As a small business, you may have signed a contract with another party, only for them to fail to uphold their end of the deal. In this scenario, what can you do if they insist on payment? Can you refuse to pay? This article will explain when you can withhold payment if the other party has breached the contract.
What is a Breach of Contract?
A breach of contract occurs when one party fails to fulfil its obligations as outlined in a contract. It is important to note that not all breaches are equal, as they vary in severity and consequences. Some serious breaches may warrant immediate termination of the contract. Other breaches may be minor and simply require the other to apologise or rectify the mistake, such as replacing the faulty goods.
The four most common breaches of contract are:
- material breach, where a business fails to perform a key element of the contract, significantly impacting its core purpose;
- minor breach, where the business makes a minor error that may not fundamentally undermine the contract but still needs to be rectified;
- anticipatory breach, where one business signals to the other that they will not be able to perform a key element of the contract; and
- actual breach, where the business fails to perform the contract entirely.
Example Scenario
Imagine you are a business that buys a dozen computers for your office. The contract states that the computers will come with two quality monitors and will be delivered to you within five days of your online order. In addition, you will receive a user manual. You agree to pay for the computers upon their delivery to the office.
In this scenario, a material breach would occur if the computers arrived with damaged monitors. A minor breach would be if the user manual was missing one or two pages about the monitors. An anticipatory breach would be if the computer company told you in advance that they could not meet the five-day delivery timeframe. An actual breach would occur if the company failed to deliver the computers altogether.
When Can You Withhold Payment?
If you can show a breach of contract, your ability to withhold payment will depend on:
- the wording of the relevant contract;
- the type of breach;
- whether the breach is linked to payment; and
- whether there is an express right in the contract to withhold payment.
The three most common ways of withholding payment include:
- a right to set off;
- pre-conditions to payment; and
- defective or incomplete work.
1. A Right to Set-off
If your contract includes a set-off clause, you may have the legal right to withhold payment. This provision allows you to set-off any amount owed to you against money that you owe the other party.
2. Pre-Conditions to Payment
You can require the other party to fulfil certain conditions before they can claim payment from you. This means that the payment terms in your contract should expressly outline the conditions for payment. If the other party fails to fulfil one or more of those conditions, you can legally withhold payment.
3. Defective or Incomplete Work
In some situations, you can withhold payment when the delivered goods or services are defective, subpar, or incomplete. If the other party fails to meet the contract’s specified standard for delivering goods or services, they cannot rightfully claim payment. You will need to establish a link between the other party’s failure to fulfil or deliver their side of the contract and the payment that you are withholding from them.
Continue reading this article below the formWhat Are the Dangers of Withholding Payment?
It is vital to ensure that your contract legally allows you to withhold payment in certain circumstances. Otherwise, the other party could take action against you under the contract’s dispute resolution clauses. Depending on your contract terms, this may result in costly court proceedings, increasing financial strain as they persist in pursuing payment from you.
Furthermore, even in cases where the other party has breached the contract, you may be in breach of the contract if you withhold payment without a legal justification. This could lead to financial liabilities, such as damages or costs.
There are also industry-specific laws that may restrict your ability to withhold payment. For example, in the construction industry, if principals are withholding payments to contractors, contractors are not allowed to withhold payments to subcontractors. This is due to the security of payment laws. Before drafting any clauses related to withholding payment, be sure to understand the relevant laws of your industry.
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Best Practice Checklist
Before you withhold payment in a contract, you should:
- thoroughly review the terms of your contract;
- check if there is an express right to set-off amounts under the contract;
- confirm if the contract requires the other party to fulfil certain conditions before claiming payment;
- check if the other business has fulfilled those conditions;
- clearly establish if the contractual breach is the reason for withholding payment;
- investigate if any relevant laws prevent you from withholding payment in a contract; and
- confirm that withholding payment will not lead your business to breach the contract.
Key Takeaways
You can only withhold payment if you can establish that the other party has breached the contract. Once the breach is established, there are typically three methods that will allow you to withhold payment:
- a right to set-off;
- establishing pre-conditions to payment; and
- refusing payment because of incomplete or defective work.
If you have any questions or need assistance on how to withhold payment, our experienced contract lawyers can assist as part of our LegalVision membership. You will have unlimited access to lawyers to answer your questions and draft and review your documents for a low monthly fee. Call us today on 1300 544 755 or visit our membership page.
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