set-off: a concept divided by a common language? · equivalent here is found in the doctrine of...

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Set-off: a concept divided by a common language?

Lorna Richardson*

This article considers independent and equitable set-off in English law with their functional equivalents in Scots law. The analysis demonstrates that set-off is not a concept divided by a common language. Indeed, there is no doctrine of set-off in Scots law. The functional equivalent of independent set-off is the doctrine of compensation in Scots law. While compensation has many similarities to independent set-off, there are some important differences, principally that compensation has retrospective effect. This has important legal and practical consequences. The functional equivalent of equitable set-off is found in one facet of the doctrine of mutuality of contract in Scots law. This is an aspect of the doctrine that has, to date, been largely ignored but is explored in this article. It is argued that using the term “set-off” in both jurisdictions masks important differences between Scots and English law in this area and

should therefore be avoided.

I. INTRODUCTION

Set-off is of signifi cant practical importance, both nationally and internationally. 1 This is unsurprising, given its practical utility. Set-off allows party B to extinguish, in whole or in part, party A’s claim against B, using B’s claim against A. This means that B need not pay the sum owed to A and, separately, seek payment of the sum owed to him by A. B can simply use the sum he owes A to extinguish his claim against A, with the party owing the higher amount paying over the balance. As such, B need not be out of pocket in the period between paying A and receiving payment from A. Yet, despite

* Lecturer, University of Edinburgh. My thanks go to Professors Clive, Davidson, Gretton, Giliker and Macgregor and Mr David Cabrelli for commenting on drafts of this paper. Any errors are my responsibility.

The following abbreviations are used: Derham: R Derham, The Law of Set-off , 4th edn (2010); Gloag : WM Gloag, The Law of Contract , 2nd edn (1929); Gullifer: L Gullifer, Goode on Legal Problems of Credit and Security , 5th edn (2013); McBryde: WW McBryde, The Law of Contract in Scotland, 3rd edn (2007); McCracken: S McCracken, The Banker’s Remedy of Set-off , 3rd edn (2010); Wood: PR Wood, English and International Set-off (1989); Zimmermann: R Zimmermann, Comparative Foundations of a European Law of Set-Off and Prescription

(2002). 1 . Zimmermann, 22. Mourre notes that set-off defences arise frequently in international arbitrations: see A

Mourre, “The Set-Off Paradox in International Arbitration” [2008] Arbitration International 387, 391.

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SET-OFF: A CONCEPT DIVIDED 239


the importance and practical utility of set-off, it is an area of law which has not been the focus of substantial scholarly analysis. 2 Despite its signifi cance in international transactions, comparative material on the topic is especially scarce. 3 While comparative analyses of civilian jurisdictions with common law systems have been undertaken 4 no such analysis has, until now, been made between Scotland, a mixed jurisdiction, and English law, 5 despite Scotland’s being described in relation to set-off as “among the most important bridge jurisdictions between the Napoleonic and common law regimes”. 6

This article provides the fi rst detailed comparative analysis of set-off between Scots and English law. It demonstrates that, while often similar results are achieved, there are signifi cant differences between the systems in relation to legal concepts that are frequently invoked by commercial parties north and south of the border. Those advising across the UK or in cross-border transactions need to have an appreciation of the limits and extent of “set-off” in both jurisdictions.

Terminology

An issue immediately arises in a comparative study of set-off in English and Scots law in relation to the terminology used for the concepts to be compared. While the term “set-off” is commonly used in Scots law, it does not have a specifi c legal meaning. 7 In England there are a number of distinct categories of set-off, each dealing with different circumstances, with each category having its own rules and effect. 8

The traditional Scottish term for setting claims against each other is compensation. Compensation is a much narrower concept in Scots law than set-off in English law. As noted, there are a number of categories of set-off in English law. There are no categories of compensation in Scots law. There is one set of rules determining when compensation is applicable, how it can be used and the effect of doing so.

The urge to fi nd a common legal term to refer to legal principles or concepts in cross-border discussions is understandable. Yet using set-off as synonymous for compensation in Scots law leads to confusion and misunderstanding. It suggests that the concepts are

2 . Zimmermann, 21. In some jurisdictions the subject has received relatively recent attention. See eg the position in England: Wood; Gullifer; and McCracken. English law is also considered in Derham.

3 . Zimmermann, 21 and the sources noted there. More recently comparative discussion of set-off appears to be focussed in the context of international commercial arbitration where issues of confl ict of laws arise: see eg C Fountoulakis, Set-off Defences in International Commercial Arbitration—A Comparative Analysis (Hart, Oxford, 2011) and P Pichonnaz and L Gullifer, Set-off in Arbitration and Commercial Transactions (Oxford University Press, Oxford, 2014).

4 . See eg H Eujen, Die Aufrechnung im Internationalen Verkehr zwischen Deutschland, Frankreich und England (Metzner, Frankfurt am Main, 1975).

5 . Wood mentions Scotland but his comments are cursory and not by any means a full treatment of the position in Scotland.

6 . Wood, [1.97]. 7 . See the discussion of terminology used in Scotland in McBryde, [25.32–25.37]. 8 . There is not a universally accepted classifi cation of the different forms of set-off in English law. The

“non-technical” terms for the classes of set-off proposed by Wood, [1.7–1.37], will, in the main, be used in this article, although a distinction will be made within his category of transaction set-off between abatement and equitable set-off.

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240 LLOYD’S MARITIME AND COMMERCIAL LAW QUARTERLY


the same or, at any rate, very similar. That is not the case. As such, “set-off” should be reserved for discussions of English law only.

Basis of comparative analysis

In this article the functional equivalents in Scots law of “independent set-off” and “equitable set-off” in English law will be identifi ed and examined. 9 The term “functional equivalence” is utilised in this paper as a means of identifying relevant counterpart materials in another jurisdiction—so called functionalistic identifi cation. 10

The analysis in Part II demonstrates that compensation in Scots law is functionally equivalent to the English law of independent set-off only. Furthermore, the examination highlights that, while compensation and independent set-off are functionally equivalent, there are some critical differences between the concepts. Particularly signifi cant is the retrospective effect of compensation, whereas independent set-off operates prospectively only. This results in opposing treatments of default remedies in Scots and English law, a trap for the unwary.

In Part III the search for a functional equivalent to equitable set-off within Scots law extends beyond the doctrine of compensation. It is argued that the functional equivalent here is found in the doctrine of retention based on the concept of mutuality in Scots contract law (“mutuality retention”). This is a facet of mutuality retention that has, to date, been largely ignored in Scots law. The analysis provides unique insights into the scope of the doctrine of mutuality retention, in particular its interaction with compensation, a relationship which has been described as “problematic” and which has “suffered from an inadequate theoretical analysis”. 11 It will be argued that recent case law in this area is conceptually unsound and that a different path should be taken in developing the law. In setting out the argument that mutuality retention in Scots law and equitable set-off in English law are functional equivalents, comparisons regarding the use and limits of both concepts are made and important differences between the concepts highlighted. Finally, suggestions are made to deal with uncertainties which exist regarding the ability to use equitable set-off in English law, drawing on the position in Scotland.

9 . Set-off between insolvent parties and the special rules that apply will not be considered. Contractual set-off, current account set-off, retainer set-off (otherwise known as the rule in Cherry v Boultbee (1839) 4 My & Cr 442) and abatement will not be considered. The operation of contractual set-off depends on the terms of the contract. Doubt has been expressed on whether current account set-off is a separate category of set-off: see Wood, [3.2–3.8]. Retainer set-off operates where the circumstances would not permit set-off: see Wood, [8.2–8.4] and Derham, [14.01–14.03]. There is doubt about whether abatement forms part of the law of set-off or is a separate doctrine: see Gullifer, [7.74] and Wood, [4.36–4.37].

10 . See C Valke and M Grellette “Three Functions of Function in Comparative Legal Studies”, in M Adams and D Heirbaut (eds) The Method and Culture of Comparative Law: Essays in Honour of Mark Von Hoecke (Hart, Oxford, 2015), 99.

11 . McBryde, [25.36].

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II. INDEPENDENT SET-OFF AND COMPENSATION

1. History of the doctrines

Independent set-off is a creature of statute in English law. 12 The Statutes of Set-off of 1729 and 1735 13 provided that, where there were mutual debts 14 between the plaintiff and defendant, one debt could be set against the other. The Statutes were repealed in 1879 15 but the right of independent set-off survived. 16 In Scots law compensation was also created by statute, by the Compensation Act 1592. 17 In terms of the Act, any debt de liquido ad liquidum 18 instantly verifi ed by writ or oath of the party, before decree, was allowed as a defence to an action. In both jurisdictions the policy to be achieved is avoiding multiplicity of action. 19 Scots law also recognises the justice or fairness of allowing compensation—that A should not be paid the sum due to him by B if he has not paid the sum he owes to B. 20 Justice or fairness are not generally recognised as reasons for independent set-off in English law. 21

2. Requirements for operation

Neither independent set-off in English law nor compensation in Scots law requires any connection between the claimant’s claim and the defendant’s cross-claim; the claims can be independent of each other. Independent set-off is only available where the claims are for sums of money or for relief due to the non-payment of money 22 such as seeking specifi c performance of a right available where the defendant has failed to pay a sum due. 23

12 . There is one case: Arnold v Richardson (1699) 1 Eq Ca Abr 8; 31 ER 833, where the court appeared to permit independent set-off before the 1729 Act but this seems to be an isolated example. Other instances where set-off of unconnected claims were permitted were usually founded on custom or implied agreement: see Derham, [2.01].

13 . 2 Geo II, c 22, s.13 and 8 Geo II, c24, s.4. 14 . For discussion of this term, see post , 243. 15 . By the Civil Procedure Acts Repeal Act 1879. 16 . The Civil Procedure Acts Repeal Act 1879, s.4(1)(b) provided that any principle, rule of law or equity

established or confi rmed or right acquired was not affected by the repeal. 17 . There is doubt on whether compensation was part of Scots law prior to the Act. Stair states that it was

not: Stair, Institutes of the Law of Scotland (hereafter “Stair, Inst”), I, XVIII, 6. So does Hume (drawing on Balfour’s report of The Queen v The Bishop of Aberdeen (1543) Mor 2545: see Hume, Lectures (1786–1822) , Vol III, ed. GCH Paton, (Stair Society, Edinburgh, 1952), 28. However, Bell asserts that, given the prevalence of Roman jurisprudence in Scotland, one should not expect a period where compensation was unknown. Bell also notes that The Queen v The Bishop of Aberdeen is not authority for the position set out by Balfour: see Bell, Commentaries on the Law of Scotland , Comm II 126. See also Lord Salvesen’s comments in Fowler v Brown 1916 SC 597, 602–603.

18 . Of a liquid claim against a liquid claim; J Trayner, Trayner’s Latin Maxims , 4th edn (Sweet & Maxwell, Edinburgh, 1993), 141.

19 . Hutchinson v Sturges (1741) Willes 261, 262; Bell, Principles of the Law of Scotland (hereafter “Bell, Principles ”), § 572; Hume, Lectures, ( supra , fn.17), 28.

20 . Bell, Principles , § 572; Hume, Lectures, ( supra , fn.17), 28. 21 . In discussing the historical development of independent set-off, McCracken notes that there is some

evidence of notions of fairness but this was ignored, given the perception of independent set-off as procedural in nature: see McCracken, 56–59. She notes “that any assumption of notions of fairness underlying [independent] set-off remains controversial”: ibid , 70.

22 . Gullifer, [7.41]. 23 . BICC Plc v Burndy Corp [1985] Ch 232.

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Compensation is available where claims are liquid and of the same nature. 24 It is not necessary that the claims be for money or relief based on the non-payment of money. For instance, where wheat is to be delivered, to and by each party, claims by the seller and the buyer can be set against each other. 25 As such, compensation is wider in scope than independent set-off. However, modern cases concern monetary claims.

For independent set-off, the claim and cross-claim must be for liquidated debts, or demands which can readily and without diffi culty be ascertained. 26 It has been held that “demands that can readily and without diffi culty be ascertained” refers to ascertaining the quantum of the claim and not the amount which might ultimately be held recoverable by the court. 27 As such, a claim will be eligible for independent set-off provided that the claims are either liquidated or capable of being quantifi ed by reference to ascertainable facts which do not require estimation or valuation, 28 even though the quantifi cation is disputed by the other party. While there is agreement that claims cannot be set against each other unless both are due and payable, some assert that the defendant’s claim must have matured before the claimant raises proceedings in respect of his claim. A cross-claim which matures during proceedings is therefore ineligible for independent set-off. 29 Derham, on the other hand, asserts that a cross-claim maturing during the currency of the claimant’s claim is eligible for set-off. 30 Although the rule that the cross-claim must exist at the time the claimant commences his action appears anomalous, 31 the weight of authority does not support Derham’s view. 32

For compensation, the claims must be liquid, that is to say the sums must be instantly due and payable and ascertained, or immediately ascertainable on the basis of the rule quod statim liquidari potest pro jam liquido habetur 33 (that which can at once be rendered liquid is held as liquid 34 ). There are some cases where this rule has been referred to but which appear to go beyond what could be described as immediately ascertainable, where several months were allowed for an illiquid claim to be made liquid. 35 The writer has argued elsewhere that these cases, properly understood, are not cases of compensation but of special retention. 36 As such, compensation in Scots law only operates where the claims are liquid or immediately capable of being made liquid.

24 . Erskine, An Institute of the Law of Scotland , (hereafter “Erskine, Inst”), II.III.15. 25 . Erskine, ibid . 26 . Stooke v Taylor (1880) 5 QBD 569, 575, per Cockburn CJ. 27 . Aectra Refi ning and Manufacturing Inc v Exmar NV (The New Vanguard) [1994] 1 WLR 1634, 1647;

[1995] 1 Lloyd’s Rep 191 , 199, per Hirst LJ. 28 . Ibid , 1649, per Hoffmann LJ. 29 . Wood, [2.145–2.150] and Gullifer, [7.43]; although Wood, [2.150] notes that this rule has not been

universally applied. 30 . Derham, [2.08–2.12]. 31 . Given that independent set-off does not take effect until judgment and does not have retrospective effect. 32 . Although note Lord Hoffmann’s obiter comment in Stein v Blake [1995] UKHL 11; [1996] 1 AC 243,

251 that legal set-off is confi ned to debts which at the time when the defence of set-off is fi led were due and payable.

33 . Erskine, Inst III, IV, 16. 34 . Trayner, Latin Maxims ( supra , fn.18), 534. 35 . Eg John Seton (1683) Mor 2566; Brown v Elies (1686) Mor 2566; and Muir and Milliken v Kennedy

(1697) Mor 2567. 36 . L Richardson, “Examining Equitable Retention” (2016) 20 Edin L Rev 18.

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While a dispute over the quantum of a claim does not preclude independent set-off, such a dispute in Scots law could make the claim illiquid 37 such that compensation would not be available. 38 To this extent, independent set-off is wider in scope than compensation. The Compensation Act 1592 allows a liquid debt, available before decree in the claim is granted, to be used as a defence to that claim. Scots law does not require the defender’s claim to be due and payable at the time the pursuer commences proceedings. The defence can be asserted at any time before decree. In this regard compensation is wider in its scope than independent set-off.

For independent set-off to be possible, the claims must be mutual, that is they must exist between the same parties in the same capacity, right or interest: 39 for example, A and B must be both creditor and debtor to each other as individuals. Independent set-off is not available if A owes a debt to B as an individual and B owes a debt to A in his capacity as trustee. English law refers to this as the requirement of mutuality. This is to be distinguished from the meaning of mutuality in Scots law which forms the basis of mutuality retention, discussed in Part III. In this instance the same word is used in both systems to mean something different. In Scots law compensation also only operates where the parties are debtor and creditor in the same legal capacity. This is referred to as the requirement of concursus debiti et crediti . 40

For independent set-off to apply, both claims must be subject to the determination of the court. If one of the claims is subject to arbitration or a foreign jurisdiction, independent set-off is unavailable. 41 Independent set-off will not apply where the parties have agreed to its exclusion. 42 Clear wording is required to contract out of the right to set-off. 43 In Scots law compensation can also be excluded by agreement. 44

3. Is the right substantive or procedural?

Independent set-off in English law is often described as being a procedural, not a substantive, defence. 45 This is due to the fact that independent set-off can only be pled as a defence to an action and only takes effect on judgment by the court. 46 As such, a defendant paying the sum due to the claimant, after deducting his cross-claim, before

37 . McBryde, [25.45]. 38 . Erskine Inst III.IV.16; Gloag , 646; Wilson, The Scottish Law of Debt , 2nd edn (Green/Sweet & Maxwell,

Edinburgh, 1991), [13.5]. 39 . Wood, [14.27–14.30]; Derham, [2.13] and [11.01–11.02]. 40 . Gloag , 646. 41 . The New Vanguard [1994] 1 WLR 1634, esp 1649–1651; [1995] 1 Lloyd’s Rep 191 , esp 200–201, per

Hoffmann LJ. 42 . Derham, [5.133]. 43 . BICC v Burndy [1985] Ch 232, 248, per Dillon LJ. 44 . McBryde, [25.56]. 45 . Derham, [2.53]. 46 . Stein v Blake [1995] UKHL 11; [1996] 1 AC 243, 251, per Lord Hoffmann. Wood suggests that

independent set-off can be a self-help remedy but that the authorities are patchy such that no real pattern emerges as to when independent set-off as a self-help remedy is available. He also argues that it is probably correct in principle that, wherever A would have a general possessory lien over property of B by custom to secure general indebtedness, A should be entitled to exercise a self-help independent set-off against B if the reciprocal claims arise out of the same relationship and circumstances that would give rise to the general lien: Wood, [2.46–2.48] and [2.61–2.67].

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judgment does not answer the claimant’s claim. The right to set-off does not exist until judgment. Once pronounced, the effect of the judgment is that the parties’ claims are extinguished to the extent of the lesser claim. Independent set-off therefore operates as a substantive extinction or reduction of the debt owed by the defendant. It is therefore more accurate to say that independent set-off is a substantive defence but that it reaches that result by procedural means. 47 Independent set-off does not have retrospective effect. 48 This, combined with the fact that it takes effect only on judgment, means that a claimant is entitled to utilise any available default remedies, such as default interest, forfeiture or acceleration clauses provided by the contract, when the defendant does not pay the sum due to him, notwithstanding the defendant’s plea of set-off.

Compensation in Scots law must also be pled by the defender and sustained by the court. 49 Likewise, compensation extinguishes parties’ claims to the extent of the lesser claim. However, a critical distinction is that in Scotland, once decree is granted, compensation operates retrospectively from the date of concourse of the claims. 50 It seems that the difference between Scots and English law on this point is historical, with English law traditionally regarding independent set-off as procedural in nature and, as such, effective only from the time of judgment. Scots law adhered more closely to Roman law 51 in recognising the substantive nature of compensation. Indeed Stair, with reference to the Code and the Digest, asserted that compensation operated ipso jure. 52 However, this view did not prevail and it is clear that compensation must be pled and upheld. 53

Authorities have noted that the retrospective nature of compensation has the effect of stopping the accrual of interest on the sums due from the date both claims existed. 54 On the same basis it seems that a creditor in Scotland with default remedies in his contract is in a less fortunate position than a creditor in England. In England the creditor is free to exercise his default remedies, as independent set-off has prospective effect. In Scotland, given the retrospective effect of compensation, the creditor will need to ensure that the debtor has no liquid claim which equals or exceeds the creditor’s claim against the debtor. Given that there is no need for the claim and cross-claim to be connected in any way, this may result in a wide search of the parties’ dealings with each other. If the debtor has a liquid claim against the creditor of equal or greater amount, the retroactive effect of compensation results in a situation where there is no default by the debtor and, as such, no trigger for any default remedies, notwithstanding that decree has not yet been granted. 55 Given this uncertainty, creditors with default remedies in Scotland will

47 . Aectra v Exmar [1994] 1 WLR 1634, esp 1650; [1995] 1 Lloyd’s Rep 191 , esp 200, per Hoffmann LJ. 48 . Wood, [2.192]. 49 . Sir William Maxwell of Monreith v Creditors of Sir Godfrey McCulloch (1738) Mor 2550; Bell, Principles ,

§ 575; Gloag , 644. 50 . Bell, Principles , §575. 51 . For a brief account of the Roman law of set-off, see ME Tigar, “Automatic Extinction of Cross-Demands:

Compensatio from Rome to California” (1965) 53 California L Rev 224, 226 and Zimmermann, 24. 52 . Stair, Inst., I XVIII 6; see in particular C 4.31.14 and D 16.2.21. 53 . See supra , fn.49. 54 . Ibid ; McBryde, [25.53]. 55 . See the commentary to the Draft Common Frame of Reference (“DCFR”), Art.III:6:107, p.1133 of the

full edition.

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wish to exclude compensation by agreement so that they can be sure of the availability of default remedies on a debtor’s failure to perform his obligations.

It has been said that, on the issue of whether the right of a debtor to set his cross-claim against the creditor’s claim is purely procedural or substantive in nature, “we appear to be dealing with a clear-cut civil law/common law divide, with Scotland in this instance joining English law”. 56 As noted above, it is suggested that independent set-off is substantive, resulting in the extinction of claims, but that a procedural means is deployed to achieve that end. This is also true of compensation. However, it is argued here that Scots does not sit so closely to English law across the civil law/common law divide and is, in fact, closer to civilian systems, 57 given the retrospective effect of compensation once sustained by the court. This is highlighted when one considers the effect of compensation on the creditor’s use of default remedies.

4. Evaluation

The above comparative analysis demonstrates that the functional equivalent of independent set-off in Scots law is compensation. However, while the doctrines are similar, there are some differences, crucially the retrospective effect of compensation in Scots law. In giving retrospective effect to compensation, Scots law sits alongside all other legal systems in the Romanistic and Germanic legal families. 58 However, while there has been some acceptance in England that independent set-off is a substantive defence reached by procedural means, English law does not give retroactive effect to set-off. This results in diametrically opposed positions regarding the use that can be made of default remedies between the systems. 59 This is apt to create diffi culties in practice where cross-border considerations arise.

There are some areas where Scots and English law should develop more closely in line with each other, given the clear policy objective in both jurisdictions of avoiding multiplicity of actions. As noted above, there is no doctrinal reason for the rule of English law that the defendant’s claim must have matured at the time the claimant raises proceedings, for set-off to apply. Removing this requirement, and bringing English law into line with Scots law, where a liquid debt due to the defender by the pursuer at any time before decree is granted in the pursuer’s claim can be used in compensation, would increase the availability of independent set-off and thus reduce circuity of action. It is also suggested that Scots law follow English law in permitting compensation where a claim is immediately quantifi able by reference to ascertainable facts, not requiring estimation or valuation, even where there is a dispute between the parties regarding quantifi cation. If such a dispute renders a claim illiquid in Scots law, as the authorities currently suggest, compensation will not be available. As a result, the defender’s disputed claim against the pursuer would have to be the subject of separate proceedings, thus failing to reduce the number of actions to deal with matters between the parties. The pursuer suffers no harm in

56 . Zimmermann, 22. 57 . In France compensation légale operates ipso jure but is held to be effective only if the defendant raises it

in court: see Zimmermann, 25. This is not dissimilar to the position in Scots law. 58 . Zimmermann, 36. 59 . See the discussion ante , 244; also the discussion in Zimmermann, 41–42.

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the event that the disputed claim is permitted by way of compensation, because the court will determine the actual amount of the claim. Furthermore, spurious disputes regarding quantifi cation by the pursuer would be discouraged, thus saving resources.

Given that only one class of set-off, independent set-off, is the functional equivalent of compensation, it is clear that the doctrine of set-off in English law is wider in scope than compensation in Scots law. Compensation is a narrow doctrine in Scots law. 60 A wider doctrine was needed in England due to the historic rule that promise and counter-promise be treated as independent. 61 Consideration will now be given to when equitable set-off may apply and its effect in order to identify its functional equivalent in Scots law.

III. EQUITABLE SET-OFF IN ENGLISH LAW AND MUTUALITY RETENTION IN SCOTS LAW

1. Equitable set-off

(a) History of the doctrine

There is no clear answer as to whether courts of equity were willing to hear cross-claims arising from the same transaction before the Statutes of Set-off made provision for independent set-off in 1729. 62 Equitable principles developed from Roman law have been suggested as the origin of any such right of set-off. 63 However, examples of equitable set-off before the Statutes are diffi cult to fi nd. 64 What is clearer is that the Statutes permitted the development of equitable set-off, with the courts of equity applying, by analogy, the relief available at law, and extending the availability of relief. 65 Equitable set-off subsequently developed into a relatively broad doctrine.

Prior to the Judicature Acts, 66 the common law and equity were administered by different courts. At that time, if a defendant had an equitable set-off, he was unable to use it to defend an action at common law. However, he could seek an injunction in equity to prevent the claimant from proceeding with his claim at law without giving credit for the defendant’s equitable cross-claim. Since 1873, when provision was made for common law and equity to be administered by one court, it has been possible to raise equitable set-off as a defence in any proceedings. 67

60 . For a fuller discussion of the narrow scope of compensation in Scots law and its relationship to retention see Richardson (2016) 20 Edin L Rev 18.

61 . Zimmermann, 31. 62 . See the sources cited in McCracken, 60 fn.66. On the Court of Chancery’s early decisions on set-off, see

the English cases discussed in Greene v Darling (1828) 10 Fed Cas 1144. 63 . Freeman v Lomas (1851) 9 Hare 109, 113; 68 ER 435, 437, per Sir George Turner V-C. For the infl uence

of Roman law on the early English law of set-off, see W Loyd, “The Development of Set-off” (1916) 64 U of Pennsylvania L Rev 541, who suggests that what probably happened was that English law, on becoming conscious of a situation that offended common sense, borrowed, without credit, from continental systems the idea of setting off connected claims but adapted it empirically to meet English law’s needs.

64 . Halsbury’s Laws of England , 5th ed., vol .11 (LexisNexis, London, 2014), [658]. 65 . McCracken, 60. 66 . The Supreme Court of Judicature Act 1873 and the Supreme Court of Judicature Act 1875. 67 . Halsbury’s Laws of England ( supra , fn.64), [658].

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It is said that set-off is not retention of the creditor’s claim by the debtor. Where a debtor sets off his cross-claim against the creditor’s primary claim, the debtor pays the creditor’s claim out of his cross-claim against the creditor. 68 The policy underlying equitable set-off is substantial justice between the parties—it being unjust to grant the claimant the benefi t of his claim without giving credit for the defendant’s cross-claim. 69

(b) Requirements for operation

In English law, for equitable set-off to apply the claims must be for money or based on the non-payment of money 70 but the claims need not be liquidated. 71 A liquidated claim can be set against a liquidated claim; 72 one claim can be liquidated and the other unliquidated; or both may be unliquidated. 73 There must be mutuality between the parties, 74 in the sense that the claims must exist between the same parties in the same capacity. 75 There must be a connection between the claims. However, it appears 76 that the claims need not be contractual for equitable set-off to operate. A claim in tort could be set-off against a claim in contract provided that there was suffi cient connection between the claims. 77 However, much of the case law has considered claims in contract. The extent of the required connection between the claim and cross-claim and the appropriate test to be applied have been the subject of signifi cant debate recently. This issue is analysed in detail below.

Equitable set-off can be excluded by agreement. 78 Some contracts are also, by law, excluded from equitable set-off. 79 Equitable set-off cannot be set up against a claim for payment of a bill of exchange or other negotiable instrument on the basis that payment by these methods is equivalent to cash. 80 It seems that payment by direct debit will

68 . Wood, [1.62]. This is said of set-off generally rather than being a matter peculiar to equitable set-off, but, given equitable set-off’s functional equivalence with mutuality retention in Scots law, is important to point out in relation to equitable set-off.

69 . Gullifer, [7.01]; Federal Commerce & Navigation Co Ltd v Molena Alpha Inc (The Nanfri) [1978] QB 927, 981; [1978] 2 Lloyd’s Rep 132 , 144, per Goff LJ.

70 . Derham, [3.02]. 71 . Wood, [4.11]. 72 . Derham, [4.63]. A defendant will prefer to claim equitable set-off rather than independent set-off where

possible, as independent set-off does not provide a substantive defence to the claimant’s claim, whereas equitable set-off does: see post , 252.

73 . Gullifer, [7.50–7.51]. 74 . Muscat v Smith [2003] EWCA Civ 962; [2003] 1 WLR 2853. Derham is critical of this requirement,

noting that there have been cases where equitable set-off has been permitted without there being mutuality between the parties: see R Derham, “Equitable set-off; a critique of Muscat v Smith ” (2006) 122 LQR 469, 477–481.

75 . As noted post , 253, mutuality is used in a different sense in Scots law. 76 . This issue is not the subject of discussion in the leading textbooks. The discussion in Wood suggests that

the claims must be contractual: see Wood, [4.51–4.53]. Derham gives examples of non-contractual claims where set-off was permitted but does not discuss the nature of the claims: see Derham, [4.04–4.07].

77 . McCracken, 92–97 and the authorities cited there. See also the many authorities cited in Gullifer, [7.50–7.51], where the cross-claim is not contractual.

78 . Derham, [5.95–5.96]. 79 . For details, see Derham, ch.5; for the position in relation to mortgages see Derham, [4.125–4.148]. 80 . Ibid , [5.25–5.29].

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also preclude equitable set-off. 81 In addition, freight due under a voyage charter must be paid without set-off. 82 This “special rule of English law” 83 is arbitrary, no clear justifi cation ever having been given, yet it continues to be an established rule followed by the courts. 84

(c) The requisite connection between claim and cross-claim

As noted above, for equitable set-off to operate the claims must be connected to each other. But just how connected need the claims be for equitable set-off to be available?

In the seminal case of Rawson v Samuel , 85 Lord Cottenham LC noted that equitable set-off could apply where the defendant could show an equitable ground for being protected from the claimant’s demand. The mere existence of a cross-claim was insuffi cient. Indeed, the fact that the cross-claim arose from the same contract as the claim, of itself, was not enough. The connection needed to be closer. Having considered the authorities, the Lord Chancellor held that the equity of the bill for injunctive relief 86 had to impeach the title to the claimant’s demand 87 —B’s claim against A had to impeach A’s title to the demand against B. In other words, B’s claim against A needed directly to reduce or extinguish the claim for which A was suing. 88

The impeachment of title test was elucidated in Federal Commerce & Navigation Co Ltd v Molena Alpha Inc (The Nanfri) , 89 where Lord Denning MR noted that equitable set-off did not mean that every cross-claim could be deducted but only

“cross-claims that arise out of the same transaction or are closely connected with it and it is only cross-claims which go directly to impeach the plaintiff’s demands, that is, so closely connected with his demands that it would be manifestly unjust to allow him to enforce payment without taking into account the cross-claim”. 90

It is also possible for equitable set-off to operate where the claims do not arise out of the same contract but where the claims are nonetheless closely connected. Lord Denning MR explained the impeachment of title rule in terms of manifest injustice—for equitable set-off to be available it would have to be manifestly unjust for the claimant to be granted his claim without the court’s taking account of the defendant’s cross-claim. His Lordship

81 . Esso Petroleum Co Ltd v Alstonbridge Properties Ltd [1997] 1 WLR 938, where Thorpe LJ and Sir John Balcombe considered that this was correct in principle but that further consideration and perhaps some modifi cation of the rule would be necessary in future.

82 . Derham, [5.02–5.09]. The law makes a distinction between freight due under a voyage charter and hire due under a hire charter: Federal Commerce v Molena Alpha (The Nanfri) [1978] QB 927; [1978] 2 Lloyd’s Rep 132 . See FD Rose, “Deductions from Freight and Hire under English Law” [1982] LMCLQ 33 .

83 . Federal Commerce v Molena Alpha (The Nanfri) [1978] QB 927, 973; [1978] 2 Lloyd’s Rep 132 , 139, per Lord Denning MR.

84 . Aries Tanker Corp v Total Transport Ltd (The Aries) [1977] 1 WLR 185, 189–190; [1977] 1 Lloyd’s Rep 334 , 337, per Lord Wilberforce.

85 . (1841) Cr & Ph 161; 41 ER 451. 86 . As noted ante , 246, a defendant claiming an equitable set-off had to seek injunctive relief in the Court of

Chancery rather than use his plea of set-off as a defence to the claimant’s common law action. 87 . Rawson v Samuel (1841) Cr & Ph 161, 179; 41 ER 451, 458, per Lord Cottenham LC. 88 . Wood, [4.41]. 89 . [1978] QB 927, 981; [1978] 2 Lloyd’s Rep 132 . 90 . Ibid , 974–975 and 140 respectively.

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was of the view that a claim for hire under a hire charter could be subject to equitable set-off but the right to set-off would be limited to cases where the owner of the vessel had deprived the charterer of use of the vessel or prejudiced him in the use of it. 91 While Lord Denning MR does not explicitly say so, it is clear that actions of that character by the owner would impeach his demand to hire from the charterer. 92 In The Leon 93 Hobhouse J noted that equitable set-off was not simply an exercise of discretion. It was granted or refused by application of the legal principle found in Rawson v Samuel.

The impeachment of title test was thrown into doubt by Boston Bank of Connecticut v European Grain and Shipping Ltd (The Dominique) . 94 In this case Lord Brandon of Oakbrook, with whom the rest of the panel agreed, noted that, while the authority most relied on as providing the correct test for equitable set-off was Rawson v Samuel , the concept of impeachment of title was no longer a familiar one. A different version of the test could be found in Government of Newfoundland v The Newfoundland Ry Co . 95 This version of the test asked whether the cross-claim fl owed out of and was inseparably connected with the dealings and transactions giving rise to the claim. 96 It has been commented, it is suggested correctly, that it is questionable to describe the inseparable connection test set out in The Dominique as a different version of the impeachment of title test. 97 They appear to be different tests, not different versions or alternative ways of formulating the same test. The inseparable connection test appears to be a less diffi cult test to meet. Indeed, if the inseparable connection test had been applied in The Nanfri , equitable set-off may well have been permitted.

Debate surrounding the effect of The Dominique on the status of the impeachment of title test and, more generally, on the correct formulation of the test for equitable set-off continued for the next twenty years. 98 In Bim Kemi v Blackburn Chemicals Ltd 99 Potter LJ 100 noted the wise refusal of the Court to become “bogged down in the nuances of difference” between the formulations of the test. He went on to state that in so far as there may be a difference, the court has been content for the outcome to be governed by the notion of fairness involved in the proposition that it must be manifestly unjust to grant the claimant’s claim without taking into account the defendant’s cross-claim. As noted above, the manifest injustice criterion set out in The Nafri . However, Potter LJ preferred Lord Brandon’s formulation of the test as set out in The Dominique , 101 where the inseparable connection test had been applied,

91 . Ibid , 976 and 141 respectively. 92 . See also the comments of Hobhouse J in Leon Corp v Atlantic Lines and Navigation Co Inc (The Leon)

[1985] 2 Lloyd’s Rep 470. 93 . Ibid , 474–475. 94 . [1989] 1 Lloyd’s Rep 431 ; [1989] AC 1056. 95 . (1888) 13 App Cas 199. 96 . The Dominique [1989] AC 1056, 1103; [1989] 1 Lloyd’s Rep 431 , 438, per Lord Brandon. 97 . Derham, [4.14]. 98 . Notably see Dole Dried Fruit and Nut Co v Trustin Kerwood Ltd [1990] 2 Lloyd’s Rep 309 ; and Esso v

Alstonbridge [1997] 1 WLR 938. See the discussion in Derham, [4.02–4.18]. 99 . [2001] EWCA Civ 457; [2001] 2 Lloyd’s Rep 93 , [29]. 100 . With whom Sedley and Jonathan Parker LJJ agreed. 101 . [2001] EWCA Civ 457; [2001] 2 Lloyd’s Rep 93 , [29].

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“unconstrained by the former concept, diffi cult to defi ne and apply, of ‘impeachment of title’ which has since been replaced, or at least redefi ned, in terms of a cross-claim which ‘fl ows out of and is inseparably connected with the dealings and transactions giving rise to the subject of the claim’”. 102

Potter LJ noted that Lord Brandon had not made reference to manifest injustice in The Dominique . While noting that it was diffi cult to envisage circumstances in which, if Lord Brandon’s test were satisfi ed, it would be other than just to allow equitable set-off, it would nonetheless be appropriate in every case to give separate consideration to the question of manifest injustice. 103 Here the Court of Appeal was moulding together the tests set out in The Nanfri and The Dominique and excluding impeachment of title as an element of the test.

The exclusion of impeachment of title from the test was confi rmed recently in Geldof Metaalconstructie NV v Simon Carves Ltd . 104 Following a review of the authorities, Rix LJ 105 stated that the impeachment of title test should no longer be used. 106 There was, he said, a formal requirement of a close connection between the claims; and a functional requirement such that it would be unjust to enforce the claim without taking the cross-claim into account. While the test involved consideration of both the closeness of connection between the claims and the justice of the case, Rix LJ did not think it was correct to speak of a two-stage test. He preferred to say that there was both formal and functional elements of the test, which elements could not be divorced from each other. The importance of the formal element of the test was to ensure that the doctrine of equitable set-off was based on principle and not discretion. The functional element was to remind litigants and the court that the ultimate rationality of the regime was equity. 107 Taking these issues into account, Rix LJ believed that Lord Denning MR’s test in The Nanfri freed of any reference to the concept of impeachment of title was the best description of the applicable test.

Applying this two-pronged test to the facts of the case, the court in Geldof held that equitable set-off could apply so that the defendant could set off a claim for damages under an installation contract against the claimant’s claim for payment of a liquidated sum under a supply contract. The installation and supply contracts related to the same site but had been entered into separately. The claimant had insisted on payment of the supply contract invoice as a precondition to returning to work on the installation contract and, as such, said the court, the claimant had brought the two contracts into an intimate relationship, even if unjustifi ably. That intimate connection had become inseparable when the defendant terminated the installation contract due to the claimant’s repudiation in ceasing works and making clear that work would not restart under the installation contract until the sums due by the defendant under the supply contract were paid. This inseparable connection between the claims made it manifestly unjust to

102 . Ibid , at [36]. 103 . Ibid , at [38]. 104 . [2010] EWCA Civ 667; [2011] 1 Lloyd’s Rep 517. 105 . With whom Maurice Kay and Patten LJJ agreed. 106 . [2010] EWCA Civ 667; [2011] 1 Lloyd’s Rep 517 , [43]. 107 . Ibid .

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enforce payment under the supply contract without taking into account the defendant’s cross-claim for damages under the installation contract. 108

While it was clear before Geldof that claims arising under different closely connected contracts could qualify for equitable set-off, 109 this case went further in holding that a party could, by its unilateral post-contractual conduct, bring otherwise unconnected contracts into close connection such that equitable set-off could apply. 110

Geldof has been followed in a number of cases 111 and was recently referred to with approval in obiter comments in the Supreme Court. 112 It therefore appears that the debate since The Dominique concerning the test to be used for determining when equitable set-off is available has been resolved and that impeachment of title no longer forms part of the test.

The defendant pleading equitable set-off has the burden of proving that his cross-claim is closely connected to the claimant’s claim. 113 While it has been said that granting or refusing equitable set-off is not a matter of discretion but of applying principle, 114 and the degree of connection between the claims was described in Geldof as the formal requirement, it will be for the court in each case to determine whether on the facts there is the requisite connection. 115 The defendant will also have to show that it would be manifestly unjust to grant the claimant’s claim without taking into account his cross-claim.

Writing in 1989, Wood was of the view that there had been a progressive liberalisation of equitable set-off. 116 Derham is of the same opinion, noting that, in redefi ning the basis on which equitable set-off can apply, the courts have expanded the scope of the defence. 117 It is argued that this is correct and that Geldof , in allowing post contractual conduct to be taken into account in determining the connection between the claims, widens the defence further still. It is suggested that the policy of the law in this area—fairness and justice between the parties—justifi es the setting-off of the defendant’s claim even where it does not impeach the plaintiff’s title but the claims are nonetheless very closely connected. However, taking into account manifest injustice to determine whether the claims are suffi ciently closely connected results in a test which is less certain and grants signifi cant discretion to the judge, who will have to determine what

108 . Ibid , [46]. 109 . Such as Dole Dried Fruit v Trustin Kerwood [1990] 2 Lloyd’s Rep 309 and Bim Kemi [2001] EWCA

Civ 457; [2001] 2 Lloyd’s Rep 93 . 110 . J Arr, “Going Places?” (2010) 160 NLJ 1006, 1007. 111 . Eg Lombard North Central Plc v Hussein (24 Jan 2011) Unreported (QB (Adm Ct)): Jervis Kay QC,

Adm Registrar); Emblaze Mobility Solutions Ltd v HMRC [2012] EWHC B7 (Ch); [2012] STI 1600; and Moondance Maritime Enterprises SA v Carbofer Maritime Trading APS [2012] EWHC 3618 (Comm); [2013] 1 Lloyd’s Rep 269 . It was also cited with approval by the Court of Appeal in Autoweld Systems Ltd v Kito Enterprises LLC [2010] EWCA Civ 1469; [2011] TCLR 1 and IG Index Ltd v Ehrentreu [2013] EWCA Civ 95.

112 . International Energy Group Ltd v Zurich Insurance Plc [2015] UKSC 33; [2016] AC 509; [2015] Lloyd’s Rep IR 598 , [90], per Lord Mance (with whom Lords Clarke, Carnwath and Hodge agreed).

113 . Lombard v Hussein (24 Jan 2011) Unreported ( supra , fn.111), [24], per Jervis Kay QC. 114 . The Leon [1985] 2 Lloyd’s Rep 470 , 474. 115 . In Addax Bank BSC v Wellesley Partners LLP [2010] EWHC 1904 (QB), [45], Eady J noted that it will

be a question of fact and degree on which the judge must form an impression. 116 . Wood, [4.9]. 117 . Derham, [4.08].

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is and what is not manifestly unjust. 118 Given the practical importance of set-off in both national and international transactions 119 and the importance of certainty in commercial transactions, this poses a diffi culty.

(d) Is the right substantive or procedural?

Unlike independent set-off, equitable set-off in English law is a substantive defence. 120 A may seek payment from B of £100. B may set off his connected claim of £50 against A. If B pays £50 to A, B will not be in default and A will not be able to exercise any available default remedies. This position in not in doubt but its legal analysis is disputed.

Wood is of the view that B can assert his set-off and that payment of the £50 in the example above is good legal tender such that A’s claim against B is discharged. 121 Derham takes a different view. While acknowledging that there are comments in some cases which suggest that the claimant’s claim is extinguished by equitable set-off, he persuasively argues that that is not the correct analysis. Instead, he argues that a debtor is entitled to withhold payment where equitable set-off applies but that the debtor is not able unilaterally to extinguish the cross-demands at law. In equity the creditor is not able to treat the debtor as being in default to the extent of the debtor’s cross-claim but at law the demands remain in existence until extinguished by judgment or agreement. 122 Derham’s view has received support in two recent High Court cases. 123

The debtor is not able to refuse to pay his creditor’s claim simply on the basis that some unspecifi ed amount of money, such as an unliquidated damages claim, is due from his creditor. When exercising equitable set-off in relation to an unliquidated cross-claim, the debtor must quantify his loss by a reasonable assessment made in good faith and set off that sum against his creditor’s claim. The debtor would be required to pay over to his creditor any amount in excess of his claim made on this reasonable assessment. If it subsequently transpires that the debtor’s quantifi cation is too high, the creditor will be able to recover the balance from the debtor but it will not result in the debtor’s being in default. 124

As noted above, the functional equivalent to equitable set-off in Scots law is not found within the doctrine of compensation. It is argued here that it is found within the doctrine of retention in Scots law. There are two forms of retention in Scots law—mutuality retention and special retention. 125 In the following section it will be shown that mutuality retention is the functional equivalent of equitable set-off in English law.

118 . See the discussion in McCracken, 201–212. 119 . See supra , fn.1. 120 . Derham, [4.29]; Wood, [4.24]. 121 . Wood, [4.24–4.26]. 122 . Derham, [4.30–4.34]. See also Derham (2006) 122 LQR 469, 470–476. 123 . Fearns (t/a Autopaint International) v Anglo-Dutch Paint & Chemical Co Ltd [2010] EWHC 2366 (Ch);

[2011] Bus LR 579; [2011] 1 WLR 366, [24–35], per George Leggatt QC; and Equitas Ltd v Walsham Bros & Co Ltd [2013] EWHC 3264 (Comm) ; [2014] Lloyd’s Rep IR 398 , [177–185], per Males J.

124 . Federal Commerce v Molena Alpha (The Nanfri) [1978] QB 927, 975; [1978] 2 Lloyd’s Rep 132 , 140, per Lord Denning MR. Cf the comments of Goff LJ at 982 and 144 respectively; but see Derham, [4.50] and the authorities cited there.

125 . For fuller discussion of special retention, see Richardson (2016) 20 Edin L Rev 18.

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2. Mutuality retention

(a) History of the principle

Mutuality retention is derived from the exceptio non adimpleti contractus (the defence of the unperformed contract). The principle, developed from Roman law, has a long pedigree in Scots law, with examples found in case law in the fi fteenth century. 126 As a result, compensation in Scots law required to deal only with liquid claims, without requiring a connection between the claims. 127 There was no need for a wider doctrine of compensation, akin to the development of equitable set-off in English law, to deal with connected cross-claims that were not both liquid.

(b) Operation of mutuality retention

The doctrine is based on the premise that A cannot seek performance from his contracting partner, B, until A has performed or is ready to perform his obligations under the contract. 128 For B to be able to retain his performance he must be able to show that the obligation he is withholding is the counterpart of the obligation which A has failed to perform. 129 There is an assumption that the obligations undertaken by each of the parties in the contract are counterparts of each other, unless there is clear evidence that the obligations are interdependent. 130 In Inveresk Plc v Tullis Russell Papermakers Ltd 131 the Supreme Court held that obligations need not be contained in the same contract to be counterparts of each other. Obligations can be counterparts where there is more than one contract, where the contracts together make up one transaction such that A’s obligations in one contract are the counterpart of B’s obligations in another related contract. The court noted, 132

“the guiding principle is that the unity of the overall transaction should be respected. The analysis should start from the position that all the obligations that it embraces are to be regarded as counterparts of each other unless there is a clear indication to the contrary.”

As well as the need for the obligation withheld by B to be the counterpart of the obligation breached by A, the breach of contract by A would also have to be material 133 for B to retain performance of his obligation. There are doubts about how serious a breach must be to be considered material for this purpose. 134 What is known is that A’s breach

126 . Although there are earlier examples: see Marioun Lady Somervale 10 July 1492, ADC 1 246 and the discussion in McBryde, [20.44].

127 . Compensation can be used where the claims are connected and both are liquid and of the same nature but there is no need for the claims to be connected for compensation to operate.

128 . McBryde, [20.44] and the authorities cited there. 129 . Ibid , [20.47]; Bank of East Asia Ltd v Scottish Enterprise 1997 SLT 1213; Macari v Celtic Football Club

1999 SC 628. 130 . Gloag , 594, Inveresk Plc v Tullis Russell Papermakers Ltd [2010] UKSC 19; 2010 SLT 941; 2010 SCLR

396, [42] and [43], per Lord Hope. 131 . [2010] UKSC 19; 2010 SLT 941; 2010 SCLR 396. 132 . Ibid , [42], per Lord Hope. 133 . Numerous expressions have been used to explain material breach. It is suggested that it is akin to

substantial breach: see McBryde, [20.91–20.94]. 134 . See the doubts expressed by McBryde as to the extent of materiality required: ibid , [20.58–20.60];

Inveresk [2010] UKSC 19; 2010 SLT 941; 2010 SCLR 396, [43], per Lord Hope; and EDI Central Ltd v National Car Parks Ltd [2010] CSOH 141; 2011 SLT 75, [111], per Lord Glennie.

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need not be so material that it would justify B’s rescission of the contract. 135 As such, A’s breach need not go to the root of the contract. 136 At the other end of the spectrum, it would appear that A’s breach would have to be more than trivial or insignifi cant. Mutuality retention is available unless the court considers its use to be inequitable. 137 As such it is argued here that there is a right to retain.

Parties’ claims need not be liquid for mutuality retention to apply—one, both 138 or none of the claims may be liquid. Mutuality retention can be excluded by agreement between the parties. 139

(c) Restricted scope of the principle?

The right to retain in Scots law is often described as B’s security for the counter performance due from A 140 —B will be able to retain performance unless and until A performs. B’s retention of performance can therefore be used to prompt A to perform because, until A does so, he will not receive and is not entitled to receive B’s counter-performance. McBryde states that the purpose of retention is to enforce obligations. 141 In the recent Inner House decision of McNeill v Aberdeen City Council 142 Lord Drummond Young 143 went further, suggesting that security for future performance was the only function of mutuality retention. 144 He stated that mutuality retention was “a right to withhold performance of substantive obligations under the contract pending performance by the other party of its obligations. The right does not go further than that”. 145 He also stated, “the principle of retention cannot generally be invoked in respect of a breach of contract that has occurred in the past and is unlikely to be repeated”. 146

It is argued here that the function of mutuality retention is not so limited. Seeking to identify the functional equivalent to equitable set-off in Scots law has illuminated the extent of the principle of mutuality retention. This analysis has highlighted aspects of the doctrine that have hitherto been largely ignored, while discussion has centred on the use of retention as security for future performance. While the reason B retains performance, in many cases, will be to try to force A to carry out his reciprocal obligation, mutuality retention can and should also ensure that B will not have to perform his contractual obligations unless and until A performs his reciprocal obligations or pays damages in

135 . Ibid . 136 . Wade v Waldon 1909 SC 571, 576, per Lord President Dunedin. See the other phrases used to describe

material breach identifi ed by McBryde, [20.91]. 137 . McNeill v Aberdeen City Council [2013] CSIH 102; 2014 SC 335; 2014 SLT 312, [30], per Lord

Drummond Young. 138 . Although if both claims were liquid compensation may also be used. 139 . WM Gloag and RC Henderson, The Law of Scotland , 13th edn (W Green, Edinburgh, 2012), [10.16]. 140 . Bell, Principles, § 1410. 141 . McBryde, [20.64]. However, he also notes that the mutuality principle means that a party in breach

cannot enforce performance by the other party: ibid , [20.48]. 142 . [2013] CSIH 102; 2014 SC 335; 2014 SLT 312. 143 . With whom Lords Eassie and McGhie agreed in relation to his analysis of contract law. 144 . Although see his comment at [30] that, if the right of retention is invoked for a purpose other than

security for future performance, “it may well be appropriate to hold that its exercise is inequitable” (emphasis added).

145 . [2013] CSIH 102; 2014 SC 335; 2014 SLT 312, [28]. 146 . Ibid , [29].

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lieu of performance. 147 In this way mutuality retention provides a defence to an action raised by A seeking performance by B, while A is in breach of the counterpart obligation under the contract. 148

There is no conceptual reason for mutuality retention to be limited so that it protects only those parties who may still be able to obtain performance or wish to obtain useful performance from their contracting partners. There is no sound basis on which A should be able to obtain decree requiring B to perform his contractual obligations simply because the performance by A of his obligations is no longer possible or desirable. On Lord Drummond Young’s analysis, A could obtain the benefi t of performance under the contract from B in such circumstances, leaving B to seek damages from A despite the fact that B was retaining performance in the face of a material breach of a counterpart obligation by A. Such a result is contrary to the very nature of the principle of mutuality in contract. It further fl ies in the face of recent Supreme Court authority. In Inveresk v Tullis Russell Papermakers Ltd , 149 Inveresk raised an action seeking payment of additional consideration due under an asset purchase agreement in terms of which Inveresk had sold various assets to Tullis. The parties had also entered into another contract, a services agreement, in terms of which Inveresk were to provide certain services to Tullis, including the manufacture, sale and distribution of specifi ed products for a certain period of time. The agreements were related. They had been entered into on the same date and the services agreement was to ensure continuity in manufacture and distribution of certain products pending their full integration into Tullis’s business following the asset purchase. The question for the court was whether Tullis could retain performance of their obligation to pay the additional consideration under the asset purchase agreement pending the outcome of a separate action which Tullis had raised against Inveresk for alleged breaches of the services agreement. The court found that Tullis were entitled to retain. They were able to do so on the basis of mutuality retention. 150 In this case Tullis were held to have legitimately exercised the right to retain when their retention would not prompt performance by Inveresk of their obligations under the services contract. The period for performance had passed and Tullis were simply seeking damages for breach of contract.

It is suggested that Lord Drummond Young’s comments in McNeill were an attempt to confi ne and control the operation of mutuality retention. There was a clear concern that retention should not be used in an abusive fashion. 151 That this broad and fl exible doctrine needs to have some limits is not disputed. What is disputed is the way in which the Inner House has recently sought to do so by confi ning its use to security for future performance by a contractual partner. Limits must be developed regarding the use of

147 . See Gloag , 623, 626–627. 148 . McBryde, [20.48]. McBryde suggests this is the limit of the mutuality principle and it does not mean that

a party in breach cannot sue at all under the contract, despite authority which suggests this: see the discussion ibid , [20.48–20.52]; HL MacQueen and J Thomson, Contract Law in Scotland , 4th edn (Bloomsbury Professional, Haywards Heath, 2016), [5.23] .

149 . [2010] UKSC 19; 2010 SLT 941; 2010 SCLR 396. 150 . On the obligations in separate contracts being counterparts of each other, see the discussion ante , 253. 151 . See the comments at [30].

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mutuality retention without unjustifi ably stunting the principle of mutuality in contract in the way suggested by the Inner House.

(d) Effect of mutuality retention

As noted above, the effect of mutuality retention in Scots law is that the party exercising the right retains or withholds performance of his obligation. The party with a defence of mutuality retention seems able to retain performance of his entire reciprocal obligation. For instance, A may sue B for the price due to A of £10,000. Suppose that B has suffered loss due to a breach by A of the contract in terms of which the price is due. B may retain his obligation to pay £10,000 until his damages claim has been determined. B’s quantifi cation of his claim may be £5,000, with that being the sum sued for, not the sum found due by the court. Nonetheless, B would be able to retain £10,000 until £5,000 had been found due to him in damages. At that stage both claims would be liquid and could be set against each other in compensation, with the result that B would have to pay to A the excess £5,000. Unlike equitable set-off in English law, there is no requirement that B quantify his claim and use only that sum against his creditor’s claim.

There is a crucial distinction between compensation and retention in Scots law. Compensation operates to extinguish debts. Retention does not. Retention operates to suspend or delay performance only. 152 Mutuality retention differs from Wood’s analysis of equitable set-off in English law and is more closely aligned with Derham’s analysis. 153 Scots law does not recognise equitable rights separately from legal rights but in Scots law a party exercising mutuality retention would not be considered to be in default, as he has a right to retain.

B’s right to retain exists for so long as A’s breach persists. 154 If A performs or pays damages, by which A’s breach is made good, B’s retention is no longer justifi ed. When that happens, B will have to render performance or set the damages payable by A against A’s claim by way of compensation. 155 Thus, compensation may follow retention. When the damages due from A to B are determined by the court, they become liquid. This liquid claim can be set against A’s liquid claim for payment. When that occurs, compensation will extinguish the obligations to the extent of the lesser obligation, akin to the effect of equitable set-off in English law.

(e) Mutuality retention in Scots law as the functional equivalent of equitable set-off in English law

Mutuality retention in Scots law is a wider principle than equitable set-off in English law. Where B retains his performance to put pressure on A to perform his obligations, in other words as security for future performance, it is beyond the functionality of equitable set-off. While using mutuality retention as security for future performance may be the

152 . Stair, Inst , I, XVIII, 6 and I, IXVIII, 7; Bell, Principles , § 1410. 153 . See ante , 252. 154 . McBryde, [20.47]. 155 . For compensation to operate, the claims must be liquid and of the same nature: see the discussion on the

operation of compensation ante , 241. See Gloag , 627.

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more common use of the right, it is not the only function of mutuality retention. As argued above, mutuality retention in Scots law can and should be available as a defence to a party retaining performance pending damages from his contractual partner in lieu of performance. When it is used in that way and is followed by compensation, it is functionally equivalent to equitable set-off.

Even where functionally equivalent, mutuality retention in Scots law is to some extent a wider principle than equitable set-off in English law in that it operates in all contracts (unless excluded by agreement) and is not excluded from being used against certain contractual claims such as claims for freight in English law. 156 Furthermore, while equitable set-off operates only where the claims are for money or a right available due to non-payment of money, 157 mutuality retention is not subject to such a restriction. An action can be raised for payment of a sum of money, delivery of an item or performance of a service and the defender can use mutuality retention provided that the pursuer has failed to perform a reciprocal obligation to a material extent. Equitable set-off, however, appears to be wider than mutuality retention in certain respects. As noted above, equitable set-off has been recognised for claims other than those arising under contract, where there is a close connection between the claims. 158 In Scots law mutuality retention is confi ned to counterpart obligations in contractual transactions. Furthermore, in Geldof 159 the Court of Appeal held that one party’s post-contractual conduct could establish the requisite connection between the claims such that equitable set-off was available to the defendant. It is suggested that the Scottish courts would be slow to fi nd that initially unrelated contracts contained reciprocal obligations simply due to the post contractual actions of one of the parties. 160

3. Evaluation

In seeking to identify the functional equivalent to equitable set-off in English law, the full extent of the mutuality principle in Scots law has been revealed. The discussion above demonstrates that one aspect of mutuality retention in Scots law is functionally equivalent to equitable set-off in English law, contrary to recent statements from the Scottish courts. However, the other, and better-known use of mutuality retention as security for future performance is not functionally equivalent to set-off. For this reason mutuality retention in Scots law and equitable set-off in English law should not be confl ated.

There are also differences in the operation of the doctrines which will, in some cases, give rise to different outcomes. It will be remembered that the test for equitable set-off in English law as set out in Geldof 161 contains both a formal and functional element—the former being the close connection between the claims, the latter that it would be manifestly unjust to allow the claimant’s claim to be enforced without taking account of the defendant’s cross-claim. The formal element in English law appears to be similar to

156 . See ante , 247. 157 . ibid. 158 . ibid. 159 . [2010] EWCA Civ 667; [2011] 1 Lloyd’s Rep 517 . 160 . Post-contractual conduct is not generally relevant to contract interpretation see McBryde, [8.30–8.33]. 161 . [2010] EWCA Civ 667; [2011] 1 Lloyd’s Rep 517 .

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the need for the obligations to be counterparts of each other before mutuality retention can be used in Scots law. In Scots law there is an assumption that the obligations undertaken by each of the parties under a contract are counterparts unless there is evidence to the contrary. In English law the fact that the claims arise from the same contract is not suffi cient, of itself, for there to be the requisite connection for equitable set-off. The defendant must also show that it would be manifestly unjust to allow the claim to be enforced, given the connection between the claims. It therefore seems easier to satisfy the requisite connection requirement, where the claims arise from the same contract, in Scots law than in English law. This is unsurprising, given that retention is based on the mutuality principle in Scots law—that parties enter into obligations in return for their contracting partner’s counter-obligations in the contract—whereas English law has historically considered promise and counter promise as independent.

It is suggested that in Scots law it is for the defender to show that the claims are counterparts and that the pursuer’s breach is suffi ciently material for him to be able to utilise mutuality retention but it is for the pursuer to show that mutuality retention is being used inequitably such that the court should not permit it. In Scots law mutuality retention is available unless the court fi nds its use inequitable, whereas in English law it is currently for the defendant to show that equity requires that he be permitted to set-off. 162

English law may, however, benefi t from moving slightly closer to the Scottish approach insofar as the connection between the parties’ claims is concerned. The test set out in Geldof , particularly the functional element, may be criticised as permitting too much judicial discretion and creating uncertainty. 163 It is suggested that certainty would be improved if English law developed an assumption that parties’ principal obligations fl owing from the same contract are suffi ciently closely connected such that it would be manifestly unjust for a claim in respect of a principal obligation to be allowed without taking account of a cross-claim arising from a principal obligation. There would also be an assumption that set-off could operate between ancillary obligations fl owing from the same contract. In most cases it is likely that a cross-claim regarding a principal obligation will be suffi ciently closely bound up with a claim in relation to a principal obligation that justice requires both claim and cross-claim to be taken into account. In many cases the same may be said of claims and cross-claims regarding ancillary obligations. The assumption would be overturned where an analysis of the contract discloses that the obligations in question are not closely connected, or other factors exist which mean it would not be manifestly unjust to allow the claimant’s claim without the defendant’s cross-claim being considered. 164 It would be for the claimant to show that the assumption should be rebutted such that the defendant was not entitled to equitable set-off. Using this approach, both connection between claims and justice between the parties are taken into account in line with recent authority. 165 There is, however, a different starting position, a change of emphasis and evidential burden. Where the claim and cross-claim do not arise from the same contract, it is suggested that the defendant would have to satisfy the test

162 . See ante , 248–252 and 254. 163 . See ante , 250–252. 164 . In a similar manner as the equitable control available to the Scottish courts. 165 . See the discussion ante , 250.

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set out in Geldof to be able to use equitable set-off. The approach advocated here may result in slightly greater availability of equitable set-off. However, policy considerations of substantial justice between the parties do not suggest that this would be problematic. The concomitant increase in certainty of the availability of equitable set-off would be benefi cial, as would the saving in resources by avoiding multiplicity of actions between the same parties in relation to the same contract.

Scots law may also benefi t from developing rules in line with the operation of equitable set-off in English law. The circumstances in which the Scottish courts will hold the use of mutuality retention inequitable are presently unclear. Unlike the equitable control in English law, this control in Scots law is not concerned with the degree of connection between the parties’ claims. 166 A signifi cant issue is that the defender seems able to retain his entire reciprocal obligation even where this exceeds the pursuer’s claim against him and is more, perhaps signifi cantly so, than the defender can claim from the pursuer for breach of the reciprocal obligation. 167 In the example above, B could retain the price of £10,000 even though the highest amount he could be awarded in damages for A’s breach of contract is £5,000. In developing the equitable control in Scots law, inspiration could perhaps be drawn from English law. In this way, where the right to retain is used as a defence by B against a monetary action 168 raised by A, and where B has an illiquid claim against A, B would have to make an assessment of his claim, in good faith. B would have to pay over any surplus to A, withholding only the reasonable quantifi cation of his claim. This approach has the benefi t of being clear, certain and equitable. 169

IV. CONCLUSION

The above analysis demonstrates that, while compensation in Scots law is functionally equivalent to independent set-off in English law, the much broader doctrine of equitable set-off in English law fi nds its functional equivalent in one aspect of mutuality retention in Scots law. To say that compensation or retention are akin to set-off in English law, as many Scots lawyers do, is therefore only partially correct. It does not tell the full story and masks signifi cant differences in the operation of the doctrines. Set-off is not a UK-wide concept. There is no doctrine of set-off in Scots law. While functional equivalents to set-off exist in Scots law, it may be concluded that set-off is not a doctrine divided by a common language within the UK. Scots law should continue to use the terms “compensation” and “retention” rather than set-off to prevent confusion with the many facets of the doctrine in English law.

The analysis between independent set-off and compensation demonstrates that compensation is a more signifi cant defence than independent set-off in English law, given that compensation in Scots law operates retrospectively. This has important consequences

166 . That being dealt with by the need for the obligations to be counterparts in Scots law. 167 . See ante , 256. 168 . Be that an action for payment or damages. 169 . DCFR, Art.III-3:401(4) provides that the performance that may be withheld is the whole or part of

the performance as is reasonable in the circumstances. Given that retention is a self-help remedy, a standard of reasonableness suffers from lack of certainty and is likely to result in dispute.

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in terms of whether the debtor is in default. In English law a party with a defence of independent set-off would, until judgment, be in default if the sum sought by the claimant was due. In Scotland the defender would not be in default as, once the court allows compensation, it operates retrospectively to the time that the cross-claims came into existence. This has important consequences for the use of default remedies by the claimant. In Scotland, where the defender could plead compensation the pursuer would not be able to utilise default remedies, whereas, despite a defendant in England pleading a defence of independent set-off, the claimant would be able to make use of default remedies. The creditor in England is therefore in a stronger position. Those advising north and south of the border need to be alive to this signifi cant difference in the operation of the doctrines. There is a real risk of mistakes being made here, given that compensation is often referred to as set-off in Scotland and the fact that the doctrines otherwise operate in a relatively similar manner. On the issue of retrospective effect, the laws of Scotland and England are likely to remain different. However, other areas where the law in both jurisdictions could be brought into line with each other to achieve the policy objective of preventing multiplicity of actions have been suggested. 170

The search for a functional equivalent to equitable set-off in Scots law has drawn into focus the scope of the principle of mutuality in Scots law, in particular use of mutuality as a defence, rather than as simply seeking to secure future performance. It is argued that recent statements by the Scottish courts that mutuality retention can be used only to secure future performance are unsound in principle and irreconcilable with Supreme Court authority. It is apparent that a doctrine as broad as mutuality retention must be controlled so that it is not used in an abusive fashion to thwart claims. This should, however, be done in a way that is principled and doctrinally coherent.

It has been suggested that equitable set-off in English law may be improved by taking inspiration from Scots law in establishing the requisite connection between the claims. The current test, as set out in Geldof , results in uncertainty as to when the courts will allow equitable set-off. An assumption, which could be overturned in certain circumstances, that claims and cross-claims in relation to principal obligations arising from the same contract, and claims and cross-claims regarding ancillary obligations from the same contract, are suffi ciently closely connected for equitable set-off to operate has been suggested. This would increase certainty but still offer suffi cient fl exibility to ensure substantial justice between the parties, in line with policy objectives.

170 . See ante , 245.

set-off: a concept divided by a common language? · equivalent here is found in the doctrine of...

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