Clauses for recovery of legal costs: What protection do they provide?

Legal costs are an important factor in court proceedings. Given lawyers’ love of guarding against risk, it is little surprise that agreements often contain clauses providing that a party in breach of the agreement must pay the legal costs that the innocent party incurs as a result of that breach. But how much protection do such clauses actually provide? This question is important to those drafting such clauses and those wishing to rely on them once a breach has occurred. Unfortunately, such clauses provide less protection than they appear to on their face, particularly if they are not drafted with an appreciation of the relevant case law and the powers courts have to award costs. This article will look at two main questions:

• What protection do clauses regarding legal costs provide?
• How can that level of protection be increased through drafting?

How courts award costs

Before going any further, it is helpful to summarise how a court awards costs. This may be useful for those who are drafting clauses at the “front end” and may not be from a litigation background. Although the precise rules for the award of costs vary between courts, four general points can be distilled. First, costs generally “follow the event”, which means the unsuccessful party will pay the legal costs of the successful party.

Second, a court may award costs on different bases, the two most important being: (i) party and party basis and (ii) indemnity basis. ^[1] The precise names for these two bases vary between courts. Whatever the name may be, party and party costs is the default basis while indemnity costs are only awarded in special circumstances. Indemnity costs are more generous as they entitle the recipient to all of its costs apart from those unreasonably incurred, while party and party costs entitles the recipient only to those costs that are reasonably incurred. ^[2]

Third, legislation gives courts a broad discretion when to make costs orders. ^[3] This discretion is not controlled by a prior contractual agreement between the parties.

Fourth, a party to a proceeding cannot claim its legal costs as a head of damages.^[4] Instead, it must rely on a costs order made by the court. Further, a party cannot claim the difference between the amount it received under a costs order and its actual legal costs as damages in a subsequent proceeding against the same party. ^[5]

What protection do clauses provide regarding recovery of legal costs?

When considering this question, a useful authority to start with is Chen and Xu v Kevin McNamara & Son Pty Ltd ^[6] (Chen). In this case, a builder sought its costs on an indemnity basis under a clause that entitled it to “any costs and fees” incurred by the builder in enforcing its rights under the agreement. ^[7] The Victorian Court of Appeal concluded that this clause only entitled the builder to party and party costs, because an agreement to pay costs “will be construed as an agreement to pay costs on a party and party basis, unless it is plain from its terms that costs are to be paid on a ‘special basis’”.^[8] Redlich JA noted the clause did not: ^[9]

• specify that the builder was indemnified;
• refer to “indemnity costs” or “special costs”; or
• contain any language that might signify that costs were contemplated on an indemnity basis.

The Court of Appeal said that even if the clause unambiguously referred to a “special basis” for awarding costs, the Court is not bound to give effect to the clause; rather, it is only a factor informing the exercise of the Court's discretion. ^[10] However, the Court will generally give effect to an agreement if the parties have “unmistakeably agreed”.^[11]

The principles in Chen are found in other cases. If the clause states that the defaulting party will pay costs on a “special basis”, the court will generally order costs on that basis, ^[12] but this may not always be the case. ^[13] Conversely, if the clause does not refer to a “special basis”, costs will generally be awarded on a party and party basis.^[14]

Would the outcome in Chen have been different if the clause had referred specifically to “legal costs” rather than simply “costs”? In Heaps v Addison Wesley Longman Australia Pty Ltd,^[15] the Supreme Court of NSW considered a clause that specifically referred to “all legal and other costs charges and expenses”. After reviewing the authorities, Master Macready concluded that the clause did not change the normal basis for awarding costs, which was party and party. ^[16]

Does an indemnity entitle you to an indemnity costs order?

As noted above, in Chen, Redlich JA observed that the relevant clause did not state that the builder was indemnified. This raises the question of whether an indemnity entitles a party to an indemnity costs order. There have been several decisions where an indemnity was found to entitle the indemnified party to an indemnity costs order. ^[17] However, there have been cases where it has not. ^[18] For example, in Kheirs Financial Services Pty Ltd v Aussie Home Loans Pty Ltd, the Victorian Court of Appeal considered a clause providing an indemnity against all costs and expenses incurred as a result of a failure to observe the relevant agreement. The Court of Appeal concluded that the clause did not entitle the party to an indemnity costs order because there was no “unequivocally plain language” that costs were to be on an indemnity basis. ^[19]

Can a further proceeding be brought to cover any shortfall after a costs order is made?

A costs order will not cover all of the legal costs of a successful party. Even an order for costs on an indemnity basis does not include costs that were unreasonably incurred. This raises the question of whether an indemnity provision can be used to claim the shortfall between a costs order and the actual costs incurred. In Abigroup Ltd v Sandtara Pty Ltd [2002] NSWCA 45 (Abigroup), the plaintiff obtained party and party costs in proceedings in the Supreme Court of NSW. It then commenced proceedings in the District Court to obtain the difference between “solicitor and client” costs and party and party costs. The plaintiff's claim was brought pursuant to a contractual indemnity. Under r 33, Pt 52 of the now-repealed Supreme Court Rules 1970 (NSW), “solicitor and client” costs were defined as all costs except for those of unreasonable amount or unreasonably incurred, unless approved by the client. The plaintiff was successful in the District Court and before the Court of Appeal. The Court of Appeal said there was no estoppel preventing the subsequent proceeding in the District Court nor any abuse of process. ^[20]

It is important to note that the plaintiff in Abigroup did not receive a complete indemnity for its costs so as not to be “out of pocket”. It seems that a contractual provision cannot provide complete costs recovery from another party to the proceeding. As noted above, a party cannot claim its costs as a head of damages and the court has the discretion to disregard any agreement entered into by the parties regarding the award of legal costs. It is submitted that this is quite logical since the award of costs is one of the mechanisms that a court may use to control the behaviour of litigants. If a party knew that it was able to recover all of its costs pursuant to a contractual provision regardless of how it conducted itself during a proceeding, it may commence a proceeding which has little prospect of success or conduct itself in a manner which otherwise harms the efficient administration of justice.

Drafting tips and dispute management tips

Three drafting tips can be drawn from the case law relating to clauses regarding legal costs. First, one should check what the bases for costs recovery are in the jurisdiction where any dispute arising from the agreement is likely to be heard. This information will be contained in the relevant court rules. Second, one should ensure that the clause specifically refers to the basis of costs recovery which allows the greatest level of protection. This is likely to be an indemnity basis, but the court rules should be checked to make sure. Third, one should refer specifically to legal costs rather than simply costs in general.

As for managing disputes, it is important to note that a clause relating to legal costs will not allow a party to recover all of its legal costs whether as a head of damage or pursuant to a costs order. Depending on its drafting, the clause may not even entitle the party to indemnity costs. These points should be kept in mind when resolving a dispute.

This article was first published in Inhouse Counsel, Vol 18 No 9, November 2014