By: Christopher C. Broughton Associate, Jones Walker LLP.
Introduction
The right to offset refers to the common sense ability to reduce or eliminate your payment obligations to a party who owes you money on another contract. With offsets, common law largely tracks common sense. The right of offset is recognized by statute and court decisions in many states as well as under federal law and the U.S. Bankruptcy Code. The right to offset can also be established in the contract or subcontract.
These variations may not be obvious or intuitive, but they have a tremendous impact on your right to get paid or your right to withhold payment. Because of the variations, you must always confirm the law applicable to your contract or subcontract, which may not be where the project or you are located.
The Right to Offset – A State by State Approach
Offset may come into play on any level of payment on a project, from owner to contractor, to contractor to sub, and down to sub-sub to a supplier. As a practical matter, however, the assertion of rights of offset or objections to them come most often at the contractor-sub interface.
States have taken different approaches to the right of offset. Although the right to offset is now codified into statute in many states, the common law right to offset was originally recognized through a court decisions. The history of the right to offset can be traced through American courts back to England.[1] As the Supreme Court of Connecticut stated, “The right of set-off of mutual debts was a doctrine of courts of equity, which came to hold that mutual debts should be set off against each other and only the balance recovered.”[2] The point of the right of offset is ‘to avoid a circuity of action’ and preventing ‘the absurdity of making A pay B when B owes A.’[3]
Other states, like California, have limited the right to offset through a court decision. Under California law, the prime contractor must pay its subcontractor within 10 days of receiving retention payments from the owner.[4] The contractor is excused from timely paying its subcontractor only if the contractor has a “good faith basis” for disputing the subcontractor’s right to receive the payment.[5] In United Riggers & Erectors, however, the California Supreme Court interpreted the “good faith” exception to that the dispute between contractor and subcontractor had to be over the scope of work to which the withheld payment related, and that the contractor cannot withhold payment on a “good faith” basis due to “[c]ontroversies concerning unrelated work or additional payments above the amount both sides agree is owed will not excuse delay.”[6]
Other states have written the right to offset into statutes. Georgia includes an entire chapter in its state code detailing the right to offset, the ins and outs of offset and recoupment, and any limitations on offset.[7] However, some states are very hostile to the right to offset. Recently, the state of Virginia expressly prohibited the right to offset in private construction projects. Any contractual clause allowing the right to offset was “void as against public policy.”[8]
Contract Clauses
Rather than strictly relying on existing state law, owners or contractors often eliminate doubt about the right to offset by including a contract clause that expressly authorizes the owner or contractor to withhold payment on the current contract to cover its costs, damages or liability incurred as a result of the contractor or subcontractor’s acts or omissions on another project.
An example of a typical contractual right to offset clause is as follows:
Contractor, without waiver or limitation of any rights or remedies of Contractor, shall be entitled from time to time to deduct from any amounts due or owed by Contractor to Subcontractor, in connection with this subcontract (or any other contract with Contractor), any and all amounts owed by Subcontractor to Contractor or owner in connection with this Subcontract.
Generally, a contract clause that clearly authorizes or prohibits offset will be enforced. However, a clause authorizing offset will be overridden by a state statute, if the statute expressly states that such clauses are prohibited and unenforceable.
Again, it is critical to know the state law that controls the contract or subcontract.
Construction Trust Fund Statutes
You must also know whether a construction trust fund statute controls payments under the contract or subcontract. While a construction trust fund statute may not expressly prohibit the right to offset, it creates a scheme that may effectively prohibit the exercise of an offset.
Construction trust fund statutes create a “trust fund” of money paid by the owner to the contractor or by the owner or contractor to a subcontractor on the project. The contractor is then required to pay subcontractors, suppliers and the like from the funds held in trust. The contractor who holds the funds in trust owes fiduciary obligations to act in the best interest of the trust’s beneficiaries, the subcontractors, suppliers, materialmen and others. Trustees may be subject to civil liability, civil penalties, and in some states, like Michigan, criminal liability for violations of the trust fund statute.[9] There are at least 15 states that have construction trust fund statutes, including Maryland, New York, and Texas.
The Texas Property Code defines the funds included in a construction trust as follows:
Construction payments are trust funds under this chapter if the payments are made to a contractor or subcontractor or to an officer director, or agent of a contractor or subcontractor, under a construction contract for the improvement of specific real property in this state.[10]
The Texas construction trust fund statute also includes the loan receipts of the owner, contractor, or subcontractor if the funds were borrowed to improve the property, and the loan is secured by a lien or mortgage on the property.[11]
The contractor, subcontractor, company agent, director or owner who receives the funds or directs the payment of the funds is considered the trustee. Additionally, some states include any party who works on or furnishes supplies for the project as a beneficiary of the trust. For example, Texas’ construction trust fund statute defines the beneficiaries as any “artisan, laborer, mechanic, contractor, subcontractor, or materialman who labors or who furnishes labor or material for the construction.”[12]
The construction trust fund blocks a contracting party’s right to offset because the trust fund requires that the funds received by the contractor from the owner on the specific project are paid through to the subcontractors and suppliers on that specific project. However, there are some states, such as Colorado, that will allow a contractor or subcontractor to offset notwithstanding its trust fund statute if the claim was “in good faith.”[13]
Federal Government Contracts
The federal government is the largest procurer of construction services, and it is no surprise that federal law recognizes the government’s common law right to offset.[14] The federal government’s authority to offset funds is also codified in the Federal Acquisition Regulations, the Bankruptcy Code and other federal rules and regulations.
Federal contracts are subject to an extensive and intricate statutory and regulatory framework that strictly limits the government’s ability to exercise its rights of setoff, including, the Contract Disputes Act. Under the Contracts Disputes Act, the government’s contracting officer is required to render a formal contracting officer’s final decision before any setoff can be asserted. In Raytheon v. United States, 105 Fed. Cl. 236 (Fed. Cl. 2012), the government’s offset claim failed because the government did not comply with the Contract Disputes Act requirements.[15]
Once the government has met the requirements of the Contract Disputes Act for the government’s claim, the contractor’s appeal and challenge to the government’s claim does not stop collection through offset. Instead, the government’s right of offset can be expanded to other contracts with the same government agency and ultimately extend to all federal agencies and the full weight of the U.S. Treasury Department for collection.
Additionally, there are other considerations in play in federal projects where the surety steps in for the obligations of its principal. There are federal court cases where a court has found that the surety’s obligations under the Miller Act supersede or limit its contractual right to offset. In United States ex rel. Acoustical Concepts, Inc. v. Travelers Cas. & Sur. Co. of Am., 635 F. Supp. 2d 434 (E.D. Va. 2009), the surety was prevented from exercising its contractual right to offset against the subcontractor for damages arising out of an unrelated non-federal project.[16] The subcontractor sued the surety under to recover against the Miller Act payment bond for funds due on the federal project. The surety offset payments on the federal project against the funds due on an unrelated, non-federal project, which was expressly allowed in the subcontract. The court prevented the surety from doing so because allowing a surety to offset in a suit on a payment bond “would result in a situation directly contrary to the Miller Act’s purpose of providing an expeditious remedy to subcontractors on federal construction projects.”[17]
Conclusion
While the right to offset is itself a simple concept,
different contractual clauses, state laws, and federal regulations can make the
right to offset very complex and prone to unpleasant surprises. To stay out of
trouble and be aware of your rights, you should know variations, limitations or
prohibitions to the general offset principles under the state or federal law
controlling your contract or subcontract.
[1] Bandy v. First State Bank, 835 S.W.2d 609, 618 (Tex. 1992).
[2] Sullivan v. Merchants’ Nat’l Bank, 108 Conn. 497, 498 (Conn. 1928)
[3] Brickley v. Wrenn, 252 Mass. 16, 21, 146 N.E. 797, 798 (Mass. 1925)(quoting Studley v. Boylston Nat’l Bank, 229 U.S. 523, 528, 33 S.Ct. 808 (1913)).
[4] Cal. Civ. Code § 8814(a).
[5] United Riggers & Erectors, Inc. v. Coast Iron & Steel Co. (2018) 4th Cal. 5th 1082, 1085.
[6] Id.
[7] See O.C.G.A. § 13-7-1 et seq.
[8] Va. Code. Ann. § 43-13.
[9] Mich. Comp. Laws § 570.152.
[10] Tex. Prop. Code § 162.001(a).
[11] Id.
[12] Id. § 162.003(a).
[13] C.R.S. § 38-22-127(2).
[14] United States v. Munsey Trust. Co., 332 U.S. 234, 239 (1947).
[15] Raytheon, 105 Fed. Cl. at 298 – 99.
[16] Acoustical Concepts, Inc., 635 F. Supp. 2d at 440.
[17] Id.
The views expressed in this article are not necessarily those of ConsensusDocs. Readers should not take or refrain from taking any action based on any information without first seeking legal advice.