An update on ‘set-off’: Employer’s right to deduct against different project elements

Earlier this year, The Technology and Construction Court (TCC) ruled in Shepherd Construction Ltd v Drax Power Ltd [2021] EWHC 1478 (TCC) that the Employer was entitled to make deductions from a final milestone payment for the second of two project elements in respect of defects arising in the first project element, regardless of the first project element having already been completed.

Background

Drax (Employer) and Shepherd (Contractor) entered into a FIDIC Yellow Book 1999 for Shepherd to design, engineer, install, and commission an 'Ecostore' facility for the unloading of biomass fuel from rail wagons and the subsequent handling and storage of that fuel, together with a conveyor system for transporting the fuel to a boiler distribution system (the "Ecostore Works"). The contract was varied several months later to include a second project element, involving the design, engineering, installation, and commissioning of a boiler distribution system to convey the fuel from the Ecostore to silos for intermediate storage, and then to the mills from which the boilers were to be fed (the "BDS Works").

Taking Over Certificates were issued for the Ecostore Works in September 2014 and the final Milestone Payment (which included retention monies) was paid on 31st December 2014.

The Taking Over Certificate for the last part of the BDS Works was issued in July 2017 and the Defects Notification Period in relation to those works expired in July 2018. In February 2019 Shepherd made an Interim Payment Application seeking payment of the balance of the retention money in respect of the BDS Works. However, Drax sought to make deductions for the cost of remedying defects in the Ecostore Works. As such, a dispute arose.

Complications

The court had three issues to consider/determine:

• Whether the correct interpretation of the contract allowed sums due for the remedying of defects in the Ecostore Works to be withheld from the retention money relating to the BDS Works.
• Even if the contract did not provide such a right of withholding, whether Drax could withhold sums relating to the defects in the Ecostore Works by way of set-off or abatement.
• Whether the Interim Payment Application was a valid application under the contract.

Outcome

Complication 1

the court considered the wording of the contract in respect of the Retention Bond, which said:

"14.9.3 However, if any work remains to be executed under Clause 11 (Defects Liability) or Clause 12 (Tests after Completion), the Employer shall be entitled to withhold the estimated cost of this work until it has been executed and to deduct the same from amounts otherwise due to the Contractor until such time as the work is completed."

The court held that with no qualification as to what "any work" meant, Drax was correct in its interpretation of the contract that "any work" included work necessary to remedy defects in the Ecostore Works as well as the BDS Works. In reaching this decision the court determined that Shepherd could have made it expressly clear what works were or were not included in the contract, but they had not. The court further considered that despite the parties agreeing that the works were for two distinct project elements, there was still only one contract.

Complication 2

Drax argued that even if clause 14.9.3 did not allow it to withhold sums for defects relating to the Ecostore Works from the retention monies in respect of the BDS Works it still was entitled to make the deduction by way of legal set-off, or equitable set-off, or by a common law right of abatement.

The court disagreed, based on its interpretation for Issue 1, and held that the effect of the contract was the relevant rights of set-off were limited rather than excluded. As the contract already allowed for the deduction of retention money (as determined in Issue 1), there was not an exclusion of Drax's right of equitable set-off but that such a right did not arise in the first place.

Complication 3

Drax argued that the Interim Payment Application was not valid because it failed to take into account claims and deductions which Drax had already asserted and which Shepherd should have considered. In order to be valid, Drax submitted that the payment application should have been limited to the balance remaining after its claims and deductions had been subtracted.

The court disagreed and reviewed what the correct payment process was under the contract. The court held that Shepherd was not limited to seeking payment of the amount which Drax considered was due. The remedy for Drax, if it believed a lesser amount was due, was to serve a pay less notice and any resulting dispute could then be resolved by way of a determination.

Thinking ahead

We consider that the court's decision places great emphasis on the importance of expressly setting out what can or cannot be done within a contract. In particular for relating to projects with multiple elements: drafting relating to payment, retention and the rights of withholding must clearly set out whether sums can or cannot be set-off from one element of works to another.

It is somewhat surprising that Drax could not rely on the general rights of set-off and abatement. We consider that those general rights would remain unless they were expressly excluded. Even if the contract was silent as to general rights (as was the case here), but contained provisions for the withholding of sums, we would (prior to this case) have considered those general rights to still be available. Therefore, this decision further reiterates our above comment that it is good practice to expressly set out the position within the contract.