UK: House Of Lords Phoenix Decision Fails To Give Clear Guidance

Co-authored by Michael Ginn

The key issue which the markets wanted answered was whether a party to a contract can exclude the consequences of its agent’s fraud. The issue is particularly important in ART transactions where the lending institution is unlikely to participate unless it is provided with an unconditional insurance "guarantee" that it intends will pay out whenever the borrowing entity defaults on its obligations to repay under the relevant financial instrument. To do the deal the insurer will be required to waive all its remedies under the insurance contract it writes (save where the insured itself has fraudulently induced the contract) including any remedies for the fraud of the insured’s agent.

The Court of Appeal’s decisions in 2001 in the "Rojak" (HIH & Ors v. Chase & Heaths) and "Phoenix" cases addressed the issue of whether the remedies for breach of warranty, non-disclosure and misrepresentation could be excluded in an insurance contract and if so, what form of words should be used to achieve this effectively. The issue has become particularly important in the raft of film finance cases that are currently jamming the courts. In the Phoenix case, insurance policies were purchased by the Chase Manhattan Bank in order to guarantee reimbursement of capital and interest loaned to various production companies to produce and market films in the event that that the films did not achieve their anticipated level of sales. The Court of Appeal in Phoenix concluded that waiver clauses in (re)insurance contracts did not have to distinguish between different types of non-disclosure or misrepresentation in order to be effective. Thus to exclude negligent misrepresentation or negligent non-disclosure by the insured or its agent, the word "negligent" did not have to be used. But what about fraud?

It has been a long established rule of law that a party to a contract, as a matter of public policy, cannot exclude the consequences of its own fraud. In the Phoenix case, the allegation of fraud centred on the brokers, Heaths. Thus a crucial issue in Phoenix was whether it was permitted, as a matter of law, to exclude the fraud of a contracting party’s agent.

The first stage in answering this question centres on the language that would need to be employed in a waiver clause to exclude fraud. Although the Court of Appeal found the concept of fraudulent misrepresentation straightforward, it found the notion of fraudulent non-disclosure conceptually difficult. Lord Justice Rix thought that whereas it was usual to talk of innocent, negligent or fraudulent misrepresentations, each with their own remedies, there were no such gradations of non-disclosure. Thus no special language would be required to exclude the consequences of fraudulent non-disclosure. Disclosure was a unitary and absolute duty and, if excluded, was excluded altogether.

Lord Hoffman found no such conceptual difficulty. Where there is a duty or an obligation for a person to speak, and that person in breach of his duty or obligation keeps quiet with the intention of inducing the other party to enter into the contract, then this can amount to fraudulent non-disclosure. The House of Lords found that to exclude fraudulent misrepresentation or non-disclosure, a waiver clause would need to employ express words which necessitate giving that meaning to the words or clearly disclose such an intention. On the present case, the House of Lords held that the particular clause in the Phoenix contract did not achieve that clear level of expression. As a consequence the House of Lords declined to rule on whether as a matter of law it was possible to exclude the fraud of one’s agent.

Although not part of the decision by the House of Lords, Lord Hobhouse and Lord Scott did provide their own differing views. For Lord Hobhouse, public policy considerations apply to whether a party to a contract should be permitted to exclude the consequences of its agent’s fraud. Confusingly, Lord Hobhouse opaquely suggests that to protect itself against such an eventuality the assured should take out a fidelity policy insuring its agent. Lord Scott took the contrary view and concluded that there was a need for such a rule. He could see no reason on the grounds of public policy why parties should not exclude their contractual liability for fraudulent misrepresentation or non-disclosure by their agent. Public policy was only relevant where the insured was complicit in the fraud of his agent.

Where do we go from here? The Court of Appeal found that there was no rule of law that a party to a contract could not exclude the fraud of its agent. The House of Lords declined to rule one way or the other. Until a dispute involving a waiver clause which expressly purports to exclude the "fraud" of its agent winds its way up to the House of Lords, we are left with uncertainty as to the true position. When drafting a waiver clause with the intention of excluding the consequences of the assured’s liability for the fraud of its agent, very clear words should be used.

Some principles for drafting waiver clauses

• A clause which excludes the duty of the insured to make disclosure will not be sufficient (without more) to also exclude the duty of its agent;

• To exclude the consequences of a warranty, the waiver clause must refer specifically to "warranties".

• Waiver clauses do not need to distinguish between innocent and negligent non-disclosure or misrepresentation in order to be effective to exclude their consequences, so long as the language of the waiver clause does not suggest that the parties did not intend to exclude negligence;

• As a matter of law based on public policy it is not possible to exclude the consequences of the insured’s own fraud;

• Subject to a contrary ruling by the House of Lords, there is no rule of law that the fraud of an agent cannot be excluded. If it is intended to exclude fraud of the agent, very clear words should be used to make that intention express.