Setoff is a legal concept that frequently arises in the construction industry. In the construction context, a party can offset a payment obligation to a receiving party with any damages suffered on another project due to the receiving party’s actions. The right to setoff frequently is expressly stated in the contract.

For example:

A Corp., a general contractor, engaged B Corp. to perform as a subcontractor on two separate projects (Project 1 and Project 2) pursuant to two subcontracts. Under the subcontract for Project 1, B Corp. was to be paid $10,000 for its work, and according to the subcontract for Project 2, B Corp. was to be paid $5,000 for its work. Both subcontracts also expressly provide that A Corp. can set off damages incurred on other contracts between the parties.

B Corp. completed the work on Project 1 and submitted its final payment application to A Corp. for $5,000, the remaining amount due under the Project 1 subcontract. However, B Corp. performed defective work on Project 2, and A Corp. had to pay $5,000 to another subcontractor, C Corp., to correct B Corp.’s work on Project 2.

A Corp., pursuant to the subcontracts, sets off the $5,000 in costs it incurred to correct B Corp.’s defective work on Project 2 and refuses to pay the remaining balance owed to B. Corp. for its work on Project 1. Is this allowed under the laws of Virginia, Maryland and Washington, DC?

Virginia

Historically, Virginia permitted setoff provisions in both public and private contracts. However, this changed in 2020 when the legislature amended Virginia’s mechanic’s lien statute to bar setoff provisions in private contracts. Now, “[a]ny contract or subcontract provision that allows a contracting party to withhold funds due under one contract or subcontract for alleged claims or damages due on another contract or subcontract is void as against public policy.”

The amendment bars setoff provisions in private contracts and renders all such provisions void and unenforceable. However, nothing in the amended statute prevents owners or contractors from withholding funds based on defective work on the project covered by the particular contract at issue. This is a key point that contractors and subcontractors should be aware of, and each should maintain extensive records pertaining to the work completed in the event that deficiencies are alleged.

The guidance on setoff provisions in public projects is less clear, but it is likely that courts will continue to uphold such provisions in the absence of any amendment similar to the Virginia Public Procurement section of the Virginia Code. One possible basis to invalidate setoff provisions in public contracts is Va. Code. 11-4.1:1, which provides that “[a] provision that waives or diminishes a subcontractor’s, lower-tier subcontractor’s, or material supplier’s right to assert payment bond claims or his right to assert payment bond claims or right to assert claims for demonstrated additional costs in a contract executed prior to providing any labor, services, or materials is null and void.” Arguably, setoff provisions, e.g., signing off on the right to setoff in contract, “waives or diminishes” a payment bond claim, and thus could not be used as a defense to such a claim. Courts are likely to conclude that a contractor or subcontractor retains the right to assert a claim for money withheld under the exercise of the setoff provision, and therefore setoff does not “waive or diminish” a contractor or subcontractor’s right to assert bond claims as is required to trigger Va. Code 11-4.1:1. Accordingly, subcontractors should assume that setoff is still permitted on public projects in Virginia and should carefully scrutinize such provisions in public contracts before contract execution.

Maryland

Maryland law prohibits setoff on both public and private contracts. Specifically, the Maryland Construction Trust Statute, which applies to both public and private works, requires a contractor or subcontractor to hold in trust those funds they receive as payment for work performed by their respective subcontractors. Should the contractor or subcontractor use trust funds “for any purpose other than to pay those subcontractors for whom the money is held in trust,” the contractor, subcontractor, as well as any of their officers, directors, or managing agents responsible for directing the improper use of trust funds, “shall be personally liable to any person damaged by the action.”

The state statute also prohibits a contractor or subcontractor from using trust funds for any purpose other than to pay their subcontractors for work performed on a particular project. Contractors exercising their rights to withhold funds should do so very carefully. Based on the statute’s plain language, withholding money owed to a subcontractor on one project to recoup or setoff damages caused by that subcontractor on a separate project violates the Maryland Construction Trust Statute. Moreover, an officer, director, or agent who knowingly directs a setoff across projects that violates the statute may be personally liable to anyone damaged.

Absent contrary authority, which does not currently exist, Maryland’s legislation provides contractors and subcontractors who seek to contest a setoff across projects ample leverage to do so. Conversely, parties who seek to exact a setoff across projects should tread carefully. Although the regulation does not bar setoff in express terms, it does expose those who attempt to setoff to potential liability, and in certain instances, personal liability, of its management.

Washington, DC

DC law is silent on the issue of whether setoff provisions are permitted in public and private contracts. Based on the absence of authority, it is generally believed that setoff is permitted in both contexts. However, a change to DC’s law may well be forthcoming.

On May 21, 2021, DC’s legislative body, the Council of the District of Columbia, introduced a bill that proposes to prohibit setoff on private construction projects. If the bill is passed into law, “any contract or subcontract provision in a contract… that allows a party to withhold funds to offset claims or damages due on another contract is rendered void against public policy.”

If this bill is approved by the mayor and established as law, setoff will be prohibited on private projects, and any such provision in a private contract that attempts to give a party authority to exact a setoff will be rendered unenforceable. A public hearing on this version of the bill is scheduled for October 19, 2022.

Until the proposed legislation is made law, setoff is likely permitted on public and private works if specifically provided for by contract. Contractors and subcontractors should continue to exercise a high degree of care in reviewing setoff provisions because it is unlikely that courts will declare such provisions invalid and unenforceable.