As a small business, you may be all too familiar with signing contracts where the other business has failed to uphold their end of the deal. However, what do you do if that business still insists on payment? Can you refuse to pay? This article explains when you can withhold payment if the other business has breached the contract.

What is a Breach of Contract?

A breach of contract is a failure by one party to comply with a requirement under a contract. Not all breaches of contract are treated the same way. Some types of breaches may lead to the immediate end of the contract. Others may be so minor that they require the other business to apologise or rectify the mistake, such as replacing the broken goods.

The four most common breaches of contract include : 

  1. a material breach, where the business fails to perform a key element of the contract;
  2. a minor breach, where the business makes a minor error;
  3. an anticipatory breach, where one business signals to the other that they will not be able to perform a key element of the contract; and 
  4. an actual breach, where the business fails to perform the contract at all. 

Example Scenario

You are a business that buys a dozen computers for the office. The contract states that the computers will be delivered to you within five days after your online order. The computers will come with two monitors. You will receive a user manual. The contract guarantees the computers will have quality monitors. You agree to pay for the computers upon delivery of the products to the office.

A material breach in this scenario would be if the computers were delivered to you with broken monitors. A minor breach would be if the user manual did not include 1-2 pages about the monitors. An anticipatory breach would be if the computer company told you that they will not deliver the computers within five days as promised. An actual breach would be if the computer company failed to deliver the computers at all.

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

Your contract may have an express right for you to withhold payment through a set-off clause. That provision allows you to set-off any owed money against money that you owe the other business.

For example, you owe a contractor $500 for delivering your goods to a destination but the contractor made the delivery five weeks late. There was a late delivery fee of $50 per week.  Under the contract, you will owe the contractor $500 and the contractor owes you $250. Therefore, by setting off the $500 against the $250, you can legally withhold $250 of the $500 being claimed by the contractor. 

2. Pre-conditions to Payment

You can require the other business to fulfil certain conditions before they are allowed to claim payment from you. That means the payment terms in your contract should outline the conditions for payment. If the other side fails to fulfil one or more those conditions, you can withhold payment. 

For example, you engage a photographer to shoot photos for your website. Your payment terms state that the photographer must provide final edited photos for your approval before they can claim full payment under the contract. The photographer sends you some unedited photos and insists on payment. You can argue that as they failed to send you final photos, they have no right to claim payment. 

Defective or Incomplete Work

In some situations, you can withhold payment because the goods or services were defective and incomplete. The other side cannot claim payment as they failed to deliver the goods or services to a standard that would trigger payment. You will have to prove a link between the failure of the other party to deliver and the payment that you are withholding.

For example, if a carpenter finishes putting in floorboards into a house but uses poor quality wood that cracks under little pressure, the builder could potentially withhold payment until the floorboards are replaced.

What Are the Dangers of Withholding Payment?

You need to make sure the contract legally allows you to withhold payment in certain circumstances. Otherwise, the other business could take action against you under the contract’s dispute resolution clauses. Depending on your contract, that could mean expensive court action as they seek to claim payment from you.

Even if the other party has breached the contract, you may also be breaching the contract if you illegally withhold payment. Your business could be similarly exposed to financial liability, such as damages or costs.

There are also industry-specific laws that restrict your ability to withhold payment. For example in the construction industry, the security of payment laws do not allow contractors to withhold payments to subcontractors just because principals are also withholding payment to contractors. Be sure you know the relevant laws of your industry before you draft any clauses around withholding payment.

Best Practice Checklist

Before you withhold payment in a contract, you should:

  1. read the terms of your contract;
  2. find out if there is an express right to set-off amounts under the contract;
  3. see if you require the other business to fulfil certain conditions before payment;
  4. check if the other business has fulfilled those conditions;
  5. confirm if the contractual breach is the reason for withholding payment;
  6. discover if there are any laws that prevent you from withholding payment in a contract; and
  7. clarify that withholding payment will not lead your business into breaching the contract.

Key Takeaways

You can only withhold payment if you can establish a breach of contract from the other business. Once the breach is established, you usually have three methods that will allow you to withhold payment. These methods are: 

  1. a right to set-off;
  2. establishing pre-conditions to payment; and
  3. refusing payment because of incomplete or defective work.

If you have any questions or need assistance on how to withhold payment, get in touch with LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.

Robert Nay
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