, articled student with AHB&L LLP

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