Spotlight on contractual indemnities

Back to basics

What is an indemnity?

An indemnity is a promise, usually made in a contract, to pay money on the happening of a specified event. Indemnities protect one party from a contract from suffering financial loss in relation to certain eventualities – usually those that would arise from the conduct of the other contracting party, or over which the other contracting party has control.

In other words, an indemnity is a contractual mechanism for allocating risk, in a similar way to a warranty in a typical M&A contract, or a guarantee in a finance contract.

Why are businesses keen on including indemnities in contracts?

An indemnity is a primary obligation; it does not depend on having to prove a breach of a contractual obligation. This offers a number of advantages over bringing a damages claim for a breach of contract:

• An indemnity will typically be triggered by losses being incurred, without the need to prove any "fault". This can also avoid rules around causation and mitigation, which can otherwise make recovery more problematic.
• If the scope of the indemnity is wide, it can allow fuller recovery of losses such as legal and other related costs than would be possible for a breach of contract claim; the parties can also choose to quantify prospective losses upfront to give greater certainty.
• The ability to pursue losses as a crystallised debt can also make recovery more straightforward in practice: indemnity claims are seen as more difficult to resist and payments are more likely to be made by an indemnifying party under an indemnity without the need for legal proceedings to be initiated.

Why are indemnities such a challenging topic?

Being creatures of contract, indemnities are highly flexible, according to how they are drafted. But this can also be a challenge. Compared to mechanisms like guarantees, indemnities are subject to few fixed rules. There is no settled "law of indemnities". As a result, the questions of whether concepts like causation and mitigation apply, and what is needed to prove the amount being claimed, are all dependent on how the indemnity is drafted.

In focus | Drafting the trigger

It is crucial that there is absolute certainty in relation to the relevant factual event that triggers the indemnity. A prime example of this issue arose in the recent Supreme Court case of Wood v Capita Insurance Services. The case turned on the interpretation of an indemnity in a share purchase agreement, which read as follows:

"The Sellers undertake to pay to the Buyer an amount equal to the amount which would be required to indemnify the Buyer against (1) all actions … losses, claims, damages … expenses and liabilities suffered or incurred, and (2) all fines, compensation or remedial action or payments imposed on … the Company (A) following and arising out of claims or complaints registered with the FSA … against the Company … (B) and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any … insurance related product ..."

The numbers and letters in bold were not included in the original text, but the court inserted them to help in the construction of the clause. The question was whether the indemnifying party (Mr Wood as the seller) was required to indemnify Capita (as the purchaser) where there had been a loss "pertaining to … mis-selling or suspected mis-selling of … insurance products" but the claim being made did not arise out of "claims or complaints registered with the FSA" but arose as the result of an internal investigation.

The critical distinction between the constructions presented by the two parties was whether:

• (A) qualified both (1) and (2), in which case the indemnity would only apply if the loss arose from a FSA claim or complaint; or
• (A) qualified part (2) only, in which case the indemnity would apply whether or not the loss arose from an FSA claim.

The Supreme Court preferred the first interpretation: the words in (A) qualified both (1) and (2), and (1) could not be read as an independent trigger. Given that no claims or complaints had been registered with the FSA, the indemnity therefore did not apply.

In focus | Causation is within your control

How close is the connection?

One of the restrictions on the recovery of damages in a breach of contract claim is the rule on legal causation. The loss must have been caused by the breach (in the sense that the loss would not have been caused absent the breach), but a new intervening act will break that chain of causation.

But the causal connection required in relation to an indemnity depends on the wording of the indemnity itself and its interpretation. For indemnities that relate to the performance by one party of its obligations, it is therefore possible to draft a wider or a narrower causal link. Campbell v Conoco suggests that there is an escalating scale of connecting links. The indemnity in that case read as follows:

"The Contractor hereby agrees to indemnify and hold harmless the Operator against … all claims arising in respect of any injury, death, sickness or ill health caused to or suffered by the Contractor and any Personnel as a result of or arising out of or in connection with the performance or non-performance of the Contract ..."

The Court of Appeal found that the connecting links in this indemnity were of increasing breadth, ending with the words "in connection with", which are as wide a connecting link as one will commonly come across. The degree of causal connection required is therefore within our control and will be determined by the words used in the drafting of the indemnity.

How remote is the loss?

In Capita v RFIB Group, the Court of Appeal held that using the causal words "directly or indirectly" within a contractual indemnity imported the Hadley v Baxendale test of remoteness into the clause. The indemnity was worded as follows:

"The Seller undertakes to indemnify … the Buyer … from any liabilities costs claims demands or expenses which [it] may suffer or incur arising directly or indirectly from … any services or products supplied … prior to the Transfer Date".

The court ruled that including the words "or indirectly" made it clear that the indemnity provided the widest link allowed by law in establishing liability for the relevant conduct. It held that the wording covered liability for losses within the second limb of Hadley v Baxendale, but that it could not cover liability for losses which are more remote than the second limb.

In focus | Are indemnities against fines or penalties enforceable?

With both the level and instance of regulatory fines on the rise, a question of increasing importance is whether a party can be indemnified against such fines or penalties.

Our view is that, where it is commercially feasible to do so, a party that could have fines or penalties imposed on it as a result of the actions or inactions of its counterparty to a commercial contract should consider seeking an indemnity to cover those potential fines and penalties from that counterparty.

However, if you are seeking such an indemnity, be aware that it may not necessarily be enforceable. For example, a party will be precluded (under the doctrine of "ex turpi causa") from recovering for damage that is a consequence of its own illegal act. By extension, this would prevent a party from enforcing an indemnity for the penalties it has to pay as a result of that act.

Thus, an indemnity against criminal liability is generally unenforceable. Where the offence is one of strict liability and the party commits the offence innocently, however, it seems that an indemnity may be enforceable.

In relation to regulatory breaches, one of the key cases is called Safeway Stores v Twigger. Safeway was a chain of supermarkets; Twigger and others was a group of former directors and employees who engaged in repeated exchanges of commercially sensitive pricing information. Following an enquiry by the OFT (as it was then), Safeway admitted breaching the Competition Act 1998 and the OFT imposed a fine. Safeway then sought to be compensated by the wrongdoers under an indemnity, but Twigger argued that ex turpi causa applied and that any recovery under the indemnity would be contrary to that maxim.

The directors were successful, and the maxim defeated the indemnity. The Court considered that the contraventions of the Competition Act 1998 were sufficiently illegal or unlawful or serious to engage the maxim; and, additionally, that the Competition Act 1998 did not impose any liability on directors and employees, only on undertakings. Safeway was therefore not vicariously liable (i.e. liable because of the actions of another) but was personally liable. If a company is personally liable, the defence can apply, and the fine may not be recoverable under an indemnity. Conversely, if the company's liability can be vicarious, i.e. liability can be imposed on the company, its directors, (or its processors, in a data processing context), then the maxim may not apply and the fine may be recoverable under an indemnity. The ex turpi causa principle is one of law but it is worth noting that its application will vary with the circumstances.

The policy driver should also be considered. It is clear that if a party can transfer a penalty to a third party, there is less deterrent to commit that offence again. (This is why an insurance policy will not generally provide cover for a regulatory fine imposed on the insured – to do so would be against public policy – but may provide cover for a regulatory fine which is imposed on a counterparty of an insured (and which that counterparty seeks to recover from the insured under an indemnity) because that claim could be regarded as a compensatory claim.) But if the contractual indemnity transfers the penalty to the party which could have ensured compliance, public policy may not be defeated, and enforcing an indemnity may not offend such public policy.

Drafting FAQs

What do the words "keep indemnified" add to an indemnity?

There is surprisingly little case law on this point. There is an argument that including the wording may help to ensure that the indemnified party is not required to combine all claims it may have during the term of the relevant agreement into one single claim. There is a second argument that including the wording may help to ensure that the indemnity survives termination of the agreement. But if that is the intention, best practice must be to include reference to the indemnity in the survival clause of the agreement.

In most instances, the words are probably superfluous.

What does it mean to say: "the indemnifying party shall indemnify and defend the other party"?

In Codemasters it was argued that including the word "defend" in an indemnity required the indemnified party to allow the indemnifying to run the defence. This was rejected. At best, it was held, the word may give the indemnified party the right to request the indemnifying party to take over the defence. The court also identified the challenging overlap between the word "defend" and the conduct of claims clause.

Best practice is to avoid using the word "defend" in indemnities and ensure all conduct of proceedings issues are dealt with in one place, namely in the "conduct of claims" clause.

What do the words "on demand" add to an indemnity?

The trigger for a claim under an indemnity will be the suffering of loss that is covered by the indemnity. It is for this reason that the limitation period for an indemnity claim will not start to run until the date that the indemnified loss is established.

There is very little consistent case law on this point. There is an argument that including the words "on demand" in an indemnity may lengthen the limitation period, in that the indemnified party may have a cause of action from when a demand is made by it, not from when the indemnifying party fails to prevent the indemnified party from suffering a loss.

Alternatively, inclusion of the words "on demand" may mean that the indemnified party can argue that its claim under the indemnity should be paid as soon as the claim has been made (or at least as soon as the amount has been agreed between the parties). However, this wording would not prevent a party from disputing whether a particular sum is covered by the indemnity. That ultimately can only be settled by litigation or other dispute resolution procedure in which case any payment will only be due and payable in accordance with any resulting court order or equivalent and not "on demand" from the indemnified party.

There are further arguments: perhaps including the words "on demand" is relevant where the agreement includes a "late payments" clause which states that interest is payable from the date of demand. Or alternatively, including such words may protect an indemnifying party from a claim being brought against it under the indemnity before being served by a demand. There is scant case law to provide a definitive view on the precise consequence that including "on demand" will have on an indemnity. We can only conclude that given the case-law is unclear on what the consequence are of adding the words "on demand" into an indemnity, the words are omitted and the parties draft expressly to provide for any of the above consequences, as required by the parties.

Are indemnities subject to contractual limitations of liability (including caps)?

There is no general rule as to whether a clause limiting liability applies to indemnities contained within the agreement. It will therefore be a question of construction. It seems most likely that the wording "liability under this Agreement" would in fact cover indemnity claims. However, it could be argued, for example, that the indemnity claim is a claim in debt, and that a debt is a promise to pay, not a liability. Far better, therefore, to draft expressly and make it clear (either in the indemnity clause, or the limitation of liability clause) whether or not the agreement cap limits the indemnity.

You should also consider whether any sums paid under a specific indemnity count towards or "use up" the agreement liability cap. Considering the issue up-front and drafting expressly to deal with the concern will help avoid later disputes. Wording such as the following may be helpful: "no amounts awarded or agreed to be paid under the indemnity in clause X shall count towards the financial cap on liability in clause Y".

As mentioned below, consideration must also be given to whether or not any exclusion of indirect losses applies in the event of a claim being brought under any indemnity.

What do the words "hold harmless" add to an indemnity provision?

The meaning of the phrase "hold harmless" has been discussed in a number of cases notably in the Supreme Court in Farstad Supply v Enviroco, in a case between the same parties in a lower Scottish Court, and in Deepak Fertilisers v (1) Davy McKee and (2) ICI Chemicals.

The result of these cases is that, in some ordinary contexts, the words "indemnify" and "hold harmless" can have the same meaning. The likely consequence of this is that including only the words "hold harmless" in a contractual provision is that it could be deemed to be an indemnity provision.

However, it seems clear that including the words "hold harmless" in an express obligation to indemnify will add something, and takes the clause beyond an obligation to reimburse. In Deepak, the Court held that a promise to hold harmless is wholly incompatible with a right to sue. It held that "an agreement to indemnify and hold harmless contains within it by necessary implication an implied term not to sue".

Thus, if party A agrees to indemnify and hold harmless party B in respect of any loss or damage suffered by party B for the breach of a third party’s intellectual property rights, party A must indemnify party B for those losses, but, in addition to that, these cases also suggest that party A cannot bring an action against party B were party A to consider that party B had caused or contributed to the loss suffered (whether through its negligence or contractual breach). Party B would have a defence to party A’s claim because its liability to party A is excluded by the words "hold harmless".

Without the words "and hold harmless", an indemnity may not protect an indemnified party against claims by the indemnifying party. However, in most circumstances, an indemnifying party is likely to resist the inclusion of these words as it would not want to rule out the possibility of bringing an action against the indemnified party where that party is partly responsible for the loss.

In Durley House v Firmdale Hotels, in considering whether the requirement of prior payment was a condition precedent to the right to be indemnified, the judge explained that one view is that where the clause requires the indemnifying party to "hold harmless" the indemnified party, the true obligation of the indemnifying party is to prevent the indemnified party from sustaining any loss or expense in the first place, rather than merely to reimburse the indemnified party only once the latter has paid or lost. However, it was not necessary to resolve this particular debate on the facts of the case, so this point remains unsettled.

Should the indemnity cover related parties?

It is quite common to see a long list of indemnified parties in a contractual indemnity. You may be familiar with wording such as the following: "The Supplier shall at all times during and after the term of this Agreement indemnify and keep indemnified the Customer, its Group Companies, the Service Recipients and their respective contractors, employees and suppliers".

As the indemnifying party, you should seek to expressly limit any indemnity to the other contracting party only, not its subsidiaries, agents, sub-contractors, directors, etc. Adopting this position will oblige the indemnified entity under the agreement to seek to put in place a contractual mechanism for recovery by it of the losses suffered by and on behalf of those other entities. You will also need to consider the "rights of third parties" clause. Commonly, the indemnifying party will want to seek to avoid a direct right of enforcement of rights by third parties.

What effect does it have to limit recovery of legal costs in an indemnity clause to "reasonable legal costs"?

It is quite common to see the phrase "costs (including reasonable legal costs)" within the list of losses that can be recovered in an indemnity clause. Following the recent case of Euro-Asian Oil v Credit Suisse, it seems that the wording "reasonable legal costs" will have a specific meaning in the context of any ensuing litigation.

In Euro-Asian Oil, after judgment was given in Euro-Asian's favour, it sought to rely on an indemnity as entitling it to a more favourable recovery of its litigation costs. The indemnity read as follows: "To protect, indemnify and to hold you [Euro-Asian Oil] harmless from and against any and all damages, costs and expenses (including reasonable attorney fees) which you [Euro-Asian Oil] may suffer".

Euro-Asian Oil argued that the words "any and all … costs" meant that the legal fees should be assessed on an indemnity basis, which is the basis that generally provides for a higher recovery, given that the costs don't have to be proportionate to the sums in issue, or to the complexity of the litigation, and any doubt is resolved in favour of the receiving party. Credit Suisse disagreed and argued that the costs should be recoverable on a standard basis.

The court found in favour of Credit Suisse, that the costs were to be awarded on the standard basis. This meant that the costs recovered had to be proportionate (for example, proportionate to the sums in issue), and if there was any doubt as to whether the costs were incurred reasonably, that doubt would be resolved in favour of the indemnifying party, not the indemnified party.

Should indemnities be accompanied by a conduct of claims clause?

A conduct of claims clause offers significant and practical protection to an indemnified party. There are many permutations of such a clause, and the practical requirements of each particular clause will need to be considered carefully. Such a clause may require the indemnified party to:

• give prompt notice in writing of events alleged to trigger an indemnity;
• allow the indemnifying party to conduct negotiations and proceedings; and
• provide all reasonable assistance to the other party – whether people, data or records – and not do anything which might prejudice the litigation or any settlement negotiations.

The clause may also require that the indemnifying party conducts the claim so as not to bring the reputation of indemnified party into disrepute. If litigation is conducted in the name of the indemnified party, it may want a right to appoint a co-counsel.

As a drafting point, seek to make compliance with the claims procedure a condition of making a claim.  In the recent case of Heritage Oil v Tullow Uganda the indemnifying party argued that there was a condition precedent of giving notice before a certain indemnity kicked in, which had not been complied with.  But it lost its argument on the basis that elsewhere in the contract was a condition precedent for an indemnity that had been clearly drafted as such. (It stated that that indemnity "shall not apply unless...".) In comparison to such clear drafting, the court did not accept that the clause in question was intended to operate as a condition precedent.

If you intend compliance with the claims procedure to be a condition of making a claim, it could deprive the indemnified party of the benefit of the indemnity even if it commits a trivial breach of the claims procedure (which may in fact cause no loss or have no prejudicial effect). As such, you need to ensure that the effect of the clause is clearly drafted (particularly if there are any conditions precedent elsewhere in the contract).

Drafting tips

If you are the indemnifying party

Where you are giving an indemnity, the concern is that any resulting claim would give rise to a claim in debt (such that the principles of mitigation and remoteness would not apply) and therefore you should seek to draft expressly such that mitigation and remoteness do apply!

First, you should consider providing for an express duty to mitigate. This could be achieved by way of a boilerplate clause in the agreement which applies on a mutual basis to all indemnities in the relevant agreement. For example: "Each party shall use reasonable endeavours to mitigate its losses under this agreement, including any losses under any indemnities set out in this agreement". Or it could be drafted to apply to a specific indemnity only: "The Indemnified Party shall not be entitled to an indemnity under clause [x] to the extent that it fails to take reasonable steps to mitigate its losses."

You should also consider the issue of remoteness. Consider any clause in the relevant agreement which excludes indirect losses, and the interplay between that clause and the indemnity clause in question. Can indirect losses be claimed under the indemnity? You can consider drafting expressly so that remoteness will in essence apply: "provided such losses are reasonably foreseeable". Including such wording might provoke the indemnified party to exclaim: "hey, this indemnity is now no more than a breach of warranty claim!". If that is the case, it is much better to have these discussions at the point of negotiation so that both parties can be clear on what they expect to be able to recover in the event that any claim is made.

If you are the indemnified party

Where you are receiving the benefit of an indemnity, your aim is likely to be ensure that the claim will be treated as a debt claim, or in the same way as a debt claim would be treated. We would therefore advise that you draft the indemnity narrowly so that the loss is quantified in the contract, or is easily quantifiable, or there is perhaps a mechanism within the contract which can be used to quantify the liquidated loss.

You should consider drafting expressly so that remoteness will not apply to any resulting claim. You could include wording such as "whether or not foreseeable" in the relevant clause.

You should also consider drafting expressly so that a duty to mitigate does not apply. Mutual wording could be included in a boilerplate provision, such as: "Neither party's recovery under any indemnity set out in this Agreement shall be subject to a duty to mitigate the losses suffered." Or perhaps you could include wording in the specific indemnity clause itself: "…shall indemnify party B (which shall have no duty to mitigate its losses)…".