In this paper I intend to highlight in a basic way the nature of an indemnity. I will explain how it differs from a guarantee, how an indemnity clause will be interpreted and how an indemnity may invoke a different regime for damages. I will point out some of the pitfalls in granting an indemnity and its potential impact on your insurance policies. I will finish with a few short lessons for draftsman of indemnities, describe situations where indemnities may be useful and leave you with a few tips when considering giving or receiving indemnities.
Indemnity Clauses And Their Effect
It is important to recognise the nature of an indemnity. It is a device that can be used to allocate risk among various parties to contracts or in projects. A simple indemnity is a promise by a person to hold harmless another person against the occurrence of a particular event. A common example is in fact a policy of insurance.
Although I won't discuss insurance policies in detail in this paper, you should be aware that liability of an indemnifier under a contract is similar to that of an insurer under a policy of insurance without all the protections an insurer can rely upon. One of those benefits that an insurer has that is not available to an indemnifier is the right of an insurer to avoid an insurance contract if there has not been a full disclosure to the insurer at the time the contract of insurance is entered into.
An indemnity is a primary obligation. It may be triggered without a breach of contract by the indemnifier. There are probably 3 general types of indemnity:
- Third Party Indemnities – where A indemnifies B against actions of C
- Self Indemnities – where A indemnifies B against A's own actions
How Does An Indemnity Differ From A Guarantee
As mentioned previously, an indemnity is a primary obligation that is not dependent upon a breach of contract before it can be enforced.
On the other hand, a guarantee has always been seen as a contingent or secondary obligation. As a result of the secondary nature of a guarantee, Courts have applied what is called the co-extensive principle. This means that the liability of the guarantor will be limited to the co-extensive rights that the beneficiary of the guarantee has against the party whose obligations are being guaranteed (the primary obligor).
The co-extensive principle means that if the obligations of the primary obligor are amended, deferred, or otherwise dealt with other than in strict accordance with the terms of the contract, the guarantee may cease to apply. This is why you see in guarantees lengthy provisions waiving the rights of the guarantor to complain about the underlying contract being amended, or the beneficiary of the guarantee delaying exercise of its rights against the primary obligor. The co-extensive principle does not apply to an indemnity. In most cases if the event against which the indemnity is given occurs, the indemnity may be enforced.
A further distinction between a guarantee and an indemnity is that because a guarantee is a contract for the debt, default or miscarriage of another person, it is required under what is known as the statute of frauds, to be evidenced in writing. In other words, a verbal guarantee may not be enforceable.
An indemnity is not considered to be a contract for the debt, default or miscarriage of another person, and therefore, need not be in writing.
A classic example of the difference between a guarantee and an indemnity being subject to interpretation by the Courts can be seen in the case of Marubeni Hong Kong and South China Limited –v- Mongolia.  1 WLR 2497 (CA Civil Division). So there are 3 principle elements of a guarantee:
- It needs to be evidenced in writing
- The liability is co-extensive with that of the principal – if the principal is discharged so is the guarantor (unless the contract of guarantee provides otherwise)
- some conduct by the beneficiary may discharge a guarantee whereas it might not discharge an indemnity.
It is important to reiterate that an indemnity renders the indemnifier liable even if the principal is not in default. An indemnity also may render the indemnifier liable for a greater amount than the principal under the contract.
The use of the terms guarantee or indemnity are indicators of the intention of the parties but the use of neither term is decisive as to the nature of the underlying obligation. The contract will always be interpreted in accordance with the terms of the contract and evidence as to the intention of the parties.
There is law that suggests indemnities should be construed according to their ordinary and natural meaning. However, in the absence of clear language, a default indemnity will not be construed to protect the indemnified party against its own negligence.
You may recall a default indemnity is where A indemnifies B against B's own actions. Decisions by Courts in the late 60's to the late 70's held that such indemnities will only be interpreted to protect B against its own actions if the language is clear and unambiguous.
Further, indemnities normally will not be interpreted to apply to protect a party against deliberate breaches by it unless the words are also clear and unambiguous.
You can probably see from the comments above that the trend for Courts is to construe ambiguities in the indemnity in favour of the party giving the indemnity. This approach was applied as recently as 2004 by the High Court in the case of Andar Transport Pty Ltd –v- Brambles Ltd (2004) 206 ALR 387. There may be some tension between the principle that indemnities should be interpreted according to their ordinary and natural meaning with the more recent tendency of Courts to adopt the commercial approach to interpreting contracts. The law is still a little unsettled in this area but the key is to ensure when drafting indemnities that the wording used is as clear and unambiguous as possible.
One final comment on interpretation of indemnities, as a matter of public policy, Courts may not enforce an indemnity to protect someone against an illegal act or claim.
There is a great deal of debate among lawyers as to the need for indemnities in contracts where it may be appropriate simply to rely on warranties contained in the contract or breaches of the ordinary clauses in the contract. This issue becomes particularly important when considering issues of damages and the time for which various provisions of the contract may be enforced. There may be a significant difference in the calculation and treatment of damages depending upon whether the damage is sought for a breach of a contractual obligation or to recover losses under an indemnity.
There are principles of remoteness of damage under contract law that may protect a guilty party against certain damages incurred by the innocent party. The classic of course is economic loss and loss of opportunity. I will not go into the situations where it may be possible to recover consequential economic loss for breach of contract. Suffice to say that if the words of the indemnity are broad enough, then the loss that can be recovered under the indemnity may go beyond the common law losses.
Under contract law, the innocent party has an obligation to mitigate the effects of a breach. For example, if there is a breach of contract leading to the failure to complete the construction or manufacture of an item, there is an obligation to have a replacement item constructed or manufactured at a reasonable cost. Unless the language of the indemnity so requires, there is no obligation to mitigate a loss before seeking to recover under an indemnity.
There may be circumstances on the other hand where an indemnity provides a lower recovery than for a breach of contract. The general measure of damages for an action for breach of contract is to place the plaintiff in a position it would have been in but for the breach. That can include a loss of profit. The wording of an indemnity may be limited to losses and costs incurred as a result of an occurrence of an event. If the indemnity is so drafted, it may not cover profits.
One of the more significant issues surrounding the utility of an indemnity is the extended time for which it may remain available for enforcement compared to a claim for breach of contract. Statutes of limitation exist in all states and territories of Australia that limit the time by which a claim must be brought for breach of contract. Normally the period is 6 years for an ordinary agreement or 10 years for a deed. Time commences to run under the statues of limitation from the date of the breach of contract. Therefore, if there is a breach of contract occurring today, the innocent party will have 6 years (or 10 years if a deed) within which to bring an action seeking damages for the breach.
Let us contemplate a contract for construction of a major office block with say a period of 3 years to completion. Let us assume the contract contains a fitness for purpose warranty. Let us also assume that the contract contains an indemnity under which the contractor agrees to indemnify the developer against any breach of warranty and the warranty is expressed to survive beyond completion of the contract (quite a usual provision). The certificate of completion is issued but during the defects liability period it is found the building is not fit for its purpose and so a breach of warranty occurs. At this point in time, the developer would have a period of 6 years to bring an action on the breach of warranty but fails to do so. The developer may at any time bring an action on the indemnity to seek recovery of its loss. It may do so many years after the right to bring damages for breach of contract has expired. In fact, having made a claim under the indemnity by serving written notice, the innocent party would then have a further 6 years from that date within which to bring legal proceedings to enforce the indemnity. I believe in most instances parties granting indemnities are not adequately advised of this potential impact and the extended period of risk they are assuming for their obligations. It is critical to understand that in this situation, the limitation period starts from the date on which the indemnifier refuses to honour the indemnity.
Before granting an indemnity it would be wise for the indemnifier to check the impact on its insurance policies.
If the indemnity is a simple one that goes no further than to give the innocent party the same rights it would have had against the indemnifier on a breach of contract, it is unlikely to cause a problem under your policies of insurance. This is subject of course to the more extended time during which liability may attach to the indemnity just discussed.
However, typical broad form exclusions in policies of insurance include wording to the effect that the policy does not cover liability assumed by the insured under any contract that would exceed liability implied by law. As mentioned earlier, it is possible that under the doctrines of remoteness of damage, there are certain losses that would not be recovered under the contract at law. If the indemnity is drafted so as to extend the liability of the indemnifier to incorporate damages or loss that otherwise would be remote, such an exclusion under the insurance policy could well apply.
There are cascading types of exclusion clauses in policies of insurance. Some are very broad and therefore attach extraordinary risk to a party giving an indemnity; others may be far more generous and may include indemnities as normal contractual provisions. The message is: you do not know until you have checked your policy of insurance against the words of the particular indemnity. Contract risk managers will need to have a close working knowledge of their organisation's policies of insurance or a very good relationship with the officer in the organisation responsible for effecting insurance.
Inventive lawyers have raised some quite interesting arguments about the interaction between indemnities and insurance. For example, if party A has the benefit of an indemnity from party B, yet party A maintains insurance itself in respect of the same risks, is there in effect double insurance? You may all be aware that if there are two policies of insurance covering the same event, the insurers can seek contribution from each other. Does this mean that an indemnifier could argue that it is only liable to the principal for half the loss if the principal is able to recover under its own insurance policy? Those types of arguments have in fact been raised in cases in the early 2000s. The main case is Caledonian North Sea Limited v London Bridge Engineering Company Limited  LLoyd’s Rep IR 249 at its various stages through the lower Courts and to the Courts of Appeal. Generally, Courts have held that the defendant should not have the benefit of the prudence of the plaintiff organising its own insurance.
However, Courts have come to that conclusion on varying legal theories that conflict with each other and different factual circumstances could have dramatically different results. One of the key issues is whether or not you have coordinate liabilities. If you do, then you share the risk. It has traditionally been felt that an insurance policy is not a coordinate liability but a secondary or subordinate liability akin to a guarantee. If the liability undertaken by an insurer is a subordinate liability, then it has a right to be subrogated to the position of the insured to make a full claim against the indemnifier. Whilst that has been the usual position, and we have all been quite comfortable with it, recent cases have suggested in fact, it is possible for an indemnity and insurance to be coordinate. For example, it has been suggested that if the principal had been required under the contract to effect insurance, the liabilities may have been coordinate. Therefore, lets once again look at our construction situation but expand it into a major project. We all know that in major projects it is usually the case that project specific insurance is undertaken. In those circumstances, if the contractor gives to the owner an indemnity against again say a fitness for purpose warranty and project insurance is taken out to cover against breaches of the construction contract, those liabilities may be coordinate. This should not be alarming as it is usually the proposition in major projects that the insurance is intended to cover fully the indemnity so that the contractor may claim on the policy as well as the developer. The risk is that if you are not precise in your drafting and have in mind the correct intention of the parties, you may inadvertently end up with a situation where the insurance and the indemnity are coordinate so that the indemnifier is released from an obligation of full liability if for some reason the insurance fails. This warning arises in other cases where it has been suggested that coordinate liability may arise under separate instruments.
There are a few short lessons for draftsmen coming out of this discussion:
- Draftsmen need to ensure that indemnity language is clear and concise to avoid ambiguity that could be construed in favour of the indemnifier. Unfortunately, ambiguity is a fairly subjective determination made by the judges on a case by case basis.
- Draftsmen should consider whether or not there is a need for an indemnity at all. Is it intended that an indemnity give rise to greater protection than would normally be available for breach of warranty or breach of contract? If not, the indemnity is not needed.
- Before drafting an indemnity it is important to understand:
- the difference in the measure of damages
- the difference from a guarantee
- the limitation issues
- the possible risk of proportionate reductions in liability on a contribution basis
- the indemnifier needs to be aware that it will have no right of subrogation against the principal obligor unless it has some separate arrangement with the principal obligor.
I would like now to mention some situations where it may be useful to insist on indemnities:
When acquiring an asset, be it shares, property or a business, there are a number of ways the purchaser may protect itself. It may do this by due diligence, extensive warranties or indemnities, or more likely a combination of all three. When buying shares in a company it is common to ask for (but not always to receive) an indemnity against the failure to disclose a material risk the vendor was aware of or should have been aware of. An indemnity is thought appropriate as the vendor is receiving value as if the risk did not exist. A breach of warranty may be inadequate because of issues of remoteness of damage and to avoid the need to complete an action for recovery before proceeding to the indemnity. Indemnities are particularly useful to protect against unwanted tax liabilities of the underlying company and in respect of undisclosed and unfunded employee benefits and entitlements.
Losses caused by third parties are not normally covered by contractual damages. So if for example, a drilling contractor is undertaking work for a mining operation, the contractor may well wish to be indemnified against losses sustained by third parties having access to the same site to carry on other operations on behalf of the mine operator. This type of indemnity is also common in construction contracts on brown field sites. Often however, the owner of the site may decline to grant the indemnity but allow extensions of time and cost adjustment to the contract.
In industries where there is inherent danger to employees with multiple parties involved in operations (again oil and gas exploration is a classic example) each party may indemnify the other against claims made by the first party's employees. This avoids issues of causation and contribution on the basis that each party takes responsibility for the safety of its own employees.
It is almost universal that the licensee of software will seek from the licensor an indemnity against losses sustained vis a viz a third party for breach of intellectual property rights.
A supplier of a product may require the licensed user to indemnify the supplier against misuse of the product by third parties allowed access to the product by the user.
Company A may be the purchaser of products for use by the whole Group. Company A may require the supplier to indemnify the Group for losses sustained if the product is faulty. Company A may need to express the indemnity to be held for the benefit of each member of the Group before the indemnity is effective. In the reverse, the supplier may seek an indemnity from Company A (or its holding company) against losses sustained from the misuse of the product from any member of the Group.
- Is the indemnity really needed or will contractual rights be sufficient?
- By asking for an indemnity, will you be asked to provide one and could that be to your own disadvantage?
- What impact may the indemnity have on your insurance?
- Are the losses against which you need protection recoverable under ordinary concepts of damage? If not, seek an indemnity.
- Will there be difficulty in determining causation of damage in the particular circumstances? If so, the parties may allocate the risk clearly by using indemnities.
- If giving an indemnity, consider capping the liability to a monetary amount.
You can see that indemnities can be a complicated beast. Yet they seem to be asked for and given willy nilly in contracts. Such a practice evidences a lack of understanding of the impact and reach that an indemnity may have. A careful consideration of the circumstances of the contract between the parties, the interaction events may have with third or even related parties and the physical environment in which performance of the contract is to be undertaken will often result in a more reasoned and rational decision about whether or not an indemnity is required.
If an indemnity is required, both sides should ensure that it has been drafted in a precise fashion so as to be unambiguous and to cover those events that it is intended to cover.
If giving an indemnity, please check it against your insurance policies. Please also understand that the indemnity may last a lot longer than you do!
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.