Many commercial agreements contain clauses stating that one party is required to indemnify the other part for legal costs in the event of a breach of contract.

A typical clause might contain something along the following lines:

“Party A shall indemnify party B against all liabilities, costs, expenses, damages and losses (including but not limited to any direct, indirect or consequential losses, loss of profit, loss of reputation and all interest, penalties and legal costs calculated on a full indemnity basis) suffered or incurred by party B arising out of or in connection with any breach of or negligent performance or non-performance of this agreement by party A”.

On the face of it a provision such as this means that, in any litigation between the parties, party B would, if successful, be able to recover from party A all of their costs incurred in connection with that litigation – without limitation.

Anyone who has been involved in litigation will know that the court normally only award costs on a “standard” basis: this means that the successful party does not recover all of their costs – only those that the court considers to have been reasonably incurred. In almost all cases this results in a reduction of the successful party’s costs and is supposed to act as an incentive to early settlement.

A clause requiring payment of costs on a “full indemnity basis” such as that set out above appears to get around this limitation on full costs recovery. But does it work?

The answer is that it does – partly. A clause of this type does not entirely displace the court’s discretion when awarding costs. However case law has established that the court will, in exercising that discretion, normally give effect to a clause of this type so that costs will be awarded an “indemnity” basis rather than a “standard” basis.

This does not, however, mean that all the successful party’s costs will be recoverable without limitation. It will still be subject to the normal court rules on indemnity costs so that unreasonable costs cannot be recovered, even though the phrase “full indemnity basis” or similar is used. Similarly, if the unsuccessful party has made an earlier settlement offer to the successful party which has not been bettered then the court is likely to take this into account when exercising its discretion on costs.

Since clauses of this sort can be effective it is important to look out for them when negotiating commercial contracts – and to consider carefully how tactically to deal with them if you are on wrong side of one in litigation.