The Court of Appeal has recently considered the application of a knock-for-knock indemnity to exclude liability for consequential loss. Its decision in Transocean Drilling UK Ltd v Providence Resources plc [2016] EWCA Civ 372 ("Transocean Drilling") was published in April and this article considers some of the key issues raised in that case. Commercial parties will be able to take some comfort from the Court of Appeal's decision which, in contrast to the High Court's earlier decision, gives effect to the natural meaning of the language used in a contract. The case also illustrates the effectiveness of precise drafting to express the contracting parties' intentions upfront, rather than relying on legal phrases which are often misunderstood or, at the very least, subject to a line of case law that is difficult to apply to the facts and circumstances of any particular dispute.

Knock-for-knock indemnities

A knock-for-knock indemnity is a mutual indemnity or cross-indemnity in which each party to a contract agrees to indemnify the other against specified losses. Broadly, it is an agreement that loss or damage should lie where it falls, irrespective of fault.

Such a contractual tool is a feature of the offshore oil and gas sector where it is generally accepted that contractors would be unable to withstand a potential claim for the destruction of an oil rig and that, practically, it would be difficult to determine fault because of the overlapping responsibilities of multiple contractors. The knock-for-knock regime offers parties certainty and has been referred to by the High Court in England and Wales as a "crude but workable allocation of risk and responsibility" (Smit International (Deutschland) GmbH. v Josef Mobius, Bau-Gesellschaft (GmbH & Co) [2001] C.L.C. 1545). That risk and responsibility is one for which parties will obtain insurance, to protect them against specified losses and to underwrite their obligation to indemnify their counterparty.

Consequential Loss

"Consequential loss" or "indirect loss" is, broadly, loss likely to arise from a special circumstance of a case (compared to "direct loss" which is deemed to arise naturally in the ordinary course of things). Following a line of cases starting with Hadley v Baxendale (1854) 9 Ex 341, it is a basic principle of contract that if a party that breaches the provisions of an agreement was aware of the special circumstance when the agreement was made, consequential losses are foreseeable and recoverable. In practice, however, limitation of liability clauses in commercial contracts often excludes liability for consequential losses, notwithstanding issues of foreseeability.

The rule in Hadley v Baxendale is harder to apply than it is to state. Depending on the facts of the case, physical damage, loss of profits, economic loss and damage to goodwill could be considered direct or indirect loss. In Transocean Drilling, the Court of Appeal stated that courts generally are now more willing to recognise that words take their meaning from their particular context and that the same word or phrase may mean different things in different documents.

The Facts

In Transocean Drilling the owner of a drilling rig had entered into a contract with a contractor to drill a well off the southern coast of the Republic of Ireland. Delays in the drilling operation gave rise to a dispute as to whether the owner could recover additional overheads known as 'spread costs' which resulted from the extended period of work. The contract contained mutual undertakings by the owner and the contractor to indemnify each other against, and hold each other harmless from, its own consequential loss. Although couched in the form of an indemnity, it was common ground that the effect of this provision was to exclude liability for losses of that kind; a position which, as indicated above, is not uncommon in commercial contracts.

The agreement between the parties defined consequential loss somewhat circularly as "any indirect or consequential loss or damages under English law", but, in addition, proceeded to give specific examples of what the parties considered to be consequential loss. The upshot of such a definition was that the court was not forced to consider the line of authorities discussing the meaning of consequential loss under the general law, but instead was required to apply the facts of the case to the language used in the knock-for-knock indemnity.

The Decision

Reversing the decision of the High Court, the Court of Appeal held that the knock-for-knock indemnity provision was effective in excluding the contractor from liability for wasted costs in the form of the spread costs which the owner had sought to recover.

The court stated that there was no reason in principle why commercial parties should not be free to contract on the basis that losses arising in the course of performing the contract should be borne in a certain way, however they choose to define them. Particularly interesting was the fact the court refused to apply restrictive principles of interpretation which are often deployed in construing clauses restricting liability. The court explained that "artificial approaches to the construction of commercial contracts are to be avoided in favour of giving the words used by the parties their ordinary and natural meaning."

Key considerations of the court included the fact that the knock-for-knock clause favoured both parties equally and was negotiated between parties of equal bargaining power. Therefore, while contracting parties may be able to take some comfort that their exclusions of liability can be taken at face value, not every "mutual" knock-for-knock indemnity clause or other exclusion of liability clause will meet these conditions if the reality is that only one party will benefit from it. The general principle of strict interpretation or any of the restrictive interpretations, such as the contra proferentum rule (which requires ambiguous words or phrases to be construed against the party who proffers them or puts them forward), could apply in such circumstances.

The case also highlights the importance of considering what types of losses the parties expect to be recoverable under the contract and, in turn, the benefits of specifically identifying these types of loss in any limitations or exclusions of liability, whether those restrictions are drafted in the manner of a knock-for-knock indemnity regime or otherwise.