Susan White | Frantz Ward
States have been slowly clawing back at a higher-tier’s ability to withhold payments owed to its lower-tier subcontractors, aiming to protect subcontractors from undue financial hardship and ensure that payment disputes are handled more equitably.
A standard withholding clause looks something like this:
The subcontractor agrees that contractor shall have the right to setoff against any monies due to subcontractor under this agreement, for any claims against subcontractor, whether rising under this agreement, or any other agreement with subcontractor.
Or, even broader, the clause could allow for the withholding of contingent liabilities that merely may occur:
Contractor shall have the right to setoff or withhold amount due to subcontractor under this agreement or any other agreement between the parties to cover contractors’ reasonable estimate of any damages, cost, or liabilities contractor has or may occur for which subcontractor may be responsible under this agreement or any other agreement between the parties.
Offset versus Setoff
A word of caution: while the terms offset and setoff are often used interchangeably – with both involving the withholding of payment from a lower-tier – they actually have distinct legal meanings.
Offset (also known as recoupment) is used to recoup costs, damages, or other amounts incurred due to a subcontractor’s actions, by withholding or deducting those amounts from payments otherwise due to that subcontractor on that same project. For instance, if the contractor still owes the subcontractor $100,000 for base scope and retainage, but the contractor incurs $30,000 worth of damages caused by the subcontractors delays on that project, the contractor can keep $30,000 of the $100,000 owed, issuing final payment of $70,000 to the subcontractor.
Setoff, on the other hand, occurs when a contractor offsets payments due on one project for damages incurred on a completely different project. For use of an example, subcontractor is owed $100,000 for work on Project A (which it successfully completed with no issues), and subcontractor and contractor are also working together on Project B, during which, contractor alleges it has incurred $60,000 worth of damages for defective work caused by subcontractor though contractor has already paid subcontractor in full for Project B. Under the theory of setoff, contractor then withholds its $60,000 worth of damages incurred on Project B from subcontractor’s payment due for Project A. The “or any other agreement” language from the two examples above illustrate the right to setoff.
Offset is generally more favored of the two since it involves withholding funds on the same project.
State Specific Enforcement of Setoff Rights
Although withholding clauses were traditionally favored and enforced, recent trends show that states are enacting legislation to limit their negative impact on subcontractors. States have become more aggressive in restricting the enforcement of setoff rights, although contractual and equitable offset rights are still often enforceable. It’s important to know your jurisdiction and its position on the enforcement of withholding clauses before getting stuck in needless back and forth negotiations concerning the same.
- States like California, Florida, and Virginia have legislation or case law that expressly prohibits or renders setoff clauses as void and unenforceable.
- Most “trust fund” states – like Maryland, New York, and Texas – have also inherently rendered setoff clauses as unenforceable.
Trust fund states require contractors to hold funds received in trust and use them exclusively to pay lower-tier subcontractors for work performed on that specific project. As a result, contractors cannot apply funds from one project to cover damages or losses on another. However, some trust fund states have specific carveouts for setoff, such as Colorado where setoff is a defense to a claim for a trust fund violation, so there’s no one size fits all model available.
Additionally, in some states, prompt payment statutes complicate the use of setoff. For example, Arizona courts have ruled that because the intent of the prompt payment statute is to ensure quick payment to subcontractors, contractors do not have a right of setoff. However, in other states, setoff may be allowed for good faith claims or legally enforceable debts, even with a prompt payment statute in place.
It’s also important to note that some states distinguish between public and private projects, permitting setoff in one context but not the other.
Another note of caution: issues can also arise when setoff is used on projects protected by payment bonds. Courts in some jurisdictions have held that even if the contractor has a contractual right to setoff, the surety company may not. Similarly, federal courts have held that a contractor is not entitled to setoff for debts owed on a non-bonded project with funds from a bonded project.
Withholding Implications for Lower-Tiers
These clauses are one-sided and only serve to the benefit of the higher-tier. If utilized, a subcontractor that has its payment withheld could be put in a cash flow crisis, especially in situations where the withholding right of the contractor is unfettered and allowed even for contingent claims. This could impact the success of the project by making it more difficult for the subcontractor to secure necessary labor and materials. Moreover, withholding can complicate payment management and billing procedures, especially when setoff is applied across multiple projects. Contractors may also use withholding as a negotiation tactic, withholding payment to pressure subcontractors into quickly resolving disputes.
Take Aways
Withholding clauses can be negotiated to ensure a more equitable risk allocation between parties.
- The contract should define clear, specific conditions for withholding, such as instances where the subcontractor has failed to pay lower-tier workers or suppliers, or when damages result from defective work. Avoid vague, open-ended clauses that allow withholding for any reason.
- Additionally, the clause can be drafted to require written notice and detailed documentation from the higher-tier.
- A maximum cap on the amount of withholding can also be negotiated into a clause as well as an agreed upon timeline for release of withheld funds.
- Finally, notice requirements and the right to cure can also be drafted into withholding clauses to provide more balanced risk between the parties.
Lower-tier parties should be vigilant about setoff language, which can extend withholding rights to payments owed on other projects and should pay attention to language that allows withholding for third-party contingent claims. They should also carefully review flow-down provisions and incorporation clauses. Even if withholding clauses do not appear in the subcontract, they may be embedded in the prime contract and unknowingly adopted through a broad prime contract incorporation clause.
Withholding clauses are a powerful tool in construction contracts, offering significant financial protection and risk management benefits for higher-tier parties, but they can also impose substantial burdens on lower-tier subcontractors. State legislatures and courts are paying attention to these implications with more changes expected in the coming years.
When one of your cases is in need of a construction expert, estimates, insurance appraisal or umpire services in defect or insurance disputes – please call Advise & Consult, Inc. at 888.684.8305, or email experts@adviseandconsult.net.