Template:Indemnity description

In an attorney's miserable existence, few things are more apt to excite the animal spirits than the request of an indemnity. Yet an indemnity is nothing more than a contractual promise to pay a defined sum should a pre-agreed circumstance - not being a breach of contract - arise. If used as the law lords intended, it can be a sensible way to allocate third-party risks that parties take on in agreeing to provide services to each other.

An indemnity is nothing more than a contractual promise to pay a defined sum should a pre-agreed circumstance arise.

But the indemnity has suffered a bit of continental drift at the hands of inexpert lawyers. An indemnity is now seen, by those who believe they're entitled to one, as a kind of smart bomb that will assassinate all evil, whilst vouchsafing loved ones to the bosom of the Earth. To those asked to provide one, on the other hand, an indemnity has the hue of the closing stages of a Joseph Conrad novel. There is much misapprehension. Much Horror. Much Fear. Much Loathing.

Much ignorance.

Of itself, an indemnity isn't better than a contractual claim. It is a contractual claim. You enforce it by taking legal action for breach of contract: namely, the indemnitor's failure to pay the indemnity amount. Since (if you've crafted it correctly) it is a claim to pay a pre-agreed sum, you don't need to prove your loss: all you need to prove is that the indemnified circumstances have happened. There is no loss to prove; no causation; no breach by the indemnitor (other than its failure to pay: a well-crafted indemnity is therefore apt for summary judgment).

An indemnity doesn't have different accounting or capital consequences to a normal contractual claim. It isn't, of itself, more severe. Nor is it, inherently, more broad or of less determinate scope, though, thanks to the continental drift, some indemnities try to catch everything under the sun. They shouldn't. Indemnities are precision tools for narrow risks, not weapons of mass destruction. The sky should not fall in under the weight of a well-proportioned indemnity.

Why all the anxiety?

Contracts are simple things: each party has something the other wants, by a contract, they memorialise their willing exchange. But, as economists will tell you, there are sometimes undesirable consequences of commercial activity: outcomes that neither party wants, nor can avoid, even if each keeps faithfully to its side of the bargain.

Indemnities compensate for losses that do not arise from breach of contract:

• They address a contingency that neither party wants: An unexpected financial loss; an adverse change in tax treatment; the commencement of legal action by a third party against one or other party to the contract as a result of its performance. It allocates these unwanted, potentially unquantifiable, "third party" risks away from the person on whom they would naturally fall.

The questions in your mind should always be:

• Why shouldn't this loss fall on the party who would, under settled legal principles, ordinary bear it? If it should, and it would, you don't need an indemnity.
• How open-ended is the loss likely to be? The more open ended the loss, the harder a job you will have persuading the other guy to wear it. (and for that matter, the court to grant it to you in any case).

Example:

A enters a derivative contract with B. To hedge itself B, buys security X. B's investment in X is subject to an unexpected tax charge. A has indemnified B against all tax liabilities arising on its hedging activities.

• A did not breach the contract
• B does not need to (and indeed cannot) claim breach of contract,
• B can call on the indemnity to require A to make a payment equal to the tax charge under the indemnity.
• If A neglects to make the indemnity payment, B has an action in breach of contract.

Claiming under an indemnity

For these reasons, an indemnified party does not need to prove the indemnifying party committed a breach of contract: it need only show that the undesirable "third party" contingency has befallen it, and that it has correctly ascertained amount which the indemnifying party has indemnified it as a result.

Liability under an indemnity

Since it isn't necessarily triggered by a breach of contract, nor is the value of indemnity necessarily constrained by ordinary contract law principles for ascertaining damages. (That is not to say you don't have to prove loss, though: beware indemnities that look like penalty clauses.)

Now we have already established that you want to reallocate this risk away from the party who would naturally bear it. That person will ask itself, as should you, could my agreeing to this indemnity, in the immortal words of Cardozo J in Ultramares Corporation v. Touche open the floodgates leading to "liability in an indeterminate amount for an indeterminate time to an indeterminate class"?

Actually a little side bar here: The more open-ended the wording of your indemnity, the more prone the courts are to analogise its extent back to ordinary contractual principals of remoteness of damage - see Total Transport Corporation v Arcadia Petroleum Ltd (The Eurus) Good note that from Olswang, by the way.

The Court of Appeal, interpreting the contract as a whole, held that the obligation to pay "any time, costs, delays or loss" caused by a party's breach only covered losses flowing directly from the breach or that were in the contemplation of the parties when they made the contract.

Indemnities and Guarantees

An indemnity is nonetheless a useful back-up to a guarantee because:

• The Statute of Frauds does not apply to an indemnity.
• The invalidity of an underlying obligation does not invalidate an indemnity.
• Variation of the terms of an underlying obligation will not discharge an indemnity whereas it might a guarantee (unless you have a good waiver of defences clause)