24 October 2008

Mistaken Indemnity

An indemnity is a contractual promise by one party to make good a specific loss suffered by another. The indemnity entitles the indemnified party to a payment if the anticipated event does indeed take place. Simple enough?
UK Corporate/Commercial Law
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An indemnity is a contractual promise by one party to make good a specific loss suffered by another. The indemnity entitles the indemnified party to a payment if the anticipated event does indeed take place. Simple enough? Yes and no.

A customer licenses software from a supplier. If the software should turn out to have been copied from a third party, the customer's use of the software will infringe the rights of that third party and the customer could end up being sued for damages. So the supplier provides the customer with an indemnity, protecting it by agreeing to cover any loss that might arise as a consequence of the uncertain copyright position. Problem solved.

When used correctly an indemnity can provide a simple remedy to a situation in which one party should not reasonably be expected to bear the burden of a particular loss from a specified event. But there are a number of popular misconceptions about indemnities which ensure that they are often misused.

Warranty vs. indemnity

One common confusion is the difference between an indemnity and a warranty. Both provide important contractual protections, but it is important to be aware of the differences.

A warranty is a contractual undertaking that a particular state of affairs exists. For example, one party to a contract warrants that it has taken all necessary action to authorise the execution and performance of its obligations under the agreement. Should that warranty turn out to be untrue, the other party has a claim for breach of warranty and might be able to recover damages for that breach. However to do so, it must show that (a) it has suffered a loss, and (b) the damage suffered is not too 'remote'. In other words:

  • the loss was a natural consequence of the breach, the type and extent of which a reasonable person would accept in the circumstances; or
  • at the time the contract was entered into, the loss was fairly and reasonably contemplated by both parties as the probable result of the breach (this would cover an unusual type of loss due to special circumstances known to the parties from the start).

Furthermore, under a claim for breach of warranty the injured party is under a duty to mitigate by taking reasonable steps to minimise the loss and not taking unreasonable steps to increase it.

An indemnity, on the other hand, is a promise to reimburse the other party in respect of a particular type of liability, should it arise. Unlike breach of warranty claims, a party does not usually need to show that the loss passes the 'remoteness' test, and nor does it have a duty to mitigate the loss. Thus an indemnity has clear advantages over a damages claim because it provides a 'guaranteed' remedy, on a pound-for-pound basis, for a defined loss.

Unfortunately parties frequently make the mistake of simply relying on the word 'indemnity' without clearly setting out what it means. This is done in the mistaken belief that because a provision contains the word 'indemnity' it will successfully protect against all losses that might flow from the indemnified event. The wise man reads on ...

Cap on liability

Is an indemnity by its very nature unlimited, so that it covers all losses that the injured party might suffer? No. It depends on the wording of the indemnity as well as on what the rest of the contract says. For example, the contract may well contain a separate limitation of liability clause which provides for specific caps on liability, which might look a bit like this: "Party X shall in no circumstances be liable to Party Y for any indirect or consequential loss or damages, and in any event, the liability of Party X to Party Y shall be limited to £1 million." Then, if a claim under the indemnity arises, unless the contract says to the contrary, the indemnity will be subject to these limitations both as to the scope and amount of the liability. If it is intended that no such limits will be placed on the amount or scope of the claim under the indemnity, then the remainder of the contract must be carefully reviewed and any conflicts or inconsistencies between the indemnity and the remaining provisions of the contract (including limitations of liability and exclusion clauses) must be resolved.

Sole remedy?

Is an indemnity the sole remedy available for the indemnified event? What happens where the parties have agreed a cap on the liability under the indemnity? For example, "Party X will indemnify Party Y against Party X's breach of contract up to £1 million."

An indemnity in relation to a breach of contract is actually an additional right to a common law breach of contract claim. So, in the above example, Party X's liability for breach of contract is not limited to £1 million; that limit applies only to claims under the indemnity. Instead of bringing a claim under the indemnity, Party Y could bring a claim for damages, which would not be subject to the cap. So the better approach from Party X's perspective would have been to include a provision along the following lines: 'Party X's total liability in contract, tort (including negligence or breach of statutory duty), misrepresentation, restitution or otherwise, howsoever arising, for any breach of contract, including under any indemnities, shall be limited to £1 million."

Indemnity for general breach of contract

Do the rules relating to remoteness of loss apply to indemnities, and is mitigation relevant? It is true that for many indemnities these restrictions do not apply, but care must be taken in relation to indemnities against general breaches of contract.

One of the most common indemnities seen in commercial agreements is as follows: 'Party X will indemnify Party Y for any loss caused to Party Y as a result of Party X's breach of this agreement.' The result being that should X breach the agreement, Y can ask X to cover the losses it has suffered.

There are few cases specifically on this issue, but those that there are suggest that the courts will not automatically assume that by including a provision in these terms the parties have indicated their wish to exclude the rules against mitigation and remoteness. So, where a contract provides an indemnity against losses arising from an ordinary breach of contract, it is unlikely that the courts will automatically hold that the indemnity covers all conceivable losses, and it is also likely that the party with the benefit of the indemnity will be required to mitigate its loss. It is certainly possible for an indemnity against breach to cover all conceivable loss, but if this is the intention the contract should say so expressly, perhaps like this: "Party X shall indemnify Party Y (who shall have no duty to mitigate) for all losses, damages, costs, claims or expenses of whatsoever nature and howsoever caused (including any indirect or consequential loss) arising out of or in connection with a breach by Party X". Obviously Party X should be very wary of agreeing to any such indemnity!

Indemnity for express obligation to make a specific payment

So far our discussion has focused on indemnities against breaches of contract. The position is different in respect of a breach of an express obligation to make a payment. Such indemnities are characterised as claims in debt. Consider the following indemnity: 'Party X shall indemnify Party Y from and against any losses suffered or incurred by Party Y arising out of or resulting from any regulatory fine, award, or penalty levied on Party Y.' The courts have held that an indemnity such as this is a debt claim and so the mitigation rules do not apply. Similarly, since what is claimed is a quantified debt rather than damages, the rules relating to remoteness of loss do not apply either.


So what are the key "takeaway" points?

  • Firstly, an indemnity for a specific sum due on the happening of an event is not a claim in damages, so mitigation and other principles relating to the assessment of damages do not apply.
  • Secondly, where the indemnity is for a general breach of contract by the indemnifier, the default position is that rules relating to remoteness of loss and an obligation to mitigate will apply. If the parties intend to include unforeseen losses, and to exclude the duty to mitigate, they need to expressly say so in the contract.

And finally, remember: the word 'indemnity' is not possessed of magical' properties. To work properly it is important that any indemnity is drafted in the context of the rest of the agreement.

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.

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