Indemnities: how they work and issues to consider when giving them

This article was produced by Olswang LLP, which joined with CMS on 1 May 2017.

From tax covenants to IP infringement, indemnities feature in most share and business transfer agreements as well as in many every day commercial contracts. We remind you of the key features of indemnities and point out some of the questions you should ask yourself before giving an indemnity.

How do indemnities work?

In its simplest form, an indemnity is a promise to pay a particular amount should a particular liability arise. For example: "the Seller agrees to pay the Buyer the amount of any pre-completion tax liability of the target".

In order to claim, the indemnified party must simply show that the relevant trigger (i.e. a demand from HMRC for tax relating to a pre-completion period) has occurred and the amount of that liability. In this way, an indemnity differs from a claim for breach of a warranty (for example, "that the Company has no outstanding liability for pre-completion tax") as no breach of contract is required, and the rules for determining what is recoverable are contained in the indemnity clause itself. As the claim is for a liquidated amount it is similar to making a claim for recovery of a debt and as a result, the usual contractual rules in relation to foreseeability of loss and the obligation to mitigate do not apply. For these reasons, a party will often consider it preferable to have the benefit of an indemnity in relation to a particular liability as opposed to having to rely on the court's assessment of loss under a claim for breach of contract.

However, indemnities are not only used to pass the risk of a particular liability from one party to another and sale and purchase agreements will sometimes provide that "the Seller agrees to indemnify the Buyer for any losses arising out of the Seller's breach of warranty".

With provisions such as these it is more difficult to construe a claim as an action in debt (and therefore outside the usual contractual rules on foreseeability and mitigation) since the Buyer's loss is not quantified in the contract - instead the loss needs to be assessed. In Total Transport Corporation v Arcadia Petroleum Ltd (The Eurus) 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.

Consequently, parties seeking an indemnity for breach of contract need to be aware that their ability to recover all losses, irrespective of foreseeability and whether they have mitigated their loss, may not be guaranteed. However, recoverability could be increased if the agreement specifically refers to the liabilities and losses that the indemnified party expects to recover (for example, loss of profits, cost of management time, the actual cost of remedying the default etc.) and also details what (if anything) it is obliged to do to mitigate its loss.

Giving indemnities

As outlined above, unlike a warranty claim where common law rules determine what is and is not recoverable, the scope and application of an indemnity depends on its specific terms. For this reason it is essential that before giving an indemnity, the drafting is carefully considered. Below are some of the key questions you should ask yourself before agreeing to give an indemnity.

Is it really necessary? Often indemnities in commercial contracts are given on a mutual basis where there is little or no real commercial imperative for the indemnity to be given by one of the parties other than that it is considered "standard language". If you are being asked to indemnify for a particular matter or breach, consider whether the payments you are receiving under the contract warrant the level of exposure you are being asked to assume. It is, in effect, an insurance policy for the other party. Would warranty protection be more appropriate instead?

Should I indemnify and "hold harmless"? It is arguable that the words "hold harmless" imply an obligation on the indemnifying party not to sue or counter-claim against the beneficiary of the indemnity - potentially meaning that the indemnifying party would be liable for losses caused by the contractual breach or contributory negligence of the beneficiary. Ideally, you should delete this language.

What does "on demand" mean? This is generally considered to be an attempt by the beneficiary of the indemnity to delay the start of the limitation period applicable to the indemnity to the point at which payment under it is demanded (as opposed to when the loss becomes apparent or quantified). Again, if possible you should delete this language.

Can I limit the scope of the loss covered? Where possible, avoid giving broadly drafted indemnities covering for example, "all losses arising out of X". You could restrict your liability to specified losses (for example, the amount of the tax liability, interest and penalties) or exclude certain types of loss (for example, loss of profit).

Can I limit the scope of the persons covered? It is not uncommon for indemnities to be drafted covering all losses incurred by "the indemnified party, its Group members, directors, officers, employees and agents…". However, it would rarely be appropriate for all losses incurred by all employees to be covered regardless of the strength of the causal link between the event triggering the indemnity and the loss suffered by that employee and regardless of whether the employee has mitigated his loss. Where employees or other third parties should legitimately be protected from particular risks, then make sure the indemnity is drafted narrowly.

Should I cap my liability? Consider carefully whether to try and cap your liability under the indemnity. Again, look at the scope of the indemnity and your potential exposure. Although in some cases an unlimited indemnity may be appropriate, often it will be possible to negotiate a commercially sensible cap. Ideally, this should be dealt with in a general limitation on liability clause which applies to claims across the entire agreement to ensure all liabilities are comprehensively covered by the limits.

Should I require the beneficiary to mitigate its loss? Without the obligation to mitigate, the indemnifying party is potentially responsible for losses which the beneficiary could have taken steps to prevent or reduce. For general indemnities, including a simple obligation on the beneficiary to mitigate its loss may be sufficient. For more detailed, specific indemnities, as well as a general duty to mitigate it is also worth setting out what particular steps you may want the beneficiary to take - for example, taking legal advice promptly and acting upon it; taking steps to stop infringing action; or changing working practices to avoid further breaches or losses.

Do I need conduct of third party claims? Where the indemnity could cover liability for claims from third parties, ask for the ability to take conduct of those claims as this will give you control over the negotiations in relation to the dispute, any legal proceedings arising and potentially the settlement of any claim.

Should I include pre-conditions to claim? Consider what conditions the other party should be required to fulfil in order to claim under the indemnity. These could include an obligation to give notice of a potential claim within a particular time period and with specified particulars, compliance with the conduct of claims clause or obtaining consent before compromising or settling any third party claim. Note that a recent case has held that clear language is needed if a clause is intended to act as a condition precedent to the right to claim. In Heritage Oil and Gas Ltd v Tullow Uganda Ltd, the court distinguished between a simple contractual requirement for the Buyer to give notice of a claim within a particular period of becoming aware of it (which did not act as a condition precedent) and a provision which stated that the indemnity did not apply unless notice of claim was given before a long stop date, which was considered clear enough to act as a condition precedent.

Any information contained in this article is intended as a general review of the subjects featured and detailed specialist advice should always be taken before taking or refraining from taking any action. If you would like to discuss any of the issues raised in this article, please get in touch with your usual Olswang contact. This article was included in our Olswang Corporate Quarterly Spring 2015 publication.