Often, a project owner, general contractor or subcontractor may contract with each other on multiple jobs. When all goes well on each project, work is performed, payment applications are submitted and approved, and payments are made on each project. But, what happens when, for example, one project goes smoothly and the other project is mired in claims and disputes? 

Consider this scenario: An owner has contracted with a general contractor on two jobs. On Job 1, the general contractor runs into trouble and the owner claims $1 million in damages. On Job 2, the general contractor completes its work successfully and submits a payment application for a substantial amount earned. The owner wants to protect itself by offsetting the payment owed to the general contractor on Job 2 with the damages incurred on Job 1.

Or in another example, a general contractor contracts with an electrical subcontractor on two jobs. The electrical subcontractor successfully completes its electrical work on Job 1 and is owed $1 million by the general contractor. On Job 2, however, the electrical subcontractor’s work is allegedly defective, and the general contractor claims that it is owed $1 million. How can the electrical subcontractor protect itself to make sure that it is paid for the work it successfully completed on Job 1?

Legally, there are two related but different relevant legal principles: recoupment and setoff. Recoupment allows a party to offset a payment due with costs incurred under the same transaction or contract. Setoff allows a party to offset a payment due on one contract with damages incurred on another contract with the same party. The key difference is that setoff allows the party to offset payments due on one job against amounts owed on another job. Recoupment limits a party’s right to offset payments to the same job. The laws governing the rights of setoff and recoupment vary by jurisdiction, and local laws need to be considered. 

A useful technique for owners, general contractors and subcontractors to protect themselves from losses when contracting with the same party on multiple jobs lies in the careful drafting of the contract language before the job even begins. 

In the first scenario, the owner should protect itself by making sure to have a provision that explicitly grants the owner the right of setoff. Such a provision should provide that the owner may setoff amounts otherwise due to the general contractor under any contract, including other projects, in an amount necessary to cover the owner’s reasonable estimate of its costs, damages or liability incurred as a result of the acts and omissions of the general contractor. 

In the second scenario, the electrical subcontractor should protect itself by making sure that there is a provision in its subcontracts that provides for prompt payment upon completion of the work, without giving the general contractor the right to setoff amounts due. Such a provision should provide that payments to the electrical subcontractor for materials, work or services furnished under the contract are due upon submission of a proper payment application to the general contractor or engineer, and that those payments are not subject to any withholding, setoff and/or recoupment under the contract or any other agreement between the parties.

Even where the contract contains a setoff provision, local laws need to be considered before offsetting payments. For example, some states have enacted “trust fund” laws which protect subcontractor payments by providing that monies paid by the owner to the general contractor for labor, material and services are held in trust for the benefit of the subcontractors. In New York, for instance, the law applies to projects for “improvement of real property, including home improvement or public improvement” and protects “payment of claims of subcontractors, architects, engineers, surveyors, laborers and materialmen.”

In California, the law provides that “[a] prime contractor or subcontractor shall pay to any subcontractor, not later than seven days after receipt of each progress payment, unless otherwise agreed to in writing, the respective amounts allowed the contractor on account of the work performed by the subcontractors . . .” However, California law also contains an exception where there is a “good faith dispute” over any portion of the amount held in trust. If a good faith dispute exists, the prime contractor or subcontractor may withhold up to 150 percent of the disputed amount. In Colorado, all funds paid to a contractor or subcontractor who have a lien or may have a lien are to be held in trust. However, Colorado law also contains an exception that allows a contractor or subcontractor who “in good faith, claims a setoff,” to withhold payment “to the extent of such setoff.”

Therefore, local law may dictate whether and to what extent a contractor has the right to setoff a payment due to a subcontractor even if the contract contains a provision expressly allowing it. Trust fund laws vary by jurisdiction, and parties should confirm whether laws of this type affect their right of setoff. In addition, in dealing with setoff, and particularly if the contract allows a party to setoff payments, general contractors and subcontractors should make sure to the greatest extent possible to protect their ability to enforce mechanic’s lien rights. 

The right of setoff or the lack thereof can have implications for project participants. Project parties would be wise to understand the applicable setoff law and carefully consider contractual setoff language before entering into contracts and before any disputes arise.