Indemnity

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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, this noble beast has fallen upon hard times. Instead of prudently allocating unwanted outcomes, these days it 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.

Overview

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.[1]

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.

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 — is, for the time being, without limitation and notwithstanding anything to the contrary in the foregoing contained, a moron.

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.

Do not start babbling on about how an indemnity relieves the indemnified party the burden of all that tedious mucking around establishing causation, foreseeability and so on: if the loss is that indeterminate, it is not suitable for an indemnity, and the court will require you to prove causation and foreseeability anyway. 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 vanillasoß, 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.

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 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.

In deep

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[2] 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.[3] 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[4]. 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

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. Hence: summary judgment.

Note, also, that summary judgment is available for certain contractual breaches: Specifically, failures to pay a specified sum, where the obligation to pay can be proved by contract, and the failure to pay can be proven by affidavit. No real question of witness credibility arises.

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:

Hold harmless

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. ===Who uses them?===

  • custodians and trustees who hold assets, have neither the risk or reward of the transaction, but could still suffer liability just because they are legal holders of the assets;
  • as a means of protecting an indemnified party against consequential loss that it could not otherwise recover against the indemnifying party.
  • A trustee wishing to negate the trustee equivalent of “ultra vires” where it acts beyond its powers. There the indemnity allows the trustee to be indemnified for that tis personal liability out of the trust’s assets. This is important not just for the trustee, it also negates any “ultra vires” effect against a bona fide third party without notice of the breach of trust.

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

See also

References

  1. When you put it like that it sounds rather like a derivative, doesn’t it?
  2. House of Lords, that is.
  3. But not exemplary damages, which are not available at contract, as any fule kno.
  4. summary judgment is a speedy civil court process where you have have a court award your claim without out all that messy and unpleasant business mucking around calling witnesses and so on.