UK: The Hidden Dangers Of "Knock for Knock" Indemnities

Last Updated: 27 July 2009
Article by David Gardner

Basic Scheme of Knock for Knock

The underlying principles of a "knock for knock" scheme are well established. Each of the Company and the Contractor agrees to save, indemnify and hold harmless the other, their affiliates and other group members against any claims or liabilities arising in respect of: (i) damage to property owned, hired or leased by it; and (ii) injury to any of its personnel. Although this is not usually expressly stated, the effect will be to exclude any liability on the part of the Contractor for damage or injury caused to Company Group property and personnel and vice versa.

In the absence of such indemnities, the rights and obligations of the parties will be determined by the terms of their contract or by the general principles of tort (negligence) liability applicable in the country where the damage occurs. The effect therefore of an indemnity expressed to apply irrespective of negligence is to reverse the legal position applicable in most jurisdictions that the party at fault in causing the damage or injury is liable. Under a "knock for knock" scheme, each party is obliged to meet any claims arising from damage to its property and personnel even if the damage is caused by fault on the part of others.

Such indemnities in common with exclusion and limitation clauses are interpreted restrictively under English law and, in the case of ambiguity, will be construed in the manner least favourable to the party seeking its protection. In particular an English court or arbitration tribunal will be reluctant to conclude that one party intended to indemnify the other against the consequences of its own negligence, unless the indemnity clearly states that this is to be the case.

The Extent of the Groups

One of the principal purposes of such indemnities is to limit the substantial risks involved in any significant off shore project to a level acceptable to most contractors and to avoid the need for multiple and overlapping layers of insurance by permitting the Company and the various contractors to carry insurance covering their own equipment and personnel rather than the damage this equipment and personnel can cause. Any significant off shore development will however involve numerous contractors and subcontractors and the "knock for knock" scheme will usually be extended to all members of each party's group. Thus the Contractor and the Company indemnify each other against any claims arising in connection with damage to property or injury to personnel of any member of their respective groups, including if they fall within the group any subcontractors and agents.

Thus, if the Contractor is held liable for damage caused to property belonging to a member of the Company's Group, the Company will be obliged to indemnify the Contractor against this liability. The Company Group member may be entitled to bring its claim against the Contractor but will, where it is operating under a parallel indemnity scheme with the Company, be obliged to indemnify the Company against its liability to the Contractor, thereby rendering the process circular.

The ambit of the Company and Contractor groups will however often be the subject of considerable disagreement with the larger oil companies in particular being reluctant to extend their indemnities to cover damage and injury caused to all of their contractors and their property. This reluctance reflects the administration required, the extent of the risk involved in obtaining "back to back" indemnities from these contractors and in some cases the complexity of field ownership structures.

Breach of Contract

Although the principle that the mutual "knock for knock" indemnities apply irrespective of negligence is well established, much less consideration is often given at the drafting stage to the extent to which the indemnities should also apply where the damage is caused by breach of contract.

In the Super Scorpio II (1998), the Contractor and the Company exchanged "knock for knock" indemnities with the Company (Elf Exploration) agreeing to indemnify the Contractor against all claims in respect of or in connection with damage to Company's Items. In addition the drilling contractor, Smedvig, undertook to "take all necessary care of Company's Items as required by good oil and gas industry practices and to return them to the Company in their original condition" and "to ensure the storage, safekeeping, protection and the general maintenance by its personnel of Company's Items." During offshore operations, a Company Item, the Super Scorpio II, a remote operate vehicle, was damaged by the negligence of one of Smedvig's employees. The owners of the Super Scorpio II obtained damages from Smedvig for the cost of repairing the ROV, and Smedvig in turn sought an indemnity from the Company against this liability.

Elf accepted that the ROV was a Company Item, but contended that the Company's obligation to indemnify the Contractor in respect of any damage done to a Company Item did not apply where the act which gave rise to the claim was itself a breach by the Contractor of its obligation under the contract to take all necessary care of the Company's Item. The Court held that the allocation of risk in the contractual indemnities was clear. The Contractor remained obliged to take care of any Company Item entrusted to it but the financial consequences of any damage to property caused by lack of care was nonetheless dealt with under the "knock for knock" indemnity regime.

A different conclusion was reached in Deepak v ICI (1998). In that case Deepak claimed that an explosion at its methanol plant in India was caused by errors in the defendant's design of the plant. These errors were said to amount to breaches both of express terms of the contract and of collateral warranties given by Davy in favour of Deepak. Throughout the construction phase and thereafter the plant was the property of Deepak, and under the indemnity provisions Deepak was obliged to indemnify Davy and its employees against any liabilities for death or injury to employees of Deepak or loss of or damage to its property.

In defending claims brought by Deepak for the cost of repairing the damage caused by the explosion and for the loss of use of the plant, Davy contended that the indemnity given by Deepak covered all such claims. The Judge regarded it as surprising that if liability for breach of an express contractual provision was not excluded by a specific exemption clause, it should effectively be excluded by an indemnity clause "whose effect is simply to stand the contract on its head, so far at any rate as liabilities for personal injury or damage to property are concerned." In the Judge's view an indemnity clause should not, in the absence of strict wording or where the logic of the clause or contract so requires, be interpreted to protect a party against liability where this is due to breach of his own contractual obligations "whether or not these obligations lie in negligence or are strict obligations."

Plainly the result in both the Super Scorpio II and Deepak cases was correct but it is still far from easy to indentify the principle that will determine whether an indemnity should cover liability arising where there is breach of contract. The Judge in Deepak suggested a distinction between "strict" contractual obligations and those that mirror duties assumed in negligence. This however was doubted by the Court of Appeal and may in any event give rise to difficulties where for example the breach is of a strict statutory obligation.

A particular issue may also arise where the Contractor's scope of work involves the transfer of title to the "Permanent Work" to the Company. The Contractor will typically be obliged to warrant aspects of the performance of the Permanent Work, to repair any defects or damage to it prior to delivery, and to guarantee that it will be free from defects during at least the warranty period. Where the Contractor is required to assume responsibility for the Permanent Work until completion, it will usually be expressly excluded from the Company's property indemnity. Often however it will be more efficient for the Company to insure the Permanent Work, and to indemnify the Contractor against any loss or damage to this. In such circumstances the Contractor may be required to assume a limited liability for each occurrence of loss or damage but the extent to which the Contractor can be liable under other provisions of the contract beyond this "duty of care" amount will frequently be unclear.

Limitations and Exclusions of Liability

Offshore contracts often include limitations and restrictions on the liability of both Contractor and Company, particularly as regards consequential loss. In WesternGeco Ltd v ATP Oil & Gas (UK) Ltd (1996), a vessel engaged by the contractor undertaking seismic survey operations caused damage to a wellhead installation belonging to a third party, Total E&P. Under Clause 19.1(c) of the contract, which was based on LOGIC terms (though with significant amendments) the Contractor was obliged to indemnify the Company against any liabilities arising in respect of damage to the property of a third party, caused by the Contractor's negligence.

The parties also agreed "that Contractor Group's liability under this Contract shall not exceed the aggregate amount of payments received by Contractor for the Work and Company shall save, indemnify and hold harmless the Contractor for any amounts in excess thereof". In response to proceedings by Total E&P as owner of the wellhead installation, the Contractor sought an indemnity from the Company to the extent that this liability exceeded the aggregate amount of payments it had received for the Work.

Faced with a potential inconsistency between the indemnity given by the Contractor in respect of damage done to the property of third parties, and that given by the Company in respect of liability in excess of the contract cap, the Judge considered that the Contractor's liability under its indemnity in respect of damage done to third party property, did not constitute a "liability under the Contract". Although liable in negligence to Total for the damage caused to the wellhead, the Contractor had no liability under the Contract to pay any money to the Company, and there was therefore no legal liability that could be subject to the limitation of liability. The Judge accepted that the position would have been different if Total had brought a claim against the Company rather than the Contractor. This rather technical approach clearly leaves open the possibility that an aggregate limitation of liability may "cap" the Contractor's liability under its indemnity obligations. It is also notable that the unamended LOGIC terms clearly provide that the limitation of liability does not apply to obligations assumed under the knock for knock indemnities.

In addition to an overall limit on the Contractor's liability most offshore contracts will also exclude any liability of either party for consequential loss. The term "consequential loss" will usually be broadly defined so as to include any loss of use, production, product, revenue or profit, and the parties will usually also agree to indemnify each other and the members of their respective groups against such loss. This clause is moreover frequently expressed to apply "notwithstanding any other provision of this contract."

In Caledonia v BT (2002) which was part of the litigation arising out of the Piper Alpha tragedy in the North Sea, the operators' insurers having settled claims brought by the relatives of the dead and injured sought reimbursement of the amounts paid under the indemnities given by the Contractor. In order to avoid litigation in the USA the Company's insurers had settled the claims at levels above those which would have been awarded by a Scottish court. The Contractor contended that this part of the damages was consequential and excluded by an express term of the contract excluding both parties from liability to the other for any consequential loss. Although the House of Lords held that the indemnity did cover all of the settlement, Lord Hoffman took the view that the consequential loss provision excluded liability for such loss where it arose from a breach of contract and therefore had no application to a claim to an indemnity for liability incurred by the operator outside the contract.

In the Caledonia case, the contract contained an exclusion of consequential loss but not an indemnity and the extent to which the indemnity in respect of consequential loss reduces the obligations under the other "knock for knock" indemnities is potentially of great importance. Where the indemnities given in respect of property and personal injury do not extend to consequential loss, then both Company and Contractor are potentially exposed to liabilities to group members for which they may have no contractual recourse under the indemnity scheme.

There remains a tendency to treat indemnities as "tucked away" at the back of the contract, and an issue to be agreed largely between insurance advisors. In fact the breadth of the property indemnity in particular and its relationship with express warranties given by the Contractor needs to be clearly identified, defined and addressed. What may appear from to be a standard knock for knock indemnity may on closer analysis prove inadequate to cover the potential liabilities that may arise on a complex offshore project. These hidden dangers may only become apparent after the liability has arisen and a time when the ability of the party liable to limit or exclude a loss has passed.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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