An indemnity is the closest thing the law has to a blank cheque to recover financial loss.
The claims to indemnify another person can arise:
- in contract law, when they show up in contract clauses
- as part of a legal remedy even when there is no contract clause for indemnification.
When they're voluntarily given in a contract, they're often given without giving them a second thought to what an indemnity claim can mean for a business.
What is an Indemnity Claim?
An indemnity claim arising from a clause in a contract creates a promise by a person to:
- compensate another person
- for any loss or harm which comes to them,
- from an event or series of events
- to put them in a position where they have not suffered loss.
It’s a legally binding promise to protect another person against loss from an event or series of events: they are indemnified and protected from liability.
Sometimes, indemnities are implied into the terms of contracts automatically, due to the nature of the legal relationship between the two parties. The indemnification and liability under the indemnity arises automatically, by operation of law.
When an indemnity clause appears in a contract, it’s standalone contractual promise which gives rise to the claim. It gives a better measure of recovery for loss than what would be available in the general law of damages. The liability is usually greater.
Indemnification Meaning
Whether indemnity liability arises under a contract or not, it compensates another person for any harm which comes to them: to put them in a position where they have not suffered loss.
It’s an additional promise which applies over and above an ordinary claim for damages for breach of contract.
They recompense the indemnified person for any loss or liability which one person incurs against specified events within the terms of the indemnity.
The end result is that the indemnifying party (aka indemnifier) holds the indemnified party (aka indemnitee) harmless against specified losses.
For this reason alone, letting them slide through in a contract review without thinking about what they mean can be a mistake.
That’s contractual indemnities. Indemnity claims arise in other contexts as well.
Uses of Contractual Indemnities
Contractual indemnities are used for a variety of purposes:
- secure contractual performance: as a contract clause to secure of performance of another person to a contract
- financial protection: to transfer financial risk of a named event from one party to the other party, where it might not ordinarily or otherwise lie
- remedy for reliance: in response to some state of affairs that a party relies on to enter into a contract. They negate the need for a misrepresentation claim where the primary remedy is rescission. That remedy may not suit the indemnified party
- remove the burden of proof for breach of contract: it can become unnecessary
Example:
A software developer wants to licence software. They’re the licensor.
The licensee normally wouldn’t know one way or the other whether the licensor owns or is authorised to licence the software.
If the licensee uses the software, and the licensor doesn’t have permission to licence the software, the licensee will infringe the copyright and maybe the patent rights of the third party that does own it.
The licensor obtains an indemnity for intellectual property infringement from the licensee to shift the risk of infringement to the licensor.
Indemnification: Types of Events
Indemnities can be given in business contracts for all sorts of reasons.
The indemnified events to enhance financial recovery might include:
- breaches of contract generally
- breaches of warranty in the context of a share purchase agreement or asset purchase
- claims for intellectual property infringement (relating to goods or services themselves):
- made by a third party against the indemnified party, or
- infringing use of a third party intellectual property rights in the goods or services, which would infringe a third party’s rights
- negligence causing loss to the indemnitee
- use of goods or services which causes damage to the indemnitee
- highly customised and defined situations, such as:
- use of particular equipment
- loss or damage to specific physical property
- use of an access road, bridge or easement
It depends on how the indemnity in the clause defined.
The parties though can agree to indemnify one another for practically anything, due to the principles of freedom of contract.
When they’re used to indemnify against breaches of warranties, they’re there to enhance recovery of loss.
Types of Indemnification in Business Law
What the main types of indemnity clause?
Like most contractual clauses, indemnities come in all shapes and sizes.
The way they end up in contracts depends on a whole host of factors, such as whether:
- standard terms of contract are used
- the negotiating power of each party is the same or markedly different
- the sort of loss intended to be covered by the indemnity
- the scale of recovery intended
- the conditions attached to the indemnity.
They can cover pure economic loss (ie loss which is not damage to property or physical injury), such as:
- reduction in value of property
- loss of use of property
- wasted expenditure
- lost revenue or loss of profit
- payment of money by the indemnified to a third party
- being deprived of a legal right
Example Indemnity Clauses
Some of the more common forms of indemnity clauses include:
- Third Party Indemnity Clauses
- Intellectual Property Indemnification Clauses
- Mutual Indemnification Clauses
- Indemnify and Hold Harmless Clauses
- Subcontractor's Indemnity for Employees
Indemnification in Contracts
Indemnities are included in contracts to recover loss at better rate than what the general law of damages will allow.
They reduce the legal hurdles to recover more.
Generally speaking, they’re easier to enforce because the indemnity creates an express remedy in the contract for payment of money:
- for a breach of a contractual promise: a warranty, innominate term or a condition.
The claimant bears the burden of proof to show a breach of the contract to get access to indemnification - when a specified event happens:
In these cases:- a breach of contract does not need to be proved, and so there is no burden of proof to show the breach, and
- there is no right to terminate by the indemnified party.
So, depending on the wording of the indemnity, the party wishing the recover does not even need to rely on a breach of contract - usually a breach of warranty – to claim on the indemnity.
Indemnities in Share Sale Agreements
Indemnities are customary in share purchase agreements (usually referred to as an SPA).
Whether it’s said or not when negotiating an SPA, the real reason for inclusion of an indemnity is that:
- it enhances recovery of financial loss
- the usual limitations on damages probably won’t apply to the indemnities, and
- the indemnified party does not need to prove that a breach of contract has taken place.
Factors limiting Damages Claims
A party’s level indemnification is decided by the exact wording used in the contract.
That’s because indemnities in any commercial contract are governed by its own terms, taking into account:
- the background facts: the events leading up to the contract being agreed
- the objective intentions of the parties, assessed as at the date of the contract
- the entire contract: all of the terms of the contract, not just the indemnity clause
Interpretation of Indemnities
Due to the way contracts are interpreted by courts, an indemnity with precisely the same wording can
- have a different legal effect
- when entered by two completely different contracting parties
In Smith v Howell (1851), it was said that:
by a contract of indemnity, [it] is meant that the party indemnified may recover all such charges as necessarily and reasonably arise out of the circumstances under which the party charged became responsible.
As I have stated, it seems that under the contract of indemnity the party is entitled to recover those costs only which have been fairly and reasonably incurred.
Then E. Scott (Plant Hire) Ltd v British Waterways Board (1982) held:
If a particular clause is considered commercially undesirable because the reader may think that it means what it says, the judicial conscience need not, I think, be unduly troubled by limiting the ambit of a clause which, by choice, fails to say what it means.
That’s brutally clear.
Mess it up, and they pay. Or you do.
When a business signs up to an indemnity, it should not be surprised when courts give the indemnification the full force of the meaning of the words used. That’s consistent with underlying principle of freedom of contract.
Factors in the terms of Contract: The Indemnification
The wording of the contract itself:
- defines the specified loss or expense for which the promise of indemnity is given
- the qualifying criterion for indemnification, and
- can displace, improve or worsen the general law of indemnities.
That means that indemnities can be drafted:
- widely to capture any sort of loss, caused by, say “any breach of this agreement” or
- narrowly to capture a specific loss, such as “a loss of data arising from defective malware protection”.
There is a minimum of 3 elements to an indemnity. You can see these in the examples above.
- Indemnified event: the events which are indemnified, whether it is:
- injury to a person
- loss or damage to property, being physical and intangible property such as intellectual property
- pure economic loss.
It could be a:
-
- specified event such as:
- use of named software
- use of particular equipment supplied under a contract or
- use of a specified access road, bridge, walkway
- general event, such as:
- performance of the contract
- use of equipment supplied
- intellectual property infringement
- specified event such as:
- Connecting factor/causal link: the nexus between the event and the extent of the loss to be identified, such as:
- caused by
- as a result of
- arising out of, and/or
- connected with
The connecting factor creates the nexus to cover the indemnified event.
- Types of loss protected by the indemnity, such as actions, demands, claims liabilities, costs and/or damages.
Terms of Indemnification
In commercial contracts, indemnification is usually brought about by references to:
- “indemnify” or “full indemnity basis”
An indemnity requires the indemnifier to prevent the indemnified party sustaining any loss or expense in the first place. It’s not merely to reimburse the indemnified once the latter has paid.
- “hold harmless” and “save harmless”: the ordinary meaning of the word "indemnify" is "to hold harmless".
- “indemnify and hold harmless”: the combination of these terms has been held to mean that the indemnifier cannot sue the indemnified party, on the basis that “hold harmless” it is inconsistent with a right to sue.
When an indemnity says “indemnify and hold harmless” for say infringement of third parties intellectual property rights, the indemnifying party cannot challenge the level of compensation if the indemnified party contributed to level of compensation to make it higher. The “hold harmless” prevents the indemnified party challenging it.
However, in Deepak Fertilisers v Davy McKee (1998) EWCA Civ 1753, the reasoning of the Court of Appeal relied on an implied term as a result of use of the words "hold harmless" in the contract.
So that reasoning can’t apply in cases, where that meaning can’t be implied due to limitations for implication of terms.
- “defend”: used by itself has been held to mean that the indemnitee may request the indemnitor to take over the defence of proceedings brought against.
To have a wider effect and force an indemnitor to defend a claim requires much more than just dropping a single stray word into a contract.
In English law references to “defend” probably also extends the indemnity to apply to paying the legal costs of defending allegations of the infringement.
Not just successful claims.
When does Liability arise under an Indemnity?
Breach of an indemnity gives rise to a right to unliquidated damages, ie not a debt (a contractual sum fixed in amount by the contract). It is not a fixed, quantified amount.
The difference is significant.
But if the terms of the indemnity clause operates to recover a specified sum upon a specified event and the terms of the indemnity trigger the obligation to pay, it will be a debt and not a claim for unliquidated damages.
When it is an unliquidated claim (ie not a debt fixed by the contract):
- a judgment of a court is required to fix the sum to a definite amount: ie the debt.
- the amount required to be paid is the amount required to prevent the indemnified person suffering loss.
It’s the amount that arises from the failure of the indemnifier to indemnify under the contract.
Sustaining Loss under an Indemnity
Under the general law (ie subject to the terms of the contract), liability arises under an indemnity:
- when the loss is suffered,
- the indemnifier is then in breach of contract
- for failing to hold the indemnified person harmless against the relevant loss
Therefore, the cause of action to entitle recovery does not arise until the indemnified person suffers actual loss:
It’s when an event covered by the indemnity takes place that counts.
That’s the position under the general law. It can be modified by the terms of the contract.
Right to Payment
Once the liability has been fixed or quantified, it doesn’t matter whether the indemnified party pays the money over to the party it is intended to pay, even if:
- the indemnified has not paid the creditor
- the contract does not include an express obligation to pay the indemnified party directly.
It’s none of the indemnifier’s business unless indemnifier has a vested interest in that taking place.
This consequence of an indemnification means that the indemnified party may be able to settle disputes other than paying money to the person to which it is liable. The indemnifying party might have any number of lawful means of persuading the creditor not to press its claim.
What is the result of Indemnification?
The effect of a contract of indemnity is that the indemnified person:
- is put in the same position,
- as if the act against which they are indemnified,
- had been done by the person who is to indemnify them, and
- at the time when it ought to have been done
Indemnification vs Breach of Contract and Damages
On a like for like basis, an indemnity better than an award of common law damages, whether its for a breach of warranty or not.
When an indemnity covers the same loss as a damages claim, indemnities almost invariably give rise to a claim which is higher in amount than the breach of warranty claim.
That's for a number of reasons.
Awards of common law damages are limited by 3 factors:
- causation of loss
- remoteness of loss: the damage is too remote to be recoverable. That’s the Rule in Hadley v Baxendale. That case limits recovery of consequential loss, and
- mitigation of loss
Although indemnities are limited, when they’re framed to recover a debt (ie liquidated damages), they’re not limited like that. That’s because principles relating to the assessment of damages for breach of contract which have no application to recovery of debts.
In claims for unliquidated damages, causation of loss is replaced by the express connecting factor in the indemnity. It can be wider or narrower than causal link required for an award of damages. The connecting factor is usually wider than what causation would allow in common law damages claims. It casts a broader net to recover losses for the indemnity claim.
Also, it ends up that there are fewer factors in play to drive the sum payable downwards to a lesser amount (as would be the case with common law damages).
And then the sum recoverable by the innocent party ends up being greater.
Restrictions on Indemnities
As with any other contract clause, qualifications and restrictions can be placed on indemnities, such as:
- the terms of the indemnity can be limited, such as to:
- impose restrictions on use of licensed products
- restrict modifications or combinations to which products might be put
- set limitations of liability under the contract
- limit the geographical regions to which intellectual property may be used
- creating an option for substitute goods or services which do not infringe intellectual property rights
- judiciously choose the law governing the contract
- impose conditions precedent to the indemnity, so that the availability of the indemnity itself is limited by conditions, such as requiring:
- co-operate with the indemnifier in defending any claim
- require control of the defence – ie conduct of legal proceedings - by the indemnifying party
- require the indemnified party to give notice of claims under the indemnity
- require consent to reasonable terms of settlement
- time bars: prohibiting claims of indemnification, if they are not made within a specified time of the events entitling a claim under the indemnity
- indemnity caps: limitations of liability cap the value that may be claimed under the indemnity
- expressly exclude claims under the indemnity brought about by negligent acts of the indemnified party
What can't be excluded or restricted are claims brought about by civil fraud. And it's more difficult to succeed on an indemnity claim when the indemnified party caused the loss suffered (to itself).
Expansion of Coverage of Indemnities
Indemnities can also be expanded to cover separate legal entities, which they would not ordinarily cover, from companies and individual sand such as:
- affiliates of the indemnified party:
- parent companies, subsidiary companies
- officers, directors, employees and agents
- third party contractors, members of the public generally
- buyers and end users of the products and services of the indemnified party
- use of the words “directly or indirectly” in respect of the connecting factor. In conjunction with the within the terms of an indemnity has been held to reference to direct loss and indirect loss within the meaning of the Rule in Hadley v Baxendale
Duration of Liability: Limitation Periods
Claims for breach of a warranty or condition of a contract may be made within 6 years of the breach of contract.
In the cases of indemnification, the limitation period for an indemnity starts when the indemnifying party's liability is established when the conditions of the indemnity have been satisfied.
That means liability arises on the date that the indemnifier:
- fails to hold the indemnified party harmless, or
- the liability has been fixed or realised.
The limitation period runs for at least 6 years from the relevant date. Special circumstances are required for it to run for longer, such as in cases of civil fraud.
That may mean the indemnity is conditional on actual payment by the indemnified party to the person to which it is liable. In that case, the cause of action will accrue only when payment has been made by the indemnified party to the person to whom it is liable.
So the limitation period may be longer for an indemnity than a breach of contract. It’s not likely to be shorter.
Differences: Contract of Indemnity v Contract of Guarantee
A guarantee is not an indemnity.
They’re two different things.
A guarantee is a contractual promise by a person who is not responsible for performance of a contract to make good performance of a party to the contract when they fail to perform.
A guarantor has a secondary obligation to perform a contract.
Legally speaking, the guarantor stands at one side until the party primarily responsible for performance of contract fails. The creditor then seeks recovery from the guarantor.
In contracts of indemnity, the party does not stand at one side until the primary party fails to perform. The indemnifier is primarily liable for performance.
Simply because a contract of guarantee says that the guarantor provides an indemnity for failure for performance of the contract, does not necessarily make that the case. It’s a matter of contractual interpretation to decide whether it is or not.
There are more ways to avoid liability under a guarantee than with an indemnity due to the secondary nature of performance of guaranteed obligations.
Unlike guarantees, indemnities do not need to be evidenced in writing and signed by the indemnifier. This means for instance, that an indemnity could be given over the telephone when the contract is formed.
Indemnities v Contracts of Insurance
A contract of insurance is a type of contract of indemnity.
What is a contract of insurance?
Contracts of insurance are contracts, which require on the happening of an event (or materialisation of a risk – ie the event happens) for:
- the payment of money, or
- to reinstate, repair or give some other benefit.
In insurance contracts, the insured event is not certain to happen. There’s some probability to it.
When it does happen, the liability on the part of the insurer arises to provide the insurance coverage.
What is the consequence of a contract of insurance?
A contract of insurance requires that:
- the insured party becomes entitled to something on the happening of some named event (say, negligence);
- the event involves an element of uncertainty;
- the insured has insurable interest in the subject matter of the contract (ie the insured person would suffer a loss if property is harmed).
And there are almost certainly exclusions, limitations and qualifications of pay-outs in contracts of insurance.
No insurer is about to expose themselves to unlimited liability. That’s what the terms of the policy are there for: to restrict liability.
For instance, it’s rare that an insurer will indemnify for unqualified consequential loss or no event has been made to limit it.
When do Indemnities arise?
When indemnities arise in business contracts, they may be:
- express terms, such as an intellectual property indemnity or what just looks like a contract of guarantee
- implied terms, and
- in contracts of insurance (which are a form of contract of indemnity)
They don’t just arise in the contexts of contracts. Indemnities a
A duty to indemnify may also arise:
- by operation of law:
- as a remedy, as part of the remedy of rescission
- when a person acts at the request of another, and the act causes damage to another person
- as part of vicarious liability from an employee’s negligence
- such as agent’s right to be indemnified for expenses and liabilities incurred during the execution of their authority (by the principal)
- in a statute, and the remedy sought by way of breach of statutory duty
Indemnity Claim Defences
As we say above, indemnities are governed by their own terms.
Defence: Unlawful Conduct
There’s a principle of public policy named ex turpi causa, being the short form of the full form ex turpi causa non oritur action. The label is important, because it has overseen over 250 years of case law.
Ex turpi causa says that no claim can be based on an illegal or immoral arrangement.
It’s a legal maxim.
In more modern language, it’s a broad principle of public policy that finds form in the detail of the law. In the same way of the maxim of clean hands.
How does ex turpi causa apply to indemnities law?
In the context of contract law, a claimant:
- can’t rely on their own breach of contract or illegal conduct to advance a legal claim
- can’t enforce contractual own legal rights
- has no right to be assisted by a court to obtain a remedy or recover compensation.
In the context of indemnities, illegal conduct by the indemnified party can be made to operate as a defence to a claim under an indemnity clause.
It would be contrary to the public interest to do so. It would be harmful to the integrity of the legal system.
Defences: Negligence of the Indemnified Party
A claim under an indemnity may arise from the indemnified party’s negligence or wrongful conduct.
In the absence of clear words, contracting parties are not understood to have agreed that an indemnity clause should apply to the consequences of their own negligence.
That’s because the law presumes that an indemnity does not apply to loss caused by the indemnified party's own fault.
It’s seen to be inherently unlikely that a party to a contract would want to release a party from liability that would ordinarily fall on them.
Canada Steamship Case
A series of guidelines were developed in Canada Steamship Lines v The King (1951) which effect indemnification:
- if the indemnity says that it applies in the event of the indemnified’s negligence, that is the effect of the contract
- the ordinary meaning of the words used in the contract are wide enough to cover negligence, it will cover negligence. Where there’s doubt, the ambiguity is resolved against the party seeking to recover on the indemnity
It’s an established rule of law. it was summarised by Devlin LJ in Walters v Whessoe Ltd (1960):
It is now well established that if a person obtains an indemnity against the consequences of certain acts, the indemnity is not to be construed so as to include the consequences of his own negligence unless those consequences are covered either expressly or by necessary implication”
Example: Negligence
Suppose I ask you to do a job for me. I indemnify you for harm that might come to you by my not providing a safe place of work for you. I provide the safe place of work. You injure yourself due to your own carelessness.
Does it make sense that you should be able to recover loss on my indemnity to you?
It doesn’t. But if the contract says that you can, or that intention can be drawn from the contract, that is what will happen.
You’ll recover from me despite your own negligence. That requires a clear intention – by express words or implied obligation in contract.
Even then, if there is negligence, but the clause could also cover damage occurring without any fault on your part. That would be recoverable in the first case.
Conclusion
It would be wrong to say that giving an indemnity is like writing a blank cheque to recover damages.
Although, it’s about the closest thing the law has to it.
But then indemnity liability and indemnity clauses go hand in hand.
Indemnities have the effect of creating a legal remedy to put the indemnified person in a position where they have not suffered loss or damage. That's what indemnity liability means.
That’s what indemnity claims are geared to protect against: they provide a legal remedy to guard against loss.
And the indemnity claim arises from the failure of the indemnifier to prevent the person indemnified from suffering the type of loss specified in the contract.
In share purchase agreements, they’re usually used are set up to recover against a breach of warranty.
Doing so will provide greater protection than an award of damages for the same breach of warranty.
Liability probably should be limited in the same way that the contract typically limits liability for breach of warranty.
Such is the exposure that indemnity clauses introduce to liability, they’re frequently accompanied by undertakings given by the indemnifying party to maintain insurance.
Without insurance, there’s a risk that the indemnity will operate as a paper remedy, rather than result in financial compensation for actual loss suffered.
Contract Indemnity Solicitors
As business contract lawyers, we advise on all types of contract indemnities. We advise on legal indemnities countrywide, where a business has given a civil indemnity against liability, where ever your business might be.
As specialist contract indemnity solicitors, you're in the right place to get legal advice on third party indemnities, an IPR indemnity, indemnification of directors, an industry specific indemnity or share indemnity. There are methods to limit indemnity liability.
We advise IT contractors, business consultants, professional services companies, suppliers and manufacturers, to name a few.
Need a contract dispute solicitor to help out to enforce an indemnity or defend liability?
Call us on +44 20 7036 9282 or email at contact@hallellis.co.uk.