Indemnity costs, what they are and when a court will order them

When a court orders one party to pay another party's legal costs, it does not simply hand over the loser's bill. The order must also specify the basis on which those costs are assessed, and the choice between the two bases, the ordinary basis and the indemnity basis, can change the amount at stake by tens of thousands of dollars.

Costs on the indemnity basis are designed to indemnify the receiving party, meaning to compensate it for the legal costs it actually and reasonably incurred in the proceedings. Indemnity costs are not automatic. They are a departure from the default position and are ordered only in defined circumstances, many of which involve hopeless cases, misconduct or rejected settlement offers.

This article covers:

What indemnity costs mean: the test a costs assessor applies and how it differs from the ordinary basis.
When courts order them: the recognised categories and the discretion behind them.
The settlement trigger: how rejected offers of compromise can switch costs onto the indemnity basis.
Contract clauses: when your own agreement already provides for indemnity costs.
A worked example: a rejected offer in practice, and the misconceptions that cost businesses money.

What the indemnity basis actually means

In NSW, s 98 of the Civil Procedure Act 2005 (NSW) gives the court full power to decide by whom, to whom and to what extent costs are to be paid, and expressly allows costs to be awarded on the ordinary basis or on the indemnity basis. The general starting point is in r 42.1 of the Uniform Civil Procedure Rules 2005 (NSW): if the court makes any order as to costs, the costs follow the event, meaning the unsuccessful party pays the successful party's costs, assessed on the ordinary basis, unless the court orders otherwise.

The indemnity basis is defined in UCPR r 42.5. Apart from one exception for costs payable out of property, all costs are to be allowed other than those that appear to have been unreasonably incurred or to be of an unreasonable amount. In practical terms, once an indemnity order is made, the receiving party is presumed to have been justified in incurring the costs it did, and the costs assessor resolves any doubt about reasonableness in its favour.

An indemnity costs order remains compensatory, not punitive. Its purpose is to make good the loss the successful party suffered in funding the litigation, not to punish the losing party: Hamod v State of New South Wales [2002] FCAFC 97; Northern Territory v Sangare (2019) 265 CLR 164.

When courts order indemnity costs

The discretion to award indemnity costs must be exercised judicially and with caution, and a party seeking one must point to a sufficient or unusual feature that takes the case outside the ordinary run: Colgate-Palmolive Co v Cussons Pty Ltd (1993) 46 FCR 225; Leichhardt Municipal Council v Green [2004] NSWCA 341. The recognised categories are not closed, but the most common situations are:

Hopeless cases: commencing, continuing or defending proceedings with no real prospect of success, such as a claim that is groundless, fanciful or obviously outside the limitation period: Baulderstone Hornibrook Engineering Pty Ltd v Gordian Runoff Ltd (No 2) [2009] NSWCA 12; Hillebrand v Penrith Council [2000] NSWSC 1058. Mere weakness in an arguable case is not enough: Wentworth v Rogers (No 5) (1986) 6 NSWLR 534.
Misconduct and wasted time: conduct calculated to occasion unnecessary expense, or conduct that causes the other party to incur costs wantonly or recklessly, including ignoring court orders, procedural directions and reasonable requests to narrow the issues: Oshlack v Richmond River Council (1998) 193 CLR 72.
Baseless allegations: allegations of fraud or dishonesty made without a proper evidentiary basis, which force the other side to meet serious charges that were never sustainable. This is one of the categories identified in Colgate-Palmolive.
Unreasonable refusal to settle: where a party fails to better an offer of compromise or unreasonably rejects a Calderbank offer, the costs consequences set out below apply.

The court may also order indemnity costs against a party whose conduct of the case caused unnecessary expense even where that party ultimately succeeded on the merits. Disentitling conduct, such as unnecessarily protracting the proceedings, can lead a court to deprive a successful party of its own costs or to order it to pay the other side's costs.

The difference between the ordinary basis and the indemnity basis

The two bases are different standards of assessment, not different types of costs. On the ordinary basis, the receiving party recovers a fair and reasonable amount for the costs and disbursements reasonably incurred in the proceedings: ss 74-80 of the Legal Profession Uniform Law (NSW), applied through UCPR r 42.2. Items that were excessive, duplicated or not reasonably incurred are cut back, and the paying party benefits from any doubt about whether a cost was justified.

On the indemnity basis, the receiving party recovers all costs except those that appear unreasonable in amount or unreasonably incurred, and any doubt is resolved in its favour. Because every item of a properly conducted case is recoverable unless shown to be unreasonable, the practical gap between the two bases is large. An ordinary-basis assessment routinely produces a figure well below the successful party's actual bill; an indemnity assessment comes much closer to it. That is why the basis matters so much: two parties can win the same case on the same facts and recover very different amounts.

Neither basis is a penalty. Both are methods of compensating the receiving party, and the amount ultimately recovered is fixed by a costs assessor, not by the court.

The settlement trigger: offers of compromise and Calderbank letters

The most common way a business ends up on the wrong end of an indemnity costs order is not misconduct but a rejected settlement offer. Under UCPR r 42.15, if a plaintiff fails to obtain a judgment more favourable than an offer of compromise made by the defendant, the plaintiff is entitled to its costs on the ordinary basis up to the date of the offer but must pay the defendant's costs on the indemnity basis from that date. A mirror rule in r 42.15A applies where a plaintiff's offer of compromise is not accepted and the plaintiff does better at trial.

Calderbank letters, named after the English decision Calderbank v Calderbank [1975] 3 All ER 333, are informal settlement offers made without prejudice save as to costs. They do not have the presumptive effect of a formal offer of compromise, but a court may order indemnity costs where the offeree's rejection was unreasonable and the final judgment was no more favourable than the offer: Miwa Pty Ltd v Siantan Properties Pte Ltd (No 2) [2011] NSWCA 344; Jones v Bradley (No 2) [2003] NSWCA 258. Because a Calderbank letter is only a discretionary factor, the offeror carries the burden of showing the rejection was unreasonable.

Contractual indemnity costs clauses

Leases, mortgages, guarantees, insurance policies and many commercial supply agreements contain clauses entitling a party to recover its costs, often expressly on an indemnity basis, if the other side defaults or brings proceedings. Courts will normally exercise their costs discretion in accordance with such a clause where its terms are sufficiently plain and unambiguous: Kyabram Property Investments Pty Ltd v Murray [2005] NSWCA 87; Macquarie International Health Clinic Pty Ltd v Sydney South West Area Health Service (No 2) [2011] NSWCA 171.

That last requirement does real work. A clause that says the defaulting party must pay the other party's costs on an indemnity basis will usually be given effect. A general clause that merely says the losing party pays the successful party's costs will be read as a reference to costs on the ordinary basis, because that is the default. Before you start or defend proceedings, check what your own contract says about costs, because the parties may have already shifted the risk between themselves.

A worked example: the rejected offer

Bayside Fitouts Pty Ltd, a commercial fitout company, completed a $180,000 fitout for a restaurant group but was paid only $60,000. It sued for the $120,000 balance. Early in the proceedings, before much money had been spent, the restaurant group served an offer of compromise of $85,000 plus costs. Bayside rejected it, convinced the whole balance was owing.

At trial Bayside recovered $80,000, less than the offer. The court applied UCPR r 42.15. Bayside recovered its costs on the ordinary basis up to the date of the offer, but from that date it had to pay the restaurant group's costs on the indemnity basis. Bayside's own lawyers had charged $55,000 in the period after the offer; the restaurant group's bill for the same period was $48,000. Because the post-offer order was on the indemnity basis, nearly all of that $48,000 was recoverable from Bayside, while Bayside recovered only part of its own outlay after the same date. A win on liability was heavily eroded by the costs consequence of rejecting a reasonable offer.

The same mechanism works in reverse for a plaintiff. A plaintiff who makes a realistic offer of compromise and then beats it at trial can expect indemnity costs from the date of the offer, which is why well-advised plaintiffs use them to pressure defendants into sensible settlements.

Misconceptions about indemnity costs

Some misconceptions about indemnity costs recur in practice:

"Indemnity costs mean I get my whole bill back": Not exactly. Even on the indemnity basis, costs that appear unreasonable in amount or unreasonably incurred are excluded under UCPR r 42.5, and the order covers costs payable between the parties, not every amount the client paid its own lawyers. Items such as the client's own management time spent on the dispute are not recoverable at all.
"The loser always pays the winner's costs": Costs are discretionary, not automatic. A successful party can be deprived of costs for disentitling conduct, such as inviting the litigation or running it for the purpose of inflating the recoverable amount: Oshlack v Richmond River Council. In some jurisdictions, such as the Family Court, each party starts by bearing its own costs.
"Indemnity costs are a punishment for the losing party": The High Court has confirmed that costs orders exist to compensate, not to punish: Northern Territory v Sangare. A formal warning of an intention to claim indemnity costs may improve the prospects of obtaining one, but such warnings should not be made lightly: Huntsman Chemical Co Australia Ltd v International Pools Australia Pty Ltd (1995) 36 NSWLR 242.
"A Calderbank letter is as good as an offer of compromise": It is not. An offer of compromise has a presumptive effect under the rules; a Calderbank letter is merely one factor in the court's discretion and the offeree's rejection must be shown to have been unreasonable: Leichhardt Municipal Council v Green.

Where a lawyer's help is worth the cost

An experienced litigator does several things that directly affect the basis on which costs are assessed:

Assessing exposure before proceedings begin: A lawyer can estimate what the costs order would look like on each basis, which is essential information for deciding whether to sue, defend or settle.
Drafting offers of compromise that work: To trigger r 42.15, an offer must comply with UCPR r 20.26: it must identify the claim and the proposed orders, must not include an amount for costs, and must be left open for a reasonable period. A defective offer quietly loses its costs protection.
Advising on Calderbank letters: Timing, content and the reasonableness of a rejection are all judged against the circumstances, and a lawyer can structure an offer that a court will treat as reasonable.
Reviewing contracts for indemnity costs clauses: Where a clause is ambiguous, a lawyer can advise whether it will be read as an indemnity provision or as a reference to ordinary-basis costs.
Making submissions on costs: After judgment, a lawyer can argue for or against an indemnity order, and can engage a costs assessor to quantify the amount actually recoverable when the bill is disputed.

Two questions to ask before you file

Before you issue proceedings or defend a claim, ask two questions. What does the contract say about costs, and what will the costs order look like if the other side makes an offer you reject? An indemnity costs order can add tens of thousands of dollars to a loss, and it is triggered far more often by a refused settlement offer than by misconduct. If you cannot answer those questions with confidence, that is the point at which legal advice is cheapest: before the costs clock starts running on the wrong basis.