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Focus: High Court rules that unenforceable liabilities can be indemnifiable losses

11 August 2010

In brief: The High Court of Australia has rejected an insurer's argument that, if a liability of an insured cannot be enforced, that insured has suffered no indemnifiable 'loss'. As Partner Malcolm Stephens (view CV) and Law Graduate Laura Johnston explain, the court distinguished between the existence of a liability and the ability to enforce that liability.

The court also considered some important issues of bankruptcy and insolvency law and these will be covered in a separate Focus.

How does it affect you?

  • Commercial agreements frequently limit a party's liability, or the enforcement of a party's liability, to the extent of that party's insurance cover. A risk for counterparties agreeing to such limitations, however, is that the insurer might refuse to grant indemnity on the basis that, if the insurer does not grant indemnity, the insured will not suffer a loss.
  • The High Court has held that, at least in some cases, an insurer must indemnify its insured for its liability to the counterparty even if the counterparty could not otherwise enforce that liability.

Background

Mr Greaves (the insured) was a director of One.Tel and the chairman of its board of directors. In an earlier proceeding, the Australian Securities & Investments Commission (ASIC) obtained orders that he pay $20 million compensation to One.Tel and a smaller sum to ASIC. Mr Greaves entered into a deed of arrangement under the Bankruptcy Act 1966 (Cth), which was valid for three years unless extended.

Under clauses of this deed:

  • Mr Greaves transferred to a trustee his rights under a directors' and officers' liability policy issued by CGU (the insurer); and
  • his creditors were barred from enforcing his debts to them until certain steps had been performed in relation to the insurance policy.

The trustee commenced proceedings seeking to enforce the insurer's liability, claiming that the $20 million owed to One.Tel was a 'loss' under the policy for which the insurer was liable to indemnify the insured. The policy defined 'loss' as 'the amount payable in respect of a Claim made against the Directors and Officers for a Wrongful Act and shall include damages, judgements, settlements, interest, costs and Defence Costs'. While the trustee's proceeding remained on foot, the three-year period of the deed's validity expired and the deed terminated.

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The decision

The insurer raised a number of grounds for denying indemnity. One of these grounds was that, because the creditors of the insured were barred from enforcing his debts to them, there existed no loss for which it was liable to indemnify the insured.

The insurer's argument succeeded before the primary judge1 but was rejected by the New South Wales Court of Appeal.2 The insurer appealed to the High Court of Australia.3

The High Court rejected the insurer's argument. It held that, notwithstanding the bar on enforcing the debts of the insured, those debts continued to exist and were a 'loss' as defined in the policy.

Central to the High Court's analysis was its distinction between the existence of a debt and the ability to enforce that debt. It held that 'the status of the $20 million as an "amount payable", which rests on (the insured's) legal liability to pay it, is not affected by any bars which may prevent particular people from enforcing the judgment debt, because the creation of those bars does not affect (the insured's) legal liability'.

A further factor the court considered was the purpose of the deed of arrangement. It stated that 'The point of the Deed was to enable the Trustee to enforce (the insured's) rights under the Policy in favour of One.Tel'. The construction of the deed relied upon by the insurer would frustrate the deed's purpose, as it would require the court to read a clause of the deed as creating a permanent bar to creditors such as One.Tel recovering amounts they were owed.

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Implications

The High Court's judgment depended, in part, on the particular wording of the deed and, to a lesser extent, on the particular wording of the policy. However, the judgment does provide useful guidance on how indemnity and liability clauses in commercial agreements should be drafted. In particular, contracting parties may prefer to accept a limit on their right to enforce liabilities, rather than accepting a limit on the liabilities themselves, where an insurance-linked limitation is otherwise agreed.

Footnotes
  1. Watson v CGU Insurance Limited [2008] NSWSC 1409.
  2. One.Tel (in liq) v Watson [2009] NSWCA 282.
  3. CGU Insurance Ltd v One.Tel Ltd (in liq) [2010] HCA 26.

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