(1) Where two parties owe each other money or other performances of the same kind, either of them (“the first party”) may set off its obligation against that of its obligee (“the other party”) if at the time of set-off,
(a) the first party is entitled to perform its obligation;
(b) the other party’s obligation is ascertained as to its existence and amount and performance is due.
(2) If the obligations of both parties arise from the same contract, the first party may also set off its obligation against an obligation of the other party which is not ascertained as to its existence or to its amount.
1. Use of set-off
Under the Principles, when two parties owe each other an obligation arising from a contract or any cause of action, each party may set off its obligation against the obligation of the other party. By mutual deduction, both obligations are discharged up to the amount of the lesser obligation (see Article 8.5). Set-off avoids the need for each party to perform its obligation separately.
The obligor from whom payment is asked, and who sets off its own obligation, is called “the first party”. The obligee who first asks its obligor for payment and against whom the right of set-off is exercised, is called “the other party”.
1. A, a sea carrier, has carried goods belonging to B from country X to country Y. A asks B for EUR 10,000 as payment for the carriage. B, who had previously become an obligee of A for an amount of EUR 10,000 as compensation for harm to other goods carried, may set off its own obligation to pay A EUR 10,000 against A’s obligation to pay it EUR 10,000. If it does so, neither A nor B will remain the other’s obligor.
2. A sells B a plot of land for the price of AUD 100,000. Subsequently B, who is a contractor, builds a house for A. The price of the construction is AUD 200,000. When A asks for the payment of the land, B may set off the price of the construction. The obligation of B to pay A AUD 100,000is totally discharged, but A remains B’s obligor for AUD 100,000.
For a party to be allowed to set off its own obligation against the obligation of the other party the conditions laid down in this Article must be satisfied.
2. Obligation owed to each other
A first condition is that each party is the obligor and the obligee of the other (paragraph (1), opening sentence). To be noted is that the parties must be so in the same capacity. Thus, set-off is not possible if the first party has an obligation to the other party in its own name but is the obligee of the other party in another capacity, for example as a trustee or as the absolute owner of a company.
3. Company A sells company B machinery for 600,000 Japanese Yen (JPY). B, which is in business with company C, a subsidiary of A, sells C products for JPY 500,000. When A asks B to pay the sales price of the machinery, B cannot set off its obligation for the sale of the products to C, even if the capital of C is totally subscribed by A, as C is an independent entity. A and B are not obligor and obligee of each other.
The condition that the obligations must be owed to each other may give rise to a problem where the other party has assigned the obligation owed to it by the first party to a third party. The first party may nonetheless set off its obligation against the other party’s obligation if the right of set-off existed against the assignor’s obligation before the assignment was notified to the obligor (see Article 9.1.13).
3. Obligations of the same kind
Both obligations must be of the same kind (paragraph (1), opening sentence). In some legal systems obligations have to be “fungible”. A monetary obligation may be set off only against a monetary obligation. A delivery of grain may be set off only against a delivery of grain of the same kind.
The concept of “obligations of the same kind” is broader than that of “fungible obligations”. Performances of non-monetary obligations may be of the same kind while at the same time not being fungible. Two obligations to deliver wine of the same vineyard but not of the same year may be obligations of the same kind, but would not be fungible. Cash and securities are not performances of the same kind in the sense of this Article. Nevertheless, as is the case with different foreign currencies, set-off may be exercised if the securities are easily convertible and if there is no agreement to the effect that only the payment of specified cash or securities is possible. Whether or not obligations are of the same kind may depend on commercial practices or special trade rules.
A personal obligation cannot be of the same kind as another type of obligation. Set-off is thus not available if one of the obligations is of a personal nature.
4. A, a crude oil producer, contracts to deliver 1,500 tonnes of crude oil by pipe-line every month to B in country X. B, in turn, must each week transfer 1,000 tonnes of crude oil by road. The crude oil produced by A and the crude oil delivered by B do not have the same origin and are not totally similar, but as their use could be identical, the two obligations relating to the crude oil can be said to be of the same kind, and if A and B are obligor and obligee for the delivery of some quantity of crude oil, set-off will be available.
5. A holds 100 ordinary shares of the company C. Shareholder B of the same company holds 120 redeemable preferred shares. They are obligee and obligor of each other, and in an earlier contract it was provided that payment would be possible by means of shares of equal value. Since the shares held by A and the shares held by B are not of the same kind, set-off cannot be exercised.
4. First party’s obligation performable
The first party must have the right to perform its obligation (paragraph (1)(a)). It cannot impose on the other party a performance which either has not yet been ascertained, or is not yet due.
6. A has sold ten trucks to B for USD 1,000,000. B must pay for the trucks before 30 September. B wishes to set off an obligation it has towards A arising from a loan to A, repayment of which is due on 30 November. Before this date B may not set off its obligation towards A, as it cannot pay A before 30 November. B’s obligation to A is not yet due.
7. A owes B EUR 200,000 for the repayment of a loan. The repayment must take place on 30 January. B is obliged to pay A for a claim for damages of EUR 140,000, under a judgment handed down on 25 January. A asks B to pay on 9 February. B, whose obligation can be performed, is allowed to set off its obligation against A’s obligation.
8. A has sold B 10,000 bottles of wine, the price of which must be paid at the latest on 30 October. B is also A’s obligee and A’s obligation is already due. B may set off its own obligation against A’s obligation on 10 October even if the latest date B’s obligation should be paid is 30 October, because A is bound to accept a payment before such date.
5. Other party’s obligation ascertained
Set-off may be exercised only when the other party’s obligation is ascertained both as to its existence and as to its amount (paragraph (1)(b)).
The existence of an obligation is ascertained when the obligation itself cannot be contested, for example, when it is based on a valid and executed contract or a final judgment or award which is not subject to review.
Conversely, an obligation to pay damages is not ascertained when the obligation may be contested by the other party.
Even if the existence of the other party’s obligation is not contested, it is not possible to exercise set-off if the obligation is not ascertained as to its amount. If the existence of the harm is not disputed, but the amount of the compensation has not been fixed, set-off will not be available.
9. A judgment requires A to pay B 200,000 Chinese Yuan Renminbi (CNY), for breach of contract. B is in turn A’s obligor for the repayment of a loan of CNY 240,000, repayment of which is already due. A asks B to pay the CNY 240,000. B may set off its obligation against A’s obligation arising from the judgment.
10. A sells B a yacht for EUR 300,000. A is liable to B for tort. The harm is not contested, but the amount of damages has not yet been fixed. A will not be permitted to set off its own obligation, as A’s obligation has not been ascertained.
The Principles do not deal with the impact of insolvency proceedings on the right to exercise set-off, which is therefore to be determined by the applicable law. Most domestic laws grant the first party the right to exercise set-off even after the other party has become involved in insolvency proceedings, thereby derogating from the principle of the equality of the creditors in insolvency proceedings.
6. Other party’s obligation due
The other party’s obligation must furthermore be due (paragraph (1)(b)). An obligation is due when the obligee has the right to request performance by the obligor, and the obligor has no available defence against that request. A defence will, for example, be available if the time of payment has not yet arrived. As a natural or moral obligation is not enforceable, the first party may not set off its obligations against such an obligation owed by the other party. The enforceability or non-enforceability of an obligation may depend on the otherwise applicable law. Consequently, in some cases the possibility to exercise the right of set-off may depend on the otherwise applicable law.
11. By a final judgment of 10 April, A was ordered to pay B USD 20,000 for the sale of cotton. A, who is B’s obligee for the repayment of a loan of USD 12,000 which was enforceable as from 10 January, may set off its own obligation against B’s obligation. B, whose obligation is ascertained and due cannot contest the set-off exercised by A.
Since the expiration of the limitation periods prevents the enforce¬ment of the obligation but does not extinguish the right itself, the first party who is not allowed to enforce the time-barred obligation may nonetheless set off that time-barred obligation (see Article 10.10).
7. Set-off of obligations arising from the same contract
Set-off is a convenient means of discharging obligations at once and at the same time. Therefore, if the two obligations arise from the same contract, the conditions of set-off are modified.
If the obligations of the two parties arise from the same contract, the first party is allowed to set off its own obligation against an obligation of the other party even where that other party’s obligation is not ascertained as to its existence or to its amount (paragraph (2)). Thus, for instance, an obligation to pay damages may be ascertained as to its existence but not as to its amount. If the minimum amount payable cannot be contested, the first party may set off its own obligation up to that minimum amount, even if the total amount of the other party’s obligation is unknown.
Even though one of the obligations is contested, the right to set-off can be exercised because all the relevant obligations capable of being set off arise from the same contract and can therefore be easily identified. This could be useful to parties in a business relationship to facilitate quick settlements of claims. Judicial intervention may however be necessary to determine whether the conditions of set-off are in fact satisfied. In international commerce, the obligations of the two parties may frequently arise from the same contract.
12. A carries turkeys for B from country X to country Y. The carriage charge is 35,000 Russian Roubles (RUB). During the carriage one hundred turkeys die due to the fault of the carrier which it acknowledges. A asks B for the payment of the carriage. B may set off the obligation to pay for the harm caused by the loss of the turkeys against A’s obligation. Although the amount of the damages is not ascertained, it would be easy to estimate the damages and determine if the conditions for set off are satisfied as the two obligations arise from the same contract.
13. A, a carrier, accepts to carry a piano for pianist B from country X to country Y. A provision of the contract expressly provides that delay penalties are to be paid if the piano is not delivered at the concert hall five days before the date of the concert. The piano is delivered at the place of destination only two days before the date of the concert. A asks for the payment of the carriage. B may set off its claim for the agreed delay penalties against A’s claim even if A contests the amount of the penalties owed for the delay.
8. Set-off by agreement
Even if the conditions of this Article are not met, the parties may achieve the effects of set-off by agreement. Likewise, parties may agree that their mutual obligations are set off automatically either at a specific date or periodically. Also, more than two parties may agree that their respective obligations shall be discharged, for example by netting.
Where the obligations are to pay money in different currencies, the right of set-off may be exercised, provided that both currencies are freely convertible and the parties have not agreed that the first party shall pay only in a specified currency.
1. Convertible currencies
Payments in different currencies are not performances of the same kind as required by Article 8.1. However, if the payments are to be made in currencies that are both convertible, set-off may nevertheless be exercised. According to Article 6.1.9, if there is no agreement to the contrary, payment may be made by the obligor in the currency of the place for payment, if this currency is convertible. On the contrary, since the relative value of a currency that is not freely convertible cannot be readily ascertained for the purpose of set-off, set-off cannot be used to impose payment in such a currency on the other party.
1. A, a wine producer in country X, sells 5,000 bottles of wine for USD 200,000 to B, a cork producer. B sells 100,000 corks to A for the price of 100,000 livros, which is the currency of the country where corks are produced and which is not convertible. A asks B for payment of the USD 200,000. B may not set off the 100,000 livros against the USD 200,000.
2. Currency specified by contract
If a contract expressly requires a party to pay in a specified currency, and if the other party has to perform its own obligation in a currency different from that currency, it will not be able to set off its own obligation against the other party’s obligation.
2. A sells B products for USD 100,000. The sales contract expressly provides that the price is to be paid by the buyer in US dollars. B, an Asian carrier, is A’s obligee for an unpaid invoice for carriage charges which must be paid in Korean Won. A requires payment of the USD 100,000. B, who contractually is obliged to pay the price of the products in US dollars, is not allowed to set off its obligation against the obligation of A to pay the carriage charges.
The right of set-off is exercised by notice to the other party.
The right of set-off is exercised by notice to the other party. It does not operate automatically or by declaration of the court. The first party must inform the other party that it will discharge its own obligation by set-off. Notice must not be conditional.
To be effective, notice must be sent after the conditions for set-off are fulfilled.
Notice may be given by any means appropriate to the circumstances and is effective when it reaches the person to whom it is given (see Article 1.10).
(1) The notice must specify the obligations to which it relates.
(2) If the notice does not specify the obligation against which set-off is exercised, the other party may, within a reasonable time, declare to the first party the obligation to which set-off relates. If no such declaration is made, the set-off will relate to all the obligations proportionally.
According to paragraph (1), the notice must specify the obligations of both parties that are to be set off. The other party, receiving the notice, must know the grounds for set-off and the amount of set-off.
1. Declaration by the other party
If the first party has two or more obligations against the other party, and if the first party has not specified the obligations it wants to be paid by set-off, the other party may freely choose which of the first party’s obligations it wants to be discharged (paragraph (2), first part).
1. A regularly sells B cloth. On 30 December B asks A for the payment of USD 50,000 that A owes it. At that date B owes A the payment of the price relating to three different sales contracts, i.e. USD 40,000, USD 35,000 and USD 45,000 respectively. If A wants to set off B’s obligation, it has to indicate in the notice which of the three obligations owed by B it wants to set off. If A does not indicate in the notice which obligation owed by B it wants to set off, B may in a reasonable time indicate to A that its obligation of USD 45,000 will be totally discharged by set off and that the obligation of USD 35,000 will be discharged up to USD 5,000. After set-off has been applied, B remains the obligor of A for USD 70,000.
2. Absence of declaration
If the notice does not specify the obligations that the first party wants to set off, and if the other party does not make any declaration as to which obligation set-off relates within a reasonable time, all the obligations of the other party will be discharged by set-off proportionally, up to the value of the first party’s obligation (paragraph (2), second part).
2. The facts are the same as in Illustration 1, except that B does not declare to which obligation set-off relates. In the absence of such a declaration, set-off will discharge the obligation of USD 40,000 of the first contract up to USD 16,670; the obligation of USD 35,000 of the second contract up to USD 14,580 and the obligation of USD 45,000 of the third contract up to USD 18,750.
(1) Set-off discharges the obligations.
(2) If obligations differ in amount, set-off discharges the obligations up to the amount of the lesser obligation.
(3) Set-off takes effect as from the time of notice.
1. Discharge by set-off
If the conditions of set-off specified in Article 8.1 are satisfied, the obligations of both parties are discharged to the extent of the set-off, as if two reciprocal payments had been made.
1. A owes USD 100,000 to B and B owes USD 100,000 to A. B asks for the payment of its obligation. A by notice declares to B that it sets off its own obligation. After set-off takes effect, the two obligations are discharged.
If the two obligations differ in their amount, set-off will discharge the obligations, but only up to the amount of the lesser obligation.
2. B owes USD 100,000 to A, who in turn owes B USD 70,000. A asks for the payment of the USD 100,000 it is owed, B declares that it wants to set off A’s obligation of USD 70,000. If the condi¬tions for set-off are met, A is no longer the obligor of B, as its obligation has been entirely discharged, but A is still the obligee of B for USD 30,000, corresponding to the part of the obligation not paid by set-off.
2. Set-off effective at the time of notice
The obligations are discharged at the time of notice if at that time the conditions required for set-off are fulfilled. Set-off does not operate retroactively. It has prospective effect only.
The date of effectiveness of set-off is consistent with the necessity to declare set-off by notice, and in practice the date when set-off is effective will be easy to know.
The situation has to be evaluated as if both obligations were paid at the time of notice. Two consequences derive from this rule. Firstly, interest on the obligations runs until the time of notice. A party who may and wants to set off its obligation, must declare set-off as soon as possible if it wishes to stop the accrual of interest. Secondly, if an undue payment has been made after set-off has been declared, restitution will take place, as the payment has no legal grounds. If the payment had been made before the notice, it is an effective payment and restitution cannot be required.
3. A owes B USD 100,000 dollars for goods sold by B. A’s obligation is ascertained and payment is due on 20 November. By a judgement dated 30 November, B is ordered to pay A USD 80,000 in damages. The obligation to pay USD 80,000 is due and ascertained at the date of the judgement, i.e. on 30 November. Set-off is exercised by A by notice on 10 December. The set-off will take place at the time of notice as all the conditions required have been satisfied before this date. The two obligations are discharged up to the amount of the lesser obligation. A will remain the obligee of B for USD 20,000. After 10 December, interest no longer accrues, except on the amount of USD 20,000.
At the time when the conditions for set-off are satisfied and notice has been given, not only are the principal obligations discharged but also related rights, e.g. rights securing an obligation, are discharged accordingly.
4. A, a banker, had lent architect B EUR 100,000 and has obtained a personal security for the payment from B’s wife. B is the obligee of A for EUR 120,000, which is money that B holds on its account in A’s bank. A asks B for the payment of the EUR 100,000. B declares set-off by notice on 12 December. The conditions required for A’s obligation and B’s obligation were fulfilled on 10 December. At the date of notice on 12 December, A’s and B’s obligations are discharged, as is the personal security given by B’s wife.