The recent Supreme Court of Victoria decision of UDP Holdings Pty Ltd (subject to a deed of company arrangement) (rec and mgr apptd) v Ironshore Corporate Capital (No 2) [2019] VSC 645 is the first judgement of its type handed down in Australia and provides essential insights into the interpretation of a Warranty & Indemnity insurance policy wording. It includes guidance on how, and when, Loss can be established. The case also raised a novel claim for compensation for a breach of the duty of utmost good faith by an Insurer.

The Facts

In 2012 Esposito Holdings decided to sell 5 Star Foods (the "business"), a milk trading and cheese manufacturing company for an asking price of $84 million. It entered negotiations with UDP Holdings, and a price of $70 million was agreed. After due diligence, the sale agreement required $62.5 million to be paid upfront and with the balance to be paid the following year. UDP entered into a buyer's Warranty and Indemnity insurance policy (the "Policy") with Ironshore which covered specific warranty claims made by Esposito under the sale agreement. Coverage was for 2 years with a $25 million policy limit. As part of the Policy, Ironshore's rights of subrogation were significantly limited and did not arise in this claim.

Shortly after completion of the sale agreement, UDP was advised that between 2011 and 2014 the business overcharged its most significant client $9.3million. UDP was not aware of the overcharging and, had they known, they would not have gone ahead with the purchase. As a result of the overcharging scandal, the business found itself in financial difficulty, resulting in managers and receivers being appointed. Ultimately, UDP sold the business for $22.5 million, suffering a $47.5 million loss.

In October 2014 Esposito commenced arbitration proceedings seeking the unpaid balance of the purchase price. UDP counterclaimed for $47.5 million for breach of warranties. In May 2015 UDP claimed under the Policy. Ironshore rejected the claim, and in February 2016 UDP commenced proceedings seeking indemnity under the Policy. In July 2016, Ironshore obtained a Court order to stay the coverage dispute and requiring the arbitration to proceed first. The arbitration was finalised in UDP's favour awarding damages of $54.1million. In December 2018 the award was confirmed by the Supreme Court of Victoria. However, no money has been recovered from Esposito. After the award was confirmed, the Court lifted the stay on the Coverage claim.

Policy Wording

Clause 3.1 of the Policy contained the indemnity clause:

Subject to the terms, conditions and limitations of this Policy, the Underwriters shall indemnify the Insured, or pay on the Insured's behalf, for all Loss which is notified (or deemed by clause 7.4 of this Policy to have been notified) by or on behalf of the Insured to the Underwriters during the Policy Period.

Clause 4.1 set out how Loss is calculated:

Subject to the other provisions of this Clause 4, Loss means:

a) That part of the amount to which the Insured is contractually, or would have been, entitled to recover against the Seller, under the Sales Agreement for a Breach of the Sale Agreement…plus

b) Any Defence costs; less

c) Any Recovered Amounts…

The Insured is not obliged to seek recovery of any amounts from any third party prior to making any Policy Claim in respect of any Insured Warranty.

Breach means any of the following:

a) Breach of clause 15.1 of the Sale Agreement in respect of the General Warranties;

b) Any circumstance giving rise to a Policy Claim under the General Indemnity

In each case in respect of any of the Insured Warranties and Indemnities.

Recovered Amounts means, in respect of a given Loss, the amount actually paid to or actually recovered by the Insured or a member of the Insured Group from any source other than the Underwriters plus the value of benefits actually obtained by the Insured or Insured Group as a direct consequence of the matter which gives rise to such Loss, such as a refund, credit or other reduction granted to the Insured.

Parties Arguments

UDP claimed that Esposito had breached its warranties and it had suffered a Loss under the Policy and was entitled to recover up to the limit of $25 million plus interest. It separately claimed that it was entitled to the costs of the Esposito arbitration, in the sum of $2,236,720.88. UDP accepted that the costs of the Arbitration against Esposito were not 'Defence costs' as defined by the Policy and did not suggest that any express term of the Policy required Ironshore to pay these costs. Instead, they claimed that Ironshore breached their duty of utmost good faith by seeking a stay of the arbitration and forcing UDP to pursue recovery against Esposito.

Ironshore claimed that while the arbitral award had established UDP's contractual entitlement to recover against the Seller, UDP had not suffered a 'Loss' under the Policy. It argued that under the Policy the quantum of the Recovered Amounts must be ascertained before Loss under the Policy could be determined. Indemnity could not occur until all Recovered Amounts had been finalised. Ironshore denied it had breached its duty of utmost good faith as it was reasonable to seek a stay given the significant overlap between the claims made in the arbitration and under the Policy.

Findings

How to Calculate Loss under the Policy?

Justice Garde accepted that UDP had suffered Loss as a result of Esposito's breach of warranties. He determined that Loss suffered was the difference between the price paid by UDP, less the real or fair value, plus the amount of the acquired liabilities. After hearing substantial expert evidence, he accepted that UDP's contractual entitlement was $30.85 million.

The central policy construction issue for the Court to determine was whether clause 4.1 of the Policy required the quantum of the 'Recovered Amounts' to be ascertained before indemnity could be confirmed. The judge applied a businesslike interpretation to the Policy having regards to the commercial purpose and the circumstances of the transaction. On this basis, he considered that Ironshore's submission was "uncertain, uncommercial and unworkable". Waiting for recovery proceedings to be finalised would leave Insureds financially exposed as recovery could take years. The Insured's would also be at the whim of the underwriters to be satisfied as to when they considered all Recovered Amounts had been received. On the other hand, the Policy adequately protected the underwriters from the possibility of double recovery by requiring that in the event of successful recovery after the claim had been paid the insured was required to account for any surplus and reimburse the insurer. Justice Garde accepted that the Recovered Amount did not need to be determined for Loss to be established and determined that UDP was entitled to the full limit of indemnity of $25 million plus interest of $5,375,855.55.

Was the Cost of the Arbitration Recoverable?

The judge was not satisfied that UDP had shown that the underwriters acted in breach of utmost good faith. UDP failed to demonstrate any impropriety, lack of competence or passivity in Ironshore's claims handling. All they had done was to seek a stay application of the coverage dispute, which was upheld by the Court. The judge accepted that an implied term of good faith does not extend to the conduct of litigation, where the parties conduct is instead to be governed by the Court and the rules of procedure.

Conclusions

The demand for W&I insurance is growing throughout the Asia Pacific region. W&I claims can be factually complex and can require insurers to take a strategic approach when managing such claims including, as in this case, how overlapping disputes between buyers, sellers and insurers, may affect their response to a claim. The case is a reminder of the court's willingness to apply a businesslike interpretation to policies having regards to the commercial purpose and circumstance of the transaction, and that W&I insurance is generally intended to be the primary source of compensation for a breach of warranty, rather than compensation of last resort.