What if We Just Call It Even?: The Right to Offset Debts from One Project Against Monies Owed on Another

Relationships often dictate the award of construction contracts, with owners doing multiple projects with the same contractor and contractors using their preferred subcontractors on multiple projects.  While this allows for some predictability, it can create sticky scenarios where a party owes money on one project while being owed money on another.  Although this is happening with frequent occurrence, the permissibility of offsetting debts from one project against monies owed on another is surprisingly opaque and the legal landscape has changed significantly in recent years.  There is no consensus among states on how to navigate this common situation, with some states specifically allowing and others specifically prohibiting the practice.  Additional factors such as the existence of a bond or a subcontractor’s bankruptcy play major roles in whether there is a right (or lack thereof) to offset.  Nonetheless, even in those states where there is no clear answer, parties may be able to look to background principles and codified rules from other contexts for guidance.

From Constantinople to Your Construction Project: A Brief History of Setoff

The right of setoff has an ancient pedigree.  Roman law, as set out in Justinian’s sixth-century Corpus Iuris Civilis, established the right of a creditor to set off an outstanding debt before paying the creditor’s own debt.  That principle avoided the earlier, more tedious practice of requiring two suits by the parties, each seeking full payment of his own debt.  But early English courts eschewed the simplicity of setoff, arguing instead that a formalistic, multi-suit approach was necessary.  It was bankruptcy cases that caused English equity to alter course, as judges were uncomfortable forcing a creditor to pay back a debt in full to a bankrupt company and receive only a portion (if anything) back to settle the bankrupt company’s debt. Eventually, the English gave in and permitted setoff in a number of situations by law and equity.

American colonists were quicker than their English compatriots to adopt the theory—particularly because of the high cost of lawyers and a multiplicity of “Vexatious Suits . . . brought by troublesome and litigious Persons.”  (Fortunately, such days are behind us.)  Virginia enacted the first setoff statute in 1645, and Pennsylvania and New York followed suit.  If a plaintiff sued, the defendant was able to show evidence that the plaintiff owed money and deduct that amount from that demanded in the case.  New Jersey even required setoff: if the defendant did not attempt to deduct the debt, he would be estopped from ever collecting it.  Setoff became a recognized concept in the United States, and the Supreme Court would come to describe it as the common right “which belongs to every creditor, to apply the unappropriated moneys of his debtor, in his hands, in extinguishment of the debts due to him.”  As a result, setoff is a background principle in modern American jurisprudence.  Nevertheless, in our patchwork system of law, different jurisdictions have taken different approaches against that presumption.

Federal Rules for Setoff

The federal government takes full advantage of the common law right of setoff.  The rule is applicable for federal projects, and if payment of an outstanding contractual debt is not made to the government within thirty days, the federal government will begin withholding payments on other contracts to offset the debt.  The federal government’s power to offset debts owed includes the ability of federal agencies to setoff tax overpayments as well.  And in keeping with the right of setoff’s historic roots in bankruptcy proceedings, the Bankruptcy Code also acknowledges (rather than establishes) a right to setoff in 11 U.S.C. § 553.

It is important to note, however, that setoff may not be allowed on a federal bonded project for debts owed on a non-bonded project.  An Eastern District of Virginia case, United States ex rel. Acoustical Concepts, Inc. v. Travelers Casualty & Surety Company of America, 635 F. Supp. 2d 434 (E.D. Va. 2009) held that—regardless of a provision allowing for setoff in the subcontractor’s contract—setoff was not permitted in a bonded project for non-bonded project debts of the subcontractor because to allow it “would result in a situation directly contrary to the Miller Act’s purpose of providing an expeditious remedy to subcontractors on federal construction projects.”

Some States Take Exception to Setoff—Even to the Point of Jail Time or Personal Liability

Despite the Supreme Court’s encompassing description of the right of setoff and the federal government’s adoption thereof, several states have rejected the idea, at least in the construction context.  Virginia, the pioneer of setoff, has gone so far as to bar “any contract or subcontract provision that allows a contracting party to withhold funds due under one contract or subcontract for alleged claims or damages due on another contract or subcontract [a]s void as against public policy.”  Under revisions to its law passed last year, a general contractor or subcontractor is even provided a civil cause of action to recover offset debts.  Other states barring setoff include Florida (which allows parties to contract for setoff but criminalizes setoff if done outside of statutory exceptions) and California (which nonetheless allows for recoupment).

A number of other states use the construction trust fund model, whereby the money paid by the owner to a contractor or by an owner or contractor to a subcontractor is held in trust for the subcontractors who worked on the project.  Any use or retention of those funds other than to pay the subcontractors for the work done on the project may expose the trustee’s officers, directors, and managing agents to personal liability.  Because retention of trust funds to pay off debts for disputes on the subcontractor’s other projects will be considered a violation of the trustee’s duties, these trust fund statutes also work as functional barriers to setoff rights.

Therefore, while a number of states permit setoff by common law, equity, or statute, it is important to review state law to determine whether a contractor can rely on a common law, equitable, or statutory right, whether a contractual clause is necessary (although it is always preferable), and whether state law will void setoff provisions or will establish a construction trust fund.  Presently, with the exception of Vermont (which has a construction trust fund statute), the New England states appear to permit setoff.  Several New England states (Connecticut, Maine, and Massachusetts) do have Prompt Pay Acts affecting private contracts, however, which are further explored below.

Prompt Pay Act—The New Frontier for Setoff Disputes

A recent trend among states has been to adopt “Prompt Pay Acts,” which provide statutory requirements for owners and contractors to make payments and often override contractual agreements.  One such requirement is the prompt release of payment to a requesting contractor or subcontractor, unless an explanation for a withholding is provided.  For example, Massachusetts’s recent Prompt Pay Act requires any owner, contractor, or subcontractor to provide “an explanation of the factual and contractual basis for the rejection [of a payment request,] . . . certified as made in good faith.”

Whether setoff for preexisting debts is permitted under these new statutes as a “good faith” reason to withhold payment is an open question; the relative newness of the statutes means that there is little case law on the topic.  Maine, for example, made explicit in its statute that its law does not prevent withholding payment for “any good faith claims against an invoicing contractor, subcontractor or material supplier,” and Rhode Island similarly provides an exception to “setoff a payment due to a subcontractor by an amount equal to the amount of an unpaid legally enforceable debt.”  Connecticut has a separate statute establishing the right to setoff debts, but the interaction of it with its Prompt Pay Act remains to be seen.  And Massachusetts merely requires a good faith basis for objection.

An example of the possible complications that might arise in the interplay of Prompt Pay Acts and setoff rights can be found in Arizona.  In Shea Connelly Dev. LLC v. Ariz. Registrar of Contractors, No. 1 CA-CV 19-0718 (Ariz. Ct. App. Nov. 3, 2020), a general contractor attempted to offset the amount owed to a subcontractor with the amount the general contractor had to pay to remedy defective workmanship.  The Arizona Court of Appeals rejected the general contractor’s argument that offset could be used as a defense to a Prompt Pay Act administrative action brought against it: “Neither offset nor recoupment apply in Prompt Pay Act proceedings . . . ,” noting that allowing extrinsic factors outside of the project to be considered would defeat the act’s goal of facilitating fast and efficient processing of payment.  Because the purpose of the Prompt Pay Acts is to send money quickly to subcontractors and the language requiring payment is often absolute, some courts might—like Arizona—decide that the state “has weighed any potential inefficiency in favor of timely payments to subcontractors and material suppliers,” and prevent the setoff.  In that case, they may limit “good faith” bases to recoupment (rather than setoff) claims, or prevent any offset at all.  Other states have made clear that their Prompt Pay Acts do not conflict with pre-existing setoff rights.

Conclusion: Right of Every Creditor or a Vanishing Remedy?

For a right with such a storied legal history, the question of whether setoff is permitted is a surprisingly difficult one to answer.  Setoff has come to be a background principle in American law, but a large number of states have pushed back against that presumption in favor of protecting payments to subcontractors.  To be safe, contractual language permitting setoff should be a minimum protection, but owners, contractors, and subcontractors would be wise to examine whether state law prevents setoff (or voids such contracts, as Virginia does).  If there is a Prompt Pay Act, some statutory safe harbors have been established, but at the least, strict compliance with the law rather than reliance on contractual provisions or common law protection will put the party seeking to exercise its setoff rights in the best position possible.