Template:Indemnity description

Of the Animal Spirits

Few things are more apt to excite an attorney's animal spirits than an indemnity. Why so, you might ask, for it is nothing more than a promise to pay a defined sum should pre-agreed circumstances arise?

Indeed so, if used as the Lord* intended. An indemnity is a sensible way — perhaps the only way — to allocate the risks of externalities two merchants might encounter in agreeing to provide one another goods and services.

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

But in the hands of mediocre finance lawyers this noble purpose has been derailed. Rather than prudently allocating unwanted outcomes, indemnities seem, to those who wield them, like smart bombs that surgically eliminate all evil whilst vouchsafing loved ones to the bosom of the Earth while, to those asked for them, they have the hue of the closing stages of a Joseph Conrad novel. There is much misapprehension. Much horror. Much fear and loathing. Much ignorance.

What an indemnity is not

An indemnity is no better than a contractual claim. It is a contractual claim. It does not have a harsher accounting or capital impact. You enforce it as you would a breach of contract: by suing the indemnifying person for its failure to pay the indemnified amount. Since (if you've crafted it correctly) it is a claim to pay a pre-defined (or at any rate deterministic) sum, the elements you need to prove your claim are easily produced: a well-crafted indemnity is therefore apt for summary judgment.

Note a point of profound importance. While the failure to honour an indemnity is a breach of contract; the occurrence of circumstances permitting a claim under one is not.

To claim under a (well-crafted) indemnity, therefore, there is no breach to allege; no loss to prove; no causation required, no value judgment needed to satisfy the indemnitor of your bona fides: all you need prove is:

• There is an indemnity
• The indemnified event has happened;
• You have calculated the indemnified sum.

Recovering for a failure to honour a (well-crafted) indemnity is also straightforward: You must prove only the above, and the following:

• You have demanded the indemnified sum from indemnitor; and
• The indemnitor has not paid it.

Nor is an indemnity (if properly crafted), broader or of less determinate scope than any other contractual claim, 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.

How is an indemnity different from a breach of contract?

Contracts are simple things: each party has something the other wants; by contract, they memorialise their willing exchange. And, should you fail to keep up your end of a bargain, your counterpart must have a means of redress. This is a claim for breach of contract. However plain your promise, the theoretical extent of the loss you cause should you fail to keep to it is limited only by the depraved imagination of the opposing lawyer: loss of bargain, hedge break costs, lost opportunity, consequential loss, taxes, reputational damage, restitution, emotional distress, nervous shock, (needless to say, but inevitably said) legal costs and even exemplary damages to punish you for your high-handed and contumelious disregard for another merchant's reasonable commercial expectations.

These things have a nebulous air to them - they will require evidence: claim and counterclaim, examination and cross, and the law has developed techniques - principally causation and remoteness of damage - to limit unnecessary excess. But in general note this: the parties expect to hold up their end of the bargain. No-one enters a contract planning to sue on it. The difficulties in proving your claim are thus counterbalanced against the general expectation that, a merchant's word being its bond, it will be a sad day when you have to do so.

But, as economists will tell you, there can be undesirable consequences of commercial activity: outcomes that neither party wants, nor can avoid, even if each keeps faithfully to its side of the bargain. For these contingencies we have indemnities. Indemnities compensate for losses that do not arise from breach of contract, but from faithful performance of it. They address a contingency that neither party wants: An unexpected financial loss; legal action by a third party against one or other party to the contract as a result of its performance. Indemnities allocate these unwanted, "third party" risks away from the person on whom they would naturally fall.

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.

You keep saying "if properly crafted"

Yes, I do.

Why all the anxiety?

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)
  

• A law lord, that is.