Project owners, general contractors and subcontractors 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. But what happens if 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 the first job, the general contractor runs into trouble and the owner claims $1 million in damages.
On the second job, 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 the second job with the damages incurred on the first job.
In another example, a general contractor contracts with an electrical subcontractor on two jobs. The electrical subcontractor successfully completes its electrical work on the first job and is owed $1 million by the general contractor.
However, on the second job, the electrical subcontractor’s work is allegedly defective, and the general contractor claims that it is owed million. How can the electrical subcontractor protect itself to make sure that it is paid for the work it successfully completed on the first job?
Setoff and Recoupment
Two related, but different, legal principles come into play: setoff and recoupment. Setoff allows a party to offset a payment due on one contract with damages incurred on another contract with the same party. Recoupment allows a party to offset a payment due with costs incurred under the same transaction or contract.
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.
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 work 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 general contractor’s acts and omissions.
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 or recoupment under the contract or any other agreement between the parties.
Trust Fund Laws
Even if the contract contains a setoff provision, local laws need to be considered before offsetting payments. For example, some states have enacted “trust fund” laws that protect subcontractor payments by providing that monies paid by the owner to the general contractor for labor, materials 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 that 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 that “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—particularly if the contract allows a party to setoff payments—general contractors and subcontractors should make sure to protect their ability to enforce mechanic’s lien rights to the greatest extent possible.
