How (not) to draft an indemnity clause

A recent UK Supreme Court case concerning the meaning of an indemnity clause provides useful guidance for commercial parties in contract drafting and interpretation. It reaffirms the modern approach to interpreting contracts, which gives primacy to the text of an agreement while also recognising the role that the context plays. The practical lesson, which goes without saying, is that lawyers and business parties should always aim for precision in contract drafting. Little should be open to intepretations.

Case

Wood v Capita Insurance Services Limited
(for link see Downloads) was about a sophisticated share sale agreement of an insurance broking business (Company). After the sale, the Company internally discovered a practice of mis-selling of insurance products prior to the share sale. The purchaser reported this to the UK Financial Services Authority (FSA) and then compensated, as agreed with the FSA, all affected clients. The purchaser claimed the cost of that compensation from the sellers. Liability of the sellers depended on the interpretation of the following indemnity clause in the agreement:

The Sellers undertake to pay to the Buyer an amount equal to the amount which would be required to indemnify the Buyer and each member of the Buyer’s Group against all actions, proceedings, losses, claims, damages, costs, charges, expenses and liabilities suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by the Company following and arising out of claims or complaints registered with the FSA... or any other Authority against the Company [or] the Sellers… and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any insurance or insurance related product or service. [Emphasis added]

The purchaser argued that the indemnity covered losses which relate to any mis-selling of insurance products prior to the sale. The sellers’ position was that the indemnity was much narrower, and related only to those losses that followed or arose out of claims or complaints registered with the FSA or any other relevant authority. The court sided with the sellers, stating that the indemnity was not wide enough. The purchaser’s remedial costs arose from its internal investigation and self-reporting to the FSA and fell outside the scope of the indemnity.

The court was also aware of the extensive warranties in the agreement, recorded in a schedule running 30 pages long. One of the warranties was that the sellers did not engage in any mis-selling practices. The warranty, however, was time barred and the purchaser could not rely on it. The court observed that it is not contrary to business common sense for the parties to agree to wide-ranging warranties that are time-barred, and in addition agree to an indemnity, which is not subject to any such time bar but is triggered only in limited circumstances.

Principles

The Supreme Court reaffirmed the modern approach to contractual interpretation - the court’s task is to ascertain the objective meaning of the language which the parties have chosen to express their agreement.

It also said the following:

  1. Textualism and contextualism are not conflicting paradigms. Both of these “tools” have to be used to ascertain the objective meaning of the language of the contract and the court, depending on the nature, formality and quality of drafting of the contract, must give more or less weight to elements of the wider context in reaching its view as to that objective meaning. This indicates that the primary tool in contract interpretation is the “text” of the agreement.
  2. It is not the court’s job to fix a bad bargain. It must not lose sight of the possibility that a provision may be a negotiated compromise or that a party may agree to something which with hindsight did not serve its interest.
  3. Business common sense is useful to ascertain the purpose of a provision and how it might operate in practice. But in “tug o’ war” of commercial negotiation, business common sense can rarely assist the court in ascertaining on which side of the line the centre line marking on the tug o’ war rope lay, when the negotiations ended.

Comments

The Wood case is a useful reiteration of how the courts will interpret contracts. Its goal is to arrive at the objective meaning of the language of the contract, using the “text” and the “context” of the contract. If the text is sufficiently clear, that may be its objective meaning. The context will play a limited role. If the text is not so clear, then the context becomes more important.

The case is also in line with a recent New Zealand Supreme Court case, Firm PI 1 Limited v Zurich Australian Insurance Ltd (for link see Downloads), where similar principles were stated. It is a welcome development that reaffirms that clearly drafted contracts will be given effect to, even if the bargain is unfair for one party.

Joshua Woo

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