Monday, August 20, 2012

Indemnity clauses in intra-group asset transfers

The English Court of Appeal recently considered an interesting and important issue arising out of an indemnity clause in an agreement for a transfer of assets and liabilities between two wholly owned subsidiaries in a corporate group. Dealing with a scenario not uncommon in intra-group transfers of assets and liabilities, the Court of Appeal in Rust Consulting v PB [2012] EWCA Civ 1070 considers the indemnity clause in such an agreement, and also scenarios in which the indemnifying company would be estopped from denying liability to third parties with claims against the indemnified company.

The claimant (Rust) carried on business as geotechnical consultants and was engaged by developers (Eagle) in 1995 to provide geotechnical engineering services in connection with the proposed development of a shopping centre. Rust was a member of the PB Group, and along with the defendant (PB Limited) was the immediate subsidiary of a UK holding company. Rust ceased trading in 1996, and entered into an Assets Purchase Agreement with PB Limited. The consideration for the transfer of assets from Rust to PB Limited was: "(i) the sum of £1,000 and (ii) the Purchaser assuming responsibility for the satisfaction, fulfilment and discharge of all of the Liabilities and the Contracts of the Business outstanding at the Effective Date and the Purchaser hereby indemnifies and covenants to keep indemnified the Vendor against all proceedings, claims and demands in respect thereof" (emphasis added).

Ten years later, Eagle gave a notice of claim to Rust, alleging negligent advice and resulting structural damage to the shopping centre. The costs of defending these legal proceedings soon exceeded the £1,000 which now constituted Rust's assets, and were borne by the UK holding company which now became Rust's creditor. Rust was then placed into creditor's liquidation. Within the group, it was decided (with the consent of the liquidators) that PB Limited (the defendant) would take over the defence of the proceedings initiated by Eagle and this led to a consent judgment being entered for Eagle against Rust for the entire amount of its claim (£8,069,822). Rust's solicitors also wrote to Eagle stating that they did not believe that Rust was liable for the entire amount but agreed to the consent judgment solely because Rust was insolvent and could not discharge the liability in any case.

Eagle then discovered the existence of the indemnity clause in the asset purchase agreement between Rust and PB Limited, and using its position as Rusts's only significant creditor, changed the liquidators and initiated proceedings against PB Limited pursuant to the indemnity clause. This posed two questions for determination:

(1) Whether the terms of the indemnity clause included not only actual liabilities, but also liabilities incurred pursuant to a consent judgment; and

(2) If not, whether PB Limited was estopped from denying its liability to Eagle on account of its involvement in Rust's defence.

PB Limited's first line of defence was that the indemnity clause indemnified Rust only against liabilities 'outstanding at the effective date'. Therefore, liability under the consent judgment, which arose from the consent judgment itself and not from the negligent performance of Rust's contract with Eagle, was not covered by the scope of the indemnity clause. PB Limited conceded that this argument was based purely on the language of the particular indemnity clause, and if the language was instead that "the purchaser shall indemnify the vendor against all proceedings, claims and demands in respect of all liabilities of the business at the effective date", the argument would not stand.

The Court of Appeal held that this textual difference did not assist PB Limited, and would also lead to uncommercial consequences (paragraph 19). By way of illustration, the Court pointed out that the implication of PB Limited's argument was that Rust's costs of defending legal proceedings against third parties would have been recoverable only if it was unsuccessful and not if it was successful. Further, the application of the indemnity clause to a consent judgment would depend on whether there was a 51% or 49% chance of the underlying claim against Rust succeeding. Relying on the 'commercial sense' approach to contractual interpretation, the Court of Appeal concluded that the indemnity clause was "capable of including bona fide settlements of claims, or sums reasonably incurred in the defence of claims, whether successfully or unsuccessfully defended". Since PB Limited had played an active role in the proceedings between Eagle and Rust, and since the Rust's original liquidators had submitted to a consent judgment on PB Limited's instructions, there was no basis on which PB Limited could now deny liability under the indemnity clause.

This finding made it unnecessary for the Court to consider the estoppel point, but it made passing observations that if required, it would have held that PB Limited was estopped from denying its liability to Eagle. PB Limited argued that the only reason it instructed Rust's liquidators to submit to a consent judgment in Eagle's favour was legal advice that this liability was outside the scope of the indemnity clause. Therefore, this mistaken belief made it unjust for PB Limited to be treated as being estopped from denying its liability to Eagle.

Rejecting this argument, Toulson LJ, who delivered the lead judgment, observed that "The underlying justification for the conclusion which I have reached is that it is not, and should not be, open to a party who causes a judgment to be entered in the belief that it is in its financial interest to do so, thereafter to challenge the correctness or reasonableness of the judgment because it comes later to perceive its commercial interest rather differently and regrets its earlier calculated decision … I am not persuaded that the motivation of the Group to try to prefer its interests over those of Rust's potential creditors is a factor which this court should take into account in PB Limited's favour. On the contrary it should be remembered that once a company has become insolvent the interests of the shareholders take second place to the rights of creditors … I do not see why it should make a difference that PB Limited acted as it did under a mistaken view of the effect of the APA and of its commercial interests. It took a deliberate step; its judgment of its commercial interests may have been erroneous, but that is not of itself a reason for this court to disapply the natural consequence of the choice which it in fact made" (paragraphs 23, 25 and 26).

In summary, this is an important decision, both for the purposes of drafting indemnity clauses in intra-group asset-purchase agreements, and when formulating dispute resolution strategies for claims made by third parties against shell companies within a group. The decision affirms that Courts may not be swayed by minor textual differences in contractual terms (especially if they have uncommercial consequences), unless the language is clearly intended to mark a departure from standard market practice. Further, it also highlights the caution required when group companies conduct legal proceedings on behalf of other shell companies within the group, against the backdrop of indemnities or other protections contained in intra-group contracts.

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