What happened?

M and S were business partners, indeed successful business partners. One day they decided to sell their business.  This raised millions of dollars, which were paid into several jointly owned entities, including one company which received $3.2 million.

A few years latter, M and S chose to go their separate ways. Agreements were drawn up to effect the separation. The way it worked was that one business partner (S) was to sell his interests, including in the company, to the other business partner (M). The agreement provided two relevant indemnities.

First and under clause 5, M and S agreed that they “they will each be liable for one half of the taxation liability assessed as payable by the Australian Taxation Office for the Joint Entities.” The Joint Entities included the company.

Secondly under clause 8, S agreed to “indemnity [M] for up to one half of any fines or penalties that may be imposed on any of the Join Entities arising out of any ATO conducted audit.”

Subsequent to the agreement (and how could it be any other way?), the ATO conducted an audit of the company for a tax year covered by the agreement. The ATO issued an amended assessment which significantly increased the tax payable by the company and included a large penalty. M, now being the sole director and shareholder of the company, arranged to pay the tax debt, but he did so through another entity - a trustee company of a family trust. 

Litigation on the construction of the indemnity

M demanded that S pay half of the tax debt and half of the penalty. S refused and the matter came before the Supreme Court of New South Wales in McLeary v Swift [2012] NSWSC 1403.

S defended the litigation on the basis that all payments had been made by the trustee company, and since the trustee company was not a party to the agreement, the indemnities were ineffectual. M countered that the reference to ‘M’ in the agreements was to be construed as being a reference to M and M’s interest in various entities including the trustee company, and alternatively that specific performance of S’s compliance with clause 5 should be ordered which would require S to make a payment to the company.

Clause 8

In respect of clause 8 of the agreement and the payment of the tax debt, the Court disagreed with M – the words of the agreement were clear. Clause 8 specified that S was to indemnify M, and the liability would only arise where M made a payment. There was simply no basis to extend the reading of ‘M’ to include other entities. The indemnity did not apply.

An escape under clause 5

The situation was different under clause 5. This clause was not drafted in terms of S indemnifying M, but instead that M and S agreed to be liable for one half of any tax liability of a Joint Entity, which included the company.  Based upon this different wording, M asserted that S’s argument on the construction of clause 8 did not apply - the relevant issue was not the scope of the word ‘M’, but whether there was a tax liability for a Joint Entity, which plainly there was.

M asserted that in this case the Court should order specific performance to mandate that S pay the company half of the tax liability (which was construed to include the penalty portion of the liability). This submission was made on the basis that a Court can compel a promisor to perform their promise by paying money to a third party, particularly where the damages suffered by the plaintiff are inadequate to meet the justice of the case. In this case, the damages were inadequate since M had not paid anything himself, and suffered no loss.

The Court agreed with M’s argument and S was ordered to pay 50% of the tax liability to the company to give effect to the indemnity in clause 5.   

Some lessons

While this case isn’t ground breaking – it doesn’t have to be – it is an important reminder that indemnities need to be prepared with some precision. Attention needs to be given to matters such as:

  • who is likely (or may potentially become likely) to incur a liability which is meant to be covered by the indemnity;
  • does the indemnity actually provide that entity in need of indemnification will be able to obtain it;
  • is the indemnity sufficiently clear. While M ultimately received indemnification (of sorts) it took litigation to reach that outcome.  Ideally, the indemnity provision should be clear enough to deliver the result without resort to a court;
  • if it is likely that a third party will be in need of indemnification, consideration needs to be given to how the indemnity will extend to the third party. Options include the wording used in the clause (compare clauses 5 and 8 above), having the indemnifying party execute a deed poll, or having the indemnified party hold the indemnity on trust for the non-party beneficiary.