Template:Indemnity description

Of the Animal Spirits

Few things are more apt to excite an adequate attorney’s animal spirits than the request of an indemnity. Once a noble creature of the common law, in the hands of mediocre lawyers the indemnity has fallen upon hard times. Rather than a means of prudently allocating unwanted outcomes, it is seen, to those who would wield it, like a smart bomb that will surgically eliminate all evil whilst vouchsafing loved ones to the bosom of the Earth. To those asked for to give one, on the other hand, an indemnity invokes the closing stages of a Joseph 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.

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.

What a (well-crafted) indemnity is not

It isn't 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 crafted yours.

It doesn’t require a breach of contract

Meanwhile, note a point of profound importance. While failing to honour an indemnity claim is a contractual breach, the circumstances giving rise to one is not. One need allege no breach and prove no loss to make a claim under a (well-crafted) indemnity. No causation is required, no value judgment needed to satisfy the indemnifier 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 therefore straightforward: You must attest to the above, and the following:

• You have demanded the indemnified sum from indemnifier; and
• 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. It might be to reimburse taxes incurred in performing the contract, or a similar unavoidable expense that would not arise but for the contract. It should have a predictable financial consequence: an indemnity is a precision tool for a narrow risk, not a weapon of mass destruction. The sky should not fall in under the weight of a well-proportioned indemnity.

An indemnity is a precision tool for a narrow risk, not a weapon of mass destruction.

This is where things have gone awry. Many latter-day indemnities are not articulated this way. It is common for indemnities to catch every contingency under the sun: The indemnifier is asked to cover “any and all losses, costs and damages, howsoever arising, incurred or suffered in diligent performance of the contract”. An indemnified party showing uncommon largesse might the indemnifier off those losses caused by its own negligence, fraud or wilful default. That’s another whole story.

If you’re asked for something as mad as that, refuse, for it implies your counterpart has not grasped the fundamentals of a bargain: accepting the losses, costs and damages that naturally arise from the diligent performance of its contractual obligations is precisely the consideration your party ought to be offering you. That is why you’re even at the table. Indemnities are there to capture unexpected and unlikely possibilities that ought not to arise, but whose provenance is beyond the promising party’s control.

There are two flavours of these:

• 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. Legal changes involving ongoing costs can be solved by re-negotiation or termination.

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.