When can you set off claims against different elements of a project?

The recent case of Shepherd Construction Ltd v Drax Power Ltd addressed the question of whether an employer was entitled to withhold sums relating to claims regarding the first of two elements of a project from a final milestone payment for the second element of the project, notwithstanding the fact that the first element of works had already been completed. The facts

Shepherd entered into a contract with Drax to undertake works for the construction of a facility for the unloading of biomass fuel from rail wagons and the subsequent handling and storage of that fuel (Ecostore works). The contract was subsequently varied to add a second element of works to construct a boiler distribution system to convey the biomass fuel from the Ecostore to silos for intermediate storage and then to the mills from which the boilers were to be fed (BDS works).

Taking over certificates for the Ecostore works were issued in September 2014 and the final milestone payment was made shortly after. Taking over certificates for the BDS works were issued in July 2017 and the defects notification period relating to those works expired in July 2018. Drax retained the balance of the retention money in respect of the BDS works and sought to make deductions from that sum as a result of defects in the Ecostore works.

The issues

Shepherd sought to recover this retention money and the following issues had to be decided by the Court:

1. Whether, on the correct interpretation of the contract, sums due for remedying the defects in the Ecostore works could be withheld from the retention money held in respect of the BDS works?
2. If the contract provided no right of withholding in such circumstances, could Drax withhold those sums by way of its general rights of set off or abatement?
3. Whether Shepherd’s interim payment application was a valid payment application pursuant to the terms of the Contract?

Contractual wording

The Court’s decision depended on the specific wording of the contract. Although they were interrelated and were part of the same project, the parties agreed that the Ecostore works and the BDS works were separate construction exercises and could have been undertaken by separate contractors.

The relevant contractual provision relating to payment of the retention money for the BDS works was that: “if any work remains to be executed under [the defects liability and tests after completion clauses] the Employer shall be entitled to withhold the estimated cost of this work until it has been executed and to deduct the same from amounts otherwise due to the Contractor until such time as the work is completed".

The Court held that the reference to “any work” was sufficient to allow the retention money for the BDS works to be withheld for defects in the Ecostore works. The Court saw this as a failure to distinguish between the Ecostore works and the BDS works, particularly with no definition, qualification or preamble as to what ‘any work’ referred.

Set off and abatement

Drax argued that the presumption to a right set off or abatement could only be excluded by express contractual wording (for which there was none). However, the Court found that there was no general rights of set off or abatement (nowithstanding that they were not expressly excluded) where contractual arrangements already made provision for the deduction of retention money.

Interim payment application

In relation to whether Shepherd’s interim payment application was valid, the Court had to consider the wording of the contract which entitled Shepherd to apply for payment taking into account ‘any claim or deduction’ by Drax. Drax argued that Shepherd’s application failed to take into account claims or deductions asserted by Drax in relation to the Ecostore works and was therefore not a valid application under the terms of the contract.

The Court rejected this argument and held that a contractor is entitled to apply for payment that it contends is due and that in doing so there is no requirement to subtract from that amount any claims and deductions asserted by an employer. As the Court rightly identified, the remedy for Drax (or any employer) where a payment application is in dispute is to serve a pay less notice.

Going forward

The Court’s decision raises important drafting considerations for construction contracts involving multiple elements of a project. In particular, it is important when drafting the payment provisions, the retention provisions and the rights of withholding to clearly set out whether the parties intend that sums can or cannot be set off from one element of works to another element.

The decision that Drax could not rely on the general rights of set-off and abatement is potentially surprising. It would have been thought by many that the general rights of set-off and abatement would still exist if they had not been expressly excluded, even if the contractual provisions setting out when certain monies could be withheld were silent on these general rights. Parties who wish to ensure that such rights are retained should consider expressly setting them out in their contracts.