Template:Indemnity description

Of the Animal Spirits

Few things are more apt to excite an lawyer’s animal spirits than sight of an indemnity. Once a proud creature of the common law, in the hands of mediocre lawyers this noble beast has fallen upon hard times. Instead of prudently allocating unwanted outcomes, these days the indemnity is seen, by those who would wield it, as a smart bomb for surgically eliminating evil whilst vouchsafing loved ones to the bosom of the Earth. Those asked to indemnify, on the other hand, feel their throats tighten in a manner redolent of the closing stages of a Conrad novel.

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 risks of externalities two merchants might encounter when providing one another goods and services.

But remember: the common law has evolved 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 their willing exchange. And, should one fail to keep to the bargain, the other must have a means of redress. However simple your promise, the theoretical extent of your counterpart’s loss you cause should you fail to keep to it is limited only by the depraved imagination of her 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, exemplary damages to punish your high-handed and contumelious disregard for your opponent’s commercial expectations. Nebulous as they are, such allegations at least require evidence, and the law has developed techniques — principally causation and remoteness of damage — to limit unnecessary excess.

So much for breach. 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 contingencies we have indemnities. They allocate these unwanted, "third party" risks away from the person on whom they would naturally fall. One should approach the request for an indemnity, therefore, with a cautious air. Your uppermost 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 you are still persuaded you do, 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 it is no more than a faintly discomfiting sense that the sky might fall on your head, expect a stouter challenge.

Lastly, who amongst you is best placed to manage this risk?

What a (well-crafted) indemnity is not

It 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. 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 and a well-crafted indemnity is 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.

It does not require a breach of contract

Meanwhile, note a point of profound importance. While failing to honour an indemnity claim is a breach of contract, the circumstances giving rise to an indemnity claim in the first place are not. No breach is required, no causation or value judgment needed to satisfy the indemnifier of your bona fides. Recovering for failure to honour a (well-crafted) indemnity is therefore straightforward: You must show the event giving rise to the indemnity has happened, that you have demanded the indemnified sum from indemnifier; and that the indemnifier has not paid it.

It 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. It is common for indemnities 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”. A magnanimous recipient might let the indemnifier off those losses caused by its own negligence, fraud or wilful default, but that’s another story.

In any case, such a wide indemnity suggests your counterpart has not grasped the fundamentals of the commercial bargain: Indemnities are not meant for the ordinary costs naturally arising from one’s diligent performance of a contract — the ordinary vicissitudes of one’s day-to-day commercial existence, that is to say. That is called consideration. It is why the other fellow is making a bargain with you in the first place.

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.

How is an indemnity different from a breach of contract?

The example par excellence:

Unexpected taxes imposed on a custodian in the course of holding securities for its client.

The tax is no-one's fault. It could not be avoided. Because of the nature of the contract, it falls on the service provider, not the beneficiary of the service. It is easily quantifiable.

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.

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)