A difficult balancing act.

A number of recent cases have involved cross-claims.

Daniel Atkinson looks at what the rulings mean and when a court, arbitrator or adjudicator will allow 'set-off'

WHEN someone with whom you have a contractual dispute lodges a claim against you, there are various ways in which to mount a defence.

You might argue a different interpretation of the contract terms, dispute the facts, or challenge the quantification of the claim.

The damage can also be mitigated by making a cross-claim in relation to the contract, or even in relation to a different contract with the same party.

If the grounds are legitimate, the cross-claim can be used to try and reduce or extinguish the claim against you. This is 'set-off', so called because the cross-claim offsets the original claim partially or in total.

If such a dispute is referred to a tribunal that has the jurisdiction to decide both the claim and cross-claim in the same proceedings, the outcome will be an account of the balance of sums due between the parties across their transactions.

But this process can come unstuck if the original claimant raises objections to the jurisdiction of the tribunal - whether a court, an arbitrator or an adjudicator - to determine the cross-claim.

There are basically three types of set-off: independent, transaction and bankruptcy.

The contract itself may also state or restrict the right of set-off.

Distinguishing transaction set-off from independent setoff is important. If the court lacks jurisdiction to decide the cross-claim then it cannot decide the independent set-off in the same proceedings as the claim because independent setoff is not a defence to a claim.

In that case the defending party may be involved in delay and the resulting cash f low problems created by having to decide the cross-claim in separate proceedings. This could be significant if, for instance, the claim can be decided in adjudication and the cross-claim cannot.

For example, last year's case of Metal Distributors UK v ZCCM Investment Holdings established that, if the claim falls within an arbitration agreement but the cross-claim does not, then the arbitrator does not have jurisdiction to decide the cross-claim unless it is a true defence to the original claim and not a counter-claim.

The main difference between the two set-offs is that transaction set-off is a cross-claim arising out of the same transaction as the claim or one so closely related that it operates as a defence to the claim.

If there is a well-founded objection to jurisdiction to decide the cross-claim, in a transaction set-off fairness of the proceedings is normally a factor in deciding whether set-off should be allowed anyway.

The authorities are generally in favour of allowing the transaction set-off to be decided in the same proceedings as the claim. But the determination of independent set-off in the same proceedings as the claim is not essential to a fair determination of the dispute.

The important point is the rules on set-off may prevent the disputes between the parties being dealt with expeditiously.

The concept of transaction set-off is intended to ensure fairness in deciding a claim by also deciding any cross-claim that should be decided at the same time.

Transaction set-off can also arise out a separate but related contract. But the mere fact that both claim and counterclaim arise out of a single trading relationship between the parties is not sufficient to supply the link necessary to support a transaction set-off. For this to happen it must be unfair for the claim to be paid without also allowing any well-founded cross-claim to be heard.

The issue then is to identify the type and extent of the connection that would make a setoff a transaction set-off instead of an independent set-off.

In the recent case of Bim Kemi AB v Blackburn Chemicals, Bim Kemi claimed damages for breach of a 1994 agreement and Blackburn cross-claimed for the breach of a 1984 agreement.

Bim Kemi tried to defeat the cross-claim but the court ruled that the two agreements were inseparably connected by the continuum of the parties' trading relationship and the fact that the 1994 agreement was supplementary to, and did not replace, the 1984 agreement.

The conduct alleged by Blackburn was a breach of the obligations of both agreements, satisfying the test of "close and inseparable connection".

In the 2004 case of Ronly Holdings v JSC Zestafoni G Nikolodze Ferroalloy Plant it was held that the arbitrator did have jurisdiction to allow a transaction set-off, even though the set-off arose under a separate, but related, contract falling outside the arbitrator's jurisdiction.

Here, consideration of the cross-claim was not an extension of jurisdiction but simply a determination of whether or not there was a valid defence to the claim.

In another 2004 case, Benfold v Lopecan, the court held that if the cross-claim exceeded the original claim in a transaction set-off, the claim could not be referred back to arbitration since there would be nothing left to refer - the matter would have been decided by the court.

In the most recent decision (Econet Satellite Services v Networks, 2006) the court considered whether transaction set-off could be excluded from the jurisdiction of the arbitration tribunal by the terms of the contract itself.

The parties entered into a number of contracts and disputes that arose under one of these contracts were referred to arbitration. A defence of transaction set-off was raised.

In this case the judge held that the parties had signed an arbitration agreement that contained the rule that a transaction set-off arising out of a different contract could not be raised. Accordingly he said the arbitration tribunal did not have jurisdiction to consider the cross-claim.

It seems that the parties may exclude transaction set-off from the jurisdiction of the arbitrator without any consideration of the resulting fairness of the proceedings or the resulting multiplicity of legal actions.

It may be of some importance in the Econet case that the judge observed that the interpretation of the arbitration rules was not contrary to commercial common sense.

The contract relied upon for set-off might be subject to a different arbitration regime and governing law. He said that the cross-claim might exceed the claim, in which case there would be a separate arbitration to establish entitlement to the balance, although this part of the reasoning is doubted.

Key points

Set-off can be used to try and reduce or extinguish a claim against you.

Independent set-off does not constitute a substantive defence to a claim.

If in transaction set-off there is an objection to jurisdiction, the fairness of the proceedings is normally a factor in deciding whether set-off should be allowed.

Set-off might be subject to an arbitration clause that prevents the court considering it with the original claim.