“Pay to be paid” clause in liability insurance policy tested

Introduction

In July 2024, the English High Court handed down a judgment on whether or not the insurers under a charterer’s liability policy were obliged to indemnify third parties, where the insured went insolvent and had not paid the underlying claim to the third parties. While holding that insurers were not obliged to pay the claim under the policy, the court expressed its views on the interpretation of policies and reconciled its interpretation of the policy with the provisions of the Third Party’s (Rights against Insurers) Act of 2010 (the 2010 Act) which deals with the effect of “paid to be paid” clauses.

The judgment is a useful guide to English law contract interpretation and a reminder that the comfort of financial protection provided to insureds and third party claimants is always subject to the terms of the liability policy they rely on.

Background to case

King Trader had time chartered its vessel the mv Solomon Trader to the insured which took out a charterer’s liability policy from the insurers covering various charterer’s liabilities to a limit of US$50 million. In February 2019, somewhat ironically, the vessel grounded on one of the Solomon Islands. In March 2021 the insured went into insolvent liquidation. The insurers commenced the English High Court proceedings in October 2022 seeking a declaration that they were not liable to pay the claim to the third parties (claimants). In March 2023 and January 2024 the arbitration tribunal seized with King Trader’s claim for damages following the grounding made awards against the insured totaling approximately US$47 million.

It was accepted that the claimants were entitled under section 9 of the 2010 Act to pursue the claims for indemnification arising out of the Arbitration awards directly against insurers. Under South African law that right of direct recourse against a liability or other insurer only arises if the insured is insolvent.

Form and terms of liability policy

The policy took the form of an insurance certificate attached to which was a booklet entitled “Charterer’s Liability: Marine Liability Policy 1-2017.” The booklet was divided into five parts, which included Part 1 described as Charterer’s Liability and Part 5 headed “General terms and conditions.”

Part 1 provided that:

“The company shall indemnify the insured against the legal liabilities, costs and expenses under this class of insurance…”;

 “Liability arising out of a final unappealable judgement or award from a competent Court, Arbitration Tribunal or other Judicial Bodies.”

Part 5 provided that the general terms and conditions applied to all classes of insurance under the policy, that the terms set out in each class of insurance prevail over the general terms in the event of a conflict and that any term appearing in the certificate prevails over all others.

The general terms included a provision that:

“It is a condition precedent to the assured’s right of recovery under this policy…that the assured shall first have discharged any loss, expense or liabilities.”

Comment by court on the 2010 Act

The court accepted that the 2010 Act had been drafted partly in response decisions of the House of Lords upholding the right of mutual Protection and Indemnity Clubs (P&I Clubs) to refuse to indemnify their ship owning members (effectively the insureds) for liabilities that the members had themselves not paid to third parties. The House of Lords upheld the “pay to be paid” clauses on the basis, partly, that the members of P&I Clubs were both the insured and the insurers and the purpose of the “pay to be paid” clause was justified by the nature of mutual insurance.

The 2010 Act was drafted in light of this long standing P&I Club practice and against the backdrop of criticism that “pay to be paid” clauses deprived third parties of the very protection offered by liability insurance in circumstances where the insured could not or would not first effect payment of the underlying claims.

Arguments and finding on the interpretation of insurance contracts

The claimants argued that on a proper interpretation of the insurance contract the pay to be paid clause could not be relied upon by insurers. Having considered previous cases the court held that in circumstances such as these. the approach to be taken in interpreting policies can be summarized as follows:

1. Where the inconsistency is between a clause specifically agreed to and a clause in an incorporated set of pre-existing printed terms, the court could either find that the standard clause is not incorporated at all, or, if it is incorporated, the court will be more ready to read it down.
2. Where the inconsistency is between two clauses which appear in a single document the argument that one of the clauses was not incorporated will be very difficult and the court will be more likely to conclude that the clauses have to be construed as if they both apply.
3. In determining whether and to what extent two clauses can co-exist, it is relevant to consider whether giving effect to the supposedly repugnant clause will still leave the substantive clauses with a real and sensible content and, if the subsidiary clause is to be read down, whether it will be left with a meaningful and sensible content.
4. There will be a greater readiness to read down, or if necessary, read out, a subsidiary clause which is inconsistent with a provision which forms part of the main purpose of the contract.

The court followed these guidelines in analysing the claimants’ arguments as follows:

1. The pay first clause is not repugnant to the terms of the certificate because it is clear that the certificate incorporated the entire booklet. No sensible reader of the certificate would imagine that all of the terms or even all of the significant terms of the policy were to be found solely on the face of the certificate;
2. The pay first clause is not repugnant to the main purpose of the policy because:



2.1 These long established clauses are specifically designed to provide that the insurer’s liability is contingent on the insured paying the underlying liability;

2.2 These clauses can co-exist with the main purpose of liability insurance provided for in P&I Club cover as is clear from the House of Lords’ decisions prior to the 2010 Act;

2.3 These clauses are expressly acknowledged in section 9 of the 2010 act; and

2.4 As a matter of substance the two parts of the policy when read together are consistent and it is artificial to read them separately.

3. The pay first clause is not inconsistent with other terms in the booklet such as the right to terminate on insolvency and the right to an indemnity on claims prior to insolvency. The court was of the view that other policies contained similar provisions and these could be given effect to along with the pay first clause.
4. There is no legitimate process of contractual interpretation which can subject the clear language of the pay first clause to the limitations suggested by the claimants. Those suggested limitations were that: the clause is applicable only if the insured has the means to pay the claim; the clause does not apply in the event of insolvency; and/or the clause does not apply in the event that a third party brings the claim rather than the insured. The court held that it could not be implied that the pay first clause only operated in the event where the insured had the ability to pay.

Conclusions

Having found in favour of the insurers the court concluded that:

“The state of English law on this issue in the light of the 2010 Act is not particularly satisfactory. … A liability policy which exposes the insured to the possibility of being rendered insolvent as a result of being unable to claim on the insurance “would provide an unsatisfactory cover.” … The maritime venture still involves major risks which can give rise to very substantial liabilities. Prudent operators seek to insure against those liabilities and a range of third parties who suffer loss and damage as a result of accidents at sea will look to insurances of this kind to be made whole. Pay first clauses reduce the efficacy of that protection when it is most needed. … Having been left outside the perimeter of statutory control, it is beyond the redemptive power of the common law rules on incorporation, interpretation and implication to deal with [pay first clauses].”

The 2010 Act has no force in South Africa, but the general rules of interpretation outlined in this decision will affect all South African marine policies subject to English law.

Given the amount involved and the effect of this decision, it is likely to be taken on appeal. Pending the outcome of an appeal or a statutory intervention, parties to liability policies and third party claimants who rely on those policies for financial comfort must understand that an inability on the part of the insured to pay the underlying claim will render the comfort of a liability policy nugatory if it includes a pay first clause. To address this concern, insureds need to negotiate different terms and third parties need to consider their own insurance arrangements in the event of a risk that the primary contractor’s liability policy does not respond.