A set-off is the subtraction or taking away of one demand from another opposite or cross-demand, to distinguish the smaller demand and reduce the greater by the amount of the less; or, if the opposite demands are equal, to extinguish both. Set-off, broadly speaking, means ‘stoppage’, much because the amount due to be set off is stopped, or, is deducted from the cross-demand. Typically, a set-off clause is seen in loan agreements between lenders and borrowers. They are also used where there may be a risk of default in payment. Often, one of the parties will utilise the set-off provision to lower or mitigate its liability to the other party. In such cases, a set-off clause is associated with the mutual settling of debt between parties by setting off their claims against one another.

Set-off under Indian Law

Indian laws prescribe two kinds of set-off: equitable set-off and legal set-off. Legal set-off is envisaged under Order VIII Rule 6 of the Code of Civil Procedure, 1908 (CPC). Under the Rule, for a legal set-off of claims, there are certain pre-conditions that require to be satisfied. Firstly, in a suit for recovery of money, the claim sought to be set off must be legally recoverable by the claimant. Secondly, such sum of money must be ascertained. Thirdly, the parties must fill the same character with respect to the claims sought to be set-off in the defendant’s suit as they fill in the plaintiff’s suit. And lastly, the sum to be recovered should not exceed the pecuniary jurisdiction of the court. In addition to the provisions of the CPC, the concept of set-off also finds a mention in the Indian Contract Act, 1872 (ICA), under the context of ‘right to lien’.

Section 171 of the ICA discusses the right to lien exercised by bankers, factors, wharfingers, attorneys and policy brokers. Section 171 grants to the aforesaid categories of persons, a right to retain as security, any goods bailed to them, in the absence of a contract to the contrary. The Punjab High Court has distinguished between the right to set-off and the right to lien in a case, wherein it was held that, “the banker’s right to lien is the right to retain one’s possession over belongings of another until certain demands of the person in possession are satisfied, for the repayment of debt, whereas, the right to set off means right of combination of several accounts, when a customer maintains more than one type of account in the bank, when the creditor has defaulted in making payment.”

Equitable set-off on the other hand, is independent of the provisions of law. It stems from the basic principles of equity, justice and good conscience. Equitable set-off cannot be claimed as a matter of right, but it depends entirely upon the discretion of the court adjudicating any such dispute.

Set-off in the absence of a contractual obligation

The English Court of Appeal examined the scope of set-off in an agreement which did not expressly provide for it in the 2010 case of Geldof Metaalconstructice v. Simon Carves Ltd. In the Geldof case, the Defendant Simon Carves, was a contractor engaged in the purchase of pressure vessels and installation of storage tanks. Geldof offered to provide both the services, and to this extent, a supply contract (which included a right to set-off) as well as an installation contract (which did not include a right to set-off) was executed. Simon Carves subsequently claimed breach of the installation contract and on account of such breach, failed to make payment to Geldof under the supply contract. Thereafter, Geldof refused to complete work under the installation contract sighting non-payment under the supply contract.

The issue before the Court of Appeal was to examine whether “the contractual right to set-off under the supply contract can be claimed under the installation contract as well.” The Court of Appeal used the test of “inseparable connection” between the two transactions and ruled that Simon Carves was entitled to obtain an equitable set-off to the extent of the counterclaim under the installation contract, because the set-off clause in the supply contract was for setting off “any other amounts lawfully due”. The Court held, relying upon the set-off clause in the supply contract, that Simon Carves was entitled to its counterclaim. Additionally, it also held that even in the absence of a set-off clause in the supply contract, they would be entitled to the claim by applying the principle of equitable set-off.

Prior to the Geldof case, the position of equitable set-off was discussed by Lord Denning in Federal Commerce & Navigation Co. Ltd v Molena Alpha Inc (famously known as The Nanfri) , wherein it was held that the right to equitable set-off stems from two closely related transactions, and that there must be a common connection between the two.

Thus, even without an express contractual provision, the law of equitable set-off can be used to aid parties to the contract but, whether such set-off is applicable would still be judged on the facts of the case.

Set-off in M&A and PE

The provisions pertaining to set-off and counter claims are hotly debated in all mergers & acquisitions (M&As) and private equity (PE) transactions.

They become most relevant where an acquisition or an investment is made in tranches, meaning thereby that all of the amounts to be paid by the purchaser or the investors, are not paid upfront. All M&A and PE transactions contain provisions whereby the sellers provide representations and indemnities to the purchaser against such purchase/ investment amount.

The question therefore arises: What happens when the purchaser or investor has a multi-million-dollar indemnity claim against the sellers, and where there is a payment due to be made by the purchasers/ investors to the sellers at the same time, for the next tranche? No purchaser or investor wants to be seen making a large indemnity claim while at the same time being forced to pay a large sum of money for the next tranche. It almost seems unconscionable. Equally, the sellers will argue that the mere raising of an indemnity claim, especially one that has not been crystallised, should not deprive the sellers of their next tranche payment which is lawfully due to them. This is usually where parties reach an impasse. Neither party is wrong.

So realistically, what are the options?

If you are the seller:

Suggest that the next tranche be put into escrow until such time that the indemnity claim is settled. This way neither the seller nor the purchaser/ investor has the benefit of the escrowed money. The thinking behind this is that it will prevent a purchaser/ investor from making a frivolous indemnity claim.

Seek interest. If the indemnity claim is decided in favour of the seller, the purchaser/ investor should be made liable for interest at a reasonable rate.

This prevents the seller from losing out on the time value of money.

Allow for the set-off only against pre-identified specific indemnities or once the liability is crystallised. While this is the ideal position for the seller to be in, this will likely make the purchaser/ investor nervous and for the purchaser/ investor, it becomes a matter of risk assessment.

If you are the purchaser/ investor:

Keep an open right to set-off for all claims against tranches payable in the future to the sellers. This is the most ideal situation to be in. However, this is unlikely to be agreed by the sellers.

Retain the right to set-off where you foresee the most liability arising. For e.g. if your target is involved in financial services, you may want to retain the right to set-off only for tax claims. If your target is a medical services or pharmaceutical company, you may want to retain the right to set-off only for non-compliances pertaining to licenses and malpractice claims.

Agree the thresholds for set-off. No one wants to get into a battle over small claims. Agree that the right to set-off will become applicable only where the claim is large enough to give the purchaser/ investor sleepless nights.

Make a risk assessment. Go back to the drawing board and speak to your advisors. Did your legal, financial or other technical diligence result in findings of any major non-compliances that could result in heavy liabilities in the future? If your target is relatively clean, and you are comfortable that the target is professionally run, you may agree to remove the right altogether. Remember, if your agreement is silent on the right to set-off, you may still be entitled to claim an equitable or legal set-off, if you fulfill the necessary requirements. While this may not be the best position to be in, it is a right, nonetheless.

Conclusion

With the rise in the number of M&A and PE transactions, it becomes critical to identify ways to protect the interests of the sellers as well as the purchaser/ investor, at the same time. Where the value of the transaction is high, a set-off mechanism sometimes proves critical to protect the interests of the purchaser/ investor.

Pritha Jha is Partner and Pavana Padmakumar is Associate at Pioneer Legal.

Disclaimer: This article is meant for informational purpose only and does not purport to be advice or opinion, legal or otherwise, whatsoever. Pioneer Legal does not intend to advertise its services through this article.

First Published:Sept 25, 2019 6:00 AM IST