It would not be fair and reasonable to allow a third party, who is not a party to the contract, to determine arbitrarily what amount can be withheld from amounts owing to a subcontractor, as a progress payment.

Withholding of progress payment by general contractor deemed unfair

by Paul Sandori

Breach of contract • Failure of general contractor to pay progress invoices • Subcontract to govern over prime contract in event of a conflict • Subcontract does not allow for set-off • Legal set-off • Equitable set-off • Set off of the amount of damages claimed by third party • Contract allowed set-off but did not apply to subcontract

Armenia Rugs/Tapis Ltd. v. Axor Construction Canada Inc.

The key issue in this case was whether a general contractor has the right to unilaterally set off the amount claimed as damages by a third party from a progress payment.

Armenia Rugs/Tapis Ltd., a subcontractor, sued Axor Construction Canada Inc., the general contractor on the RCMP building in Ottawa, for payment of $112,656. That was the value of work completed by Armenia under the contract to install ceramic tiles on the exterior walls of the building in the fall of 2002. After working on the job site for two and one-half months without being paid the progress invoices that were due, Armenia gave notice it was terminating the contract and refused to return to complete the balance of the work on the project.

Armenia had a dispute on the project with the International Labourer’s Union. The Union alleged that Armenia’s subtrade had hired labourers who were not members of the Union to mix the glue for the tiles. Axor notified Armenia that it would be setting off from the amount owing to Armenia the sum of $40,000 claimed as damages by the Union until the issue was resolved.

Armenia was obliged by its contract to employ only unionized labourers and, in addition, to “hold harmless the contractor, the owner and their affiliated companies from and against proceedings.”

The contract specified that the subcontract work was to be performed in accordance with the provisions of both the subcontract agreement between Axor and Armenia and with those of the prime contract between Axor and Public Works Canada. In the event of a conflict between the terms of the subcontract agreement and the prime contract, the subcontract agreement would govern.

The subcontract did not provide for a right of set-off but Article 10 of the subcontract provided that the subcontractor “shall indemnify and hold harmless Axor from any claims against it for damages, losses, and expenses, etc. arising out of the performance of the subcontractor’s work.”

The prime contract provided the Government of Canada with a right to set off money owed to it by Axor from any progress payment, but did not mention any right of set-off between Axor and its subcontractors.

The case between Armenia and Axor was heard by Justice Smith of the Ontario Superior Court of Justice. She first reviewed the law pertaining to set-off. The law recognizes two different kinds of set-off: (a) statutory or legal set-off, and (b) equitable set-off.

Legal Set-off

The right to legal set-off, said the judge, requires the fulfillment of two conditions:

• both obligations must be debts, and
• both debts must be mutual.

The term “mutual debts” means debts due from either party to the other for sums of money which can be established with certainty at the time of pleading.

Section 111 of the Courts of Justice Act, R.S.O. 1990, c. 43, provides that, in an action for a payment of a debt, the defendant may by way of defence claim a set-off against the plaintiff’s claim a debt owed by the plaintiff to the defendant. Mutual debts may be set off against each other, even if they are of a different nature.

The amount that Axor was proposing to withhold from Armenia was not a debt but rather a claim for an amount of damages that the Union might be awarded in some future proceeding. Thus, it was not a mutual cross‑obligation between Axor and Armenia and, as a result, the requirements for a legal set-off were not met.

Equitable Set-off

With regard to the requirements for equitable set-off, Justice Smith quoted from I.C.F. Spry, Principles of Equitable Remedies, 6th Ed. (Sydney: Law Book Co., 2001):

What must be established is a relationship between the respective claims of the parties, which is such that the claim of the defendant is so closely connected with the rights that are relied on by the plaintiff, that it would be unjust that he could proceed without permitting a set off.

The practical difference between a right of set-off and a counterclaim is usually that a judgment may not be obtained against a party that has a right to set off an amount against the amount claimed, whereas when a counterclaim is made, judgment may be obtained on the initial claim.

In this case, the general contractor asserted a right to unilaterally set off the full amount claimed against it by a third party, for undetermined damages. At the same time Axor insisted that the subcontractor continue to work on the project without receiving payment which was due for the work and services that had already been performed.

Justice Smith commented:

The timely payment of progress payments to contractors and subcontractors working on construction projects is of fundamental importance to contractors and subcontractors in the construction industry. The failure to pay a subcontractor a progress payment will often prevent the subcontractor from being able to pay its sub trades and its material suppliers on the project. The consequences of non-payment of a progress payment are potentially very serious to all parties involved.

Axor relied on the case of Swagger Construction Limited v. The University of British Columbia as authority to allow it to set off the amount claimed as damages by the Union against a progress payment which was acknowledged to be due and payable.

In the Swagger case, the architects had issued a certificate of substantial performance and the owner had taken possession of the building. The architect had also certified a progress payment of $674,287 as being due and owing to the contractor. The owner sought to set off an amount in excess of $4 million for damages for delay and the cost of correcting deficiencies on the project against the amount owing to the contractor as certified by the architect.

In Swagger, the set-off was pleaded as part of the owner’s defence to the action commenced by the contractor. Thus, in that case, there were mutual cross-obligations between the two parties to the contract, namely the owner and the contractor. On the other hand, in the case before Justice Smith, Axor was seeking to set off the amount of damages claimed against it by a third party, the Labourer’s Union.

The facts of the case were also distinguishable from the facts in the Swagger case on three key counts:

• no action had been commenced by Armenia against Axor when Axor set off the $40,000 from the progress payment and the set-off was not part of a defence pleading as in Swagger;
• the claim for damages was made by a third party, the Labourer’s Union, and was not a claim between the same two parties to the contract;
• there was no evidence of how the amount of the damages was calculated in either case, but in Swagger the amount of the owner’s claim for damages of $4 million greatly exceeded the amount owing to the contractor.

The court agreed with the reasoning in Swagger that the right to assert an equitable set-off exists at common law unless such a right is specifically waived in the contract. The contract between Axor and Armenia did not waive any right to equitable set-off and therefore that right continued to exist between the parties.

However, Justice Smith found that Axor was not entitled to unilaterally set off the sum of $40,000 and to withhold payment of this sum from Armenia’s progress payment. She summed up the reasons as follows:

• The amount claimed as damages by the Union was an arbitrary amount and there was no reliable objective evidence or method to ascertain the correct amount. If the Labourer’s Union had claimed damages of $100,000, asked the judge, could Axor have withheld that amount from a progress payment that was due and owing to Armenia? This would not be fair and reasonable. The fact that the Union’s claim was ultimately settled for only $5,000 demonstrated the unreliability of the amount claimed as damages.
• It would not be fair and reasonable to allow a third party, who is not a party to the contract, to determine arbitrarily what amount can be withheld from amounts owing to a subcontractor, as a progress payment.
• In addition, it was not clear that Armenia actually owed to Axor the amount claimed by the Labourer’s Union. Axor could not prove that the Union had a meritorious case against it for an ascertainable amount.
• The claim for damages was made by a third party, the Labourer’s Union, and was not a claim for deficiencies or damages for delay involving the same two parties to the contract.
• The claim to set-off was not made as a defence pleading in an action, but was a unilateral decision of the general contractor.

The court also found that it would be manifestly unfair to the subcontractor to allow a general contractor to withhold the full amount of any claim for damages made by a third party from an interim progress payment, which is due and payable to the subcontractor, and to require the subcontractor to continue working on the project without being paid when:

• the merits of the claim for damages by the third party and the liability of the subcontractor cannot be shown on a prima facie basis; and
• the amount being withheld has not been determined or is not accurately quantified based on reliable objective evidence.

Finally, there remained the question whether Public Works Canada’s right to set off against Axor in the prime contract applied to the subcontract.

The prime contract provided Public Works Canada with a right of set-off against Axor but the subcontract between Armenia and Axor did not provide for a right of set-off against progress payments, but Article 10 did oblige Armenia to “indemnify and hold harmless” the owner and contractor against claims, damages, and so on.

Justice Smith decided that the plain and ordinary meaning of Article 10 did not give Axor a right to withhold from amounts payable to a subcontractor any amounts payable by a subcontractor to Axor. The prime contract gave Public Works Canada a right to assert a set-off against Axor but did not give the same right of set-off to Axor relative to its subcontractors.

Armenia was therefore entitled to be paid for work performed on the site under the contract.

Ontario Superior Court of Justice
   Smith J.
   March 20, 2006