Indemnity

You might like the Jolly Contrarian’s sample rebuttal letter when someone asks you for a wide indemnity.

Under an indemnity, one party (the “indemnifier”) agrees to pay the other the “indemnified”) an agreed amount should a specified event occur during the contract.

The “events” covered by an indemnity are usually unexpected costs and expenses the indemnified party incurs while performing obligations under the contract, the benefits of which accrue exclusively to the indemnifying party: things like tax charges levied on a custodian relating to assets it holds for its clients. Without an indemnity, the party incurring these costs would just have to wear them. This would be a windfall for the benefiting party.

An indemnity thus creates a payment obligation under the contract where one would not otherwise exist. If the indemnified event occurs and the indemnifier doesn’t pay, the indemnifiee has an action in breach of contract.

And that’s about it. An indemnity gives you a right to sue where, without it, you would not have one.

Indemnity for breach of contract? No, sir.

In any case, indemnities should not, ever, cover losses arising from breach of contract. Like, ever. Anyone who tells you anything different — and in this old salt’s long and grim experience, many people who should know far better will — should be directed to the coat check. Here is why: if the other guy has breached the contract, Q.E.D. you have a right of action under the contract. You don’t need an indemnity. This is self-evidently true. An indemnity claim for a defined amount of money. It requires no proof of breach, causation, or quantification. All of these things are vital to the allocation of losses following breach of contract.

There is, we think, a common misconception amongst eaglery that an indemnity can vouchsafe a claim for breach: that it can, somehow, make recovery under a contract quicker, more certain or more straightforward.

It cannot.

At the limit, a well-crafted indemnity would stipulate a fixed sum payable on breach of contract, regardless of loss, and this the courts would regard as an unenforceable penalty.

An indemnity is subtly different from a hold harmless, though the two often sit together like an angel and a demon on opposite shoulders of the contract. (Under a hold harmless, one party agrees not to sue the other for losses it incurs in performing the contract.)

What an indemnity is

“Why the excitement,” you might ask, “for isn’t an indemnity simply a promise to pay a defined sum should pre-agreed circumstances arise?” Quite so, if used as the Lords intended. For an indemnity is a sensible way — perhaps the only way — to allocate the third-party risks two merchants might encounter when faithfully providing one another goods and services.

Now the common law already has a sophisticated means for allocating losses between the parties to a commercial bargain. It is called the law of contract. Contracts are simple things: each party has something the other wants; by contract, they memorialise the willing exchange. Should either side not keep to the bargain, the other may sue.

Contractual damages are limited only by the depraved imagination of your lawyer: loss of bargain, loss of opportunity, consequential loss, taxes, reputational damage, restitution, hedge-breakage costs, emotional distress, nervous shock, (needless to say, but inevitably said) legal costs and, if that is not enough, aggravated damages to compensate for the mental distress of having ones expectation’s cruelly forsaken — in our time of snowflakery, undoubtedly a vibrant head of recovery. Nebulous as they are, such allegations at least require evidence, and the law has developed techniques — causation and remoteness of damage — to limit unnecessary excess.

Now any economist will tell you there can be undesirable consequences of commercial activity, that neither party wants, nor can avoid, even if each keeps faithfully to the bargain. For these “externalities” we have indemnities. They allocate these risks away from the person on whom they would naturally fall. One should therefore approach the request for an indemnity, with caution.

Your first question should always be “why”: Why shouldn’t this loss fall on the fellow who would ordinarily bear it? If it would, and it should, you don’t need an indemnity.

If it would but it shouldn’t, consider how well you can articulate the risk and likely loss? If you can describe it with minute precision, all well and good: your counterparty might be minded to accept: if you have no more than a faintly discomfiting sense that the sky might fall on your head when performing the contract, and you want to be indemnified for that, expect a stouter challenge.

What a (well-crafted) indemnity is not

An indemnity is not “better” than a contract

An indemnity is no better than a contractual claim. It is a contractual claim. It does not have a harsher accounting impact. Its capital treatment is the same. You enforce it as you would a breach of contract: by suing the indemnifier for its failure to pay the indemnified amount.

Now. Since (if well-crafted) it is a claim to pay a pre-defined (or at any rate deterministic) sum, proving your claim is not hard: prove you have the contract, prove you’ve suffered the loss and—that’s it. A well-crafted indemnity is therefore apt for summary judgment. But careful, counsel: aptness for summary judgment is not a magic property of all indemnities: it depends on how well you have crafted yours.

An indemnity does not require a breach of contract. In fact they should be mutually exclusive

Indemnities are never appropriate to compensate for a breach of contract. Never.

Like, never ever.

While failing to honour an indemnity claim may be a breach of contract, the circumstances giving rise to an indemnity claim in the first place are not. Indemnities address unwanted externalities that arise from faithful performance of the contract that fall on one party where equity — but not law of the contract — suggests they should fall on the other. An indemnity is simply a contractual technique to mutually reassign such an externality from one party to the other so that the law of contract does require it. That is all.

Thus: if there has been a breach of contract causing a loss, you don’t need an indemnity, because the law of contract already reassigns that externality on the breaching party automatically. This is called “damages for breach of contract”. There are important limitations on one’s liability for breach of contract — questions of causation, remoteness of damage, foreseeability and proof of loss — developed over centuries in the Darwinian crucible of the common law. They are there for the very good reason that, when things turn to vanillesoße, the parties to a contract are certain to disagree about how badly they are wounded and who is at fault. This is a function of their motivated irrationality and conflicting interests.

To claim under a well-crafted indemnity, no breach is required. There is no causation to prove, or value judgment needed about what the loss has been. Recovering for failure to honour a (well-crafted) indemnity is therefore straightforward: You must prove the indemnified liability has arisen, that you have demanded it from indemnifier; and that the indemnifier has not paid it. Hence: summary judgment.

So, friends, do not let your opponents babble about how an indemnity relieves the indemnified party the burden of all that tedious mucking around establishing causation, foreseeability and so on: it does not. If the loss you are seeking to recover is that indeterminate, it is not suitable for an indemnity. Indemnities are designed for identifiable, deterministic sums that require no judgment or evaluation to arrive at. If your indemnity claim requires that kind of thing the court will require you to prove that loss, and — if it arises from breach — the breach and its causation and foreseeability anyway.

The reason — the only reason, readers — a well-crafted indemnity is supposed to be exempt from this kind of enquiry is that it is meant to be a pre-agreed — at least uncontroversially obvious — amount, so there is no need to get into foreseeability, causation, quantum and so on. You did foresee it. You did quantify it: you wrote it into the contract.

Hence, if you are inclined to seek indemnification “for any loss of any type, kind or variety that the indemnified party shall on its own certification suffer” — and there is scarcely a corporate services provider out there who is not — you should not be seeking an indemnity. You should be putting on a tin hat and going with a year’s supply of tinned beans and a musket to sit in an air-raid shelter.

An indemnity is not (necessarily) of indeterminate scope

Nor is a (well-crafted) indemnity broader or of less determinate scope than any other contractual claim. A good one should have a predictable and reasonable financial consequence: It might be to reimburse taxes or similar unavoidable expenses a merchant incurs in performing the contract, that it would not, but for that contract. The sky should not fall in under the weight of a well-proportioned indemnity.

It is a precision tool to allocate responsibility for a narrow risk, not a weapon of mass destruction.

You keep saying “well-crafted indemnity”

Yes, I do. This is where things have gone awry. Many latter-day indemnities are not well-crafted at all. Often they try to catch every contingency under the sun: “any and all losses, costs and damages, howsoever arising, incurred or suffered in diligent performance of the contract”. Magnanimous ones might let the indemnifying party off those losses caused by the indemnified party’s negligence, fraud or wilful default, but that’s another story.

In any case, such a wide indemnity suggests your counterparty has not grasped the fundamentals of the commercial bargain: Indemnities are not meant for the ordinary costs of one’s performance of a contract. That is called consideration. It is why the other fellow is making a bargain with you in the first place. You’re meant to just pay that, and be grateful.

What are fit topics for an indemnity then?

Indemnities capture unexpected and unwanted possibilities brought about by performance of the contract which ought not to arise, whose provenance is beyond the indemnified party’s control, but which do.

There are two flavours of these:

• Retrospective tax events: Events that arise from the perfidy of higher powers: changes in law, retrospective taxes, and unbudgeted cost blowouts which are levied on the indemnified party as a direct result of performing the contract, which it could not reasonably have anticipated or avoided, and which the commercial equity of the situation supports allocating other than where they would naturally fall. In this correspondent’s opinion, that is limited really to retrospectively imposed taxes. Allocation of other un-budgeted costs can be resolved by re-negotiation or termination.
• Losses caused by the indemnifier’s misbehaviour to a third party: Events that arise though the mendacity — though not actual breach of contract — of the indemnifier. These arise where the indemnifier has given a third party an interest that, unbeknownst to indemnified party, its honest performance of the contract somehow abrogates. These a reasonable indemnifier should not resist, seeing as they are within its gift to prevent.

Liability under an indemnity

Since it isn't necessarily triggered by a breach of contract, nor is the value of indemnity constrained by ordinary contract law principles for 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 restrict its extent along the lines of 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. There, the Court of Appeal held that an 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.

The difference between an indemnity and a reimbursement obligation

You will sometimes see indemnities mentioned in the same breath as obligations to “reimburse” extraordinary costs an agent incurs in carrying out services for its client. You might think, based on the discussion above, that the two ideas bear some similarities — albeit that reimbursement obligations seem benign, and indemnities toxic. You would be right about that. They are so similar that some commentators, including this one, would call them identical.

Indeed, calling an indemnity a reimbursement obligation points up the difference between a good one and a bad one quite nicely: compare:

• “You must reimburse me for any taxes I am charged on securities I hold in custody for you” — to which a sensible reaction, is “ok boss; seems fair enough”; with.
• “You must reimburse me for any costs, expenses, foregone profits, lost business opportunities I suffer — on my say so — as a result of carrying out my services for you” — to which a sensible reaction is, “sorry but what planet are you on because it doesn’t resemble any I’ve come across in this arm of the galaxy.”

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)
  

Usage

They are often used:

• to protect agents and custodians in a transaction who are dealing with assets but do not have principal risk or reward in the transaction, but none the less could be opened to significant liability as a consequence of their role;
• as a means of protecting an indemnified party against consequential loss that it could not otherwise recover against the indemnifying party.
• In the context of a trust to negate the trustee equivalent of “ultra vires” for a corporation, where the trustee acts outside the scope of the powers conferred on it by the trust deed. In that case an indemnity allows the trustee (who would in such a case be personally liable for its actions) to be indemnified for that liability out of the trust’s assets. This is important not just for the trustee, but also third party counterparties: it negates any potential “ultra vires” effect against a bona fide third party without notice of the breach of trust. Such an indemnity is standard (the trustee would almost certainly require it as a condition for accepting its appointment), and would usually be produced as an ordinary part of due diligence in the context of an ISDA Master Agreement negotiation. (the trustee would almost certainly require it as a condition for accepting its appointment), and it is not unreasonable or difficult for the trustee to provide us with this evidence.

Scope of losses

• Direct losses as a result of breach of contract: Needless to say, an indemnity is not required from a party to recover direct losses suffered as a result of breach of contract by that party: the innocent party has an ordinary action available for breach of contract. Asking for an indemnity for normal breach of contract makes you look slightly dense.
• Other losses suffered by the indemnified party: Indemnities may cover “consequential losses” incurred by a party arising out of the contract even where they're unrelated to any action of the indemnifying party. However, the latter case opens the indemnifying party up to significant and indeterminate liability and it would be well advised to resist giving such an indemnity.

See also

• consequential loss
• indemnifying party
• indemnified party

Negligence, fraud or wilful default

An indemnity is the one time in a contract that it makes sense to exclude liability for negligence, fraud or wilful default, a contractual standard which otherwise is the product of muddy logic.

Generally the standard of conduct one must be held to in a contract is, of course, the contractual one. But where an indemnity is concerned, one party has agreed to assume liability for the other’s loss even though the indemnifier has not breached the contract or even acted foolishly in any way. And nor is the fact that indemnified party has itself performed the contract the end of it: The loss in question arises through the agency of some third party, away from the contract in which the indemnity lies. (A loss as between the two parties to the contract would be governed by the law of contract and breach and not an indemnity).

Here the eventuality is one the parties have not bargained upon, and that is beyond their control. This is just the sort of place where the courts can step in to imply reasonable boundaries on liability. A “negligence” carve out invites that.

Hence the indemnifier may seek to restrict its liability under the indemnity to compensate only losses which the beneficiary has not itself been negligent in incurring, in that tortious sense.
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