This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.
Summary and implications
In any contract negotiation, there is nothing quite like the word "indemnity" to get the parties' pulses racing. No-one likes to give them and everyone wants the benefit of them. However, do indemnities actually mean what everyone thinks they mean? If not, what is all the fuss about?
Common perception
An indemnity is an obligation to pay any loss or damage incurred by another party (i.e. to hold such party harmless), which includes both losses suffered by the indemnified party directly and losses incurred because of the indemnified party's liability to third parties.
The common perception of indemnities is that if you have one, you are better off because the usual rules on remoteness and mitigation (which are needed, amongst other things, to make a successful claim for damages for breach of contract or in tort) do not apply. The remoteness test is essentially a test of foreseeability, so if you have an indemnity, great, you do not have to prove that the indemnifying party had or should have had knowledge of the type or kind of loss suffered. Neither does it matter if you acted unreasonably by not seeking to mitigate the loss you suffered. You have an indemnity after all and you can expect pound for pound recovery for your loss ("classic indemnity").
Reality
However, the true nature of indemnities is not so straightforward. Looking at various cases, it is clear that indemnities fall into two separate categories:
- indemnities for debt claims; and
- indemnities for damages claims.
If an indemnity falls into the first category, it is true that the rules of remoteness and mitigation do not apply and it would be a classic indemnity (Jervis v Harris [1996] Ch 195). However, if the indemnity falls into the second category, the position is more muddled. The courts have held that if an indemnity falls into the second category, whether the rules of remoteness and mitigation are excluded depends on the nature and terms of the contract and that each case must be governed by its own facts and circumstances (TotalTransportCorp v Arcadia Petroleum Ltd (The Eurus) [1998] C.L.C. 90).
Cutting through the mess
Debt claims
Starting with the first and simpler category of indemnity, a debt is a claim for a specified sum of money that is ascertainable under the terms of the contract when payment becomes due. A debt claim consequently would not require the court's guidance to quantify the loss suffered by the indemnified party. For example, if an indemnity was given in relation to LADs in a building contract, it would most likely qualify as a debt claim and the rules on remoteness and mitigation would not apply.
Damages claims
Most indemnities in construction contracts, though, do not relate to debt claims and instead provide protection against things like:
- JCT – claims and proceedings relating to infringement of patent rights, personal injury, death and third party property damage;
- NEC3 – loss or damage to the works, plant or materials; and
- FIDIC – breach of applicable laws, interference with the convenience of the public, loss of goods during transport and infringement of intellectual property rights, etc.
In The Eurus, the court acknowledged that indemnities for damages claims such as those above are generally used by commercial parties in two contexts:
- "as simply damages awarded for tort or breach of contract"; or
- as referring to "all loss suffered which is attributable to a specified cause, whether or not it was in the reasonable contemplation of the parties".
In this case, the clause in question was held not to be an indemnity because it did not actually contain the word "indemnity" and no intention of the parties was found to elevate it to a classic indemnity above the indemnifier's other contractual obligations in the contract.
Stacking the cards in the indemnified party's favour
There is unfortunately no guaranteed drafting that will automatically turn indemnities for damages claims into classic indemnities. However, there are a number of steps that an indemnified party could take to improve its chances that the courts will construe its indemnity so that it excludes the rules of remoteness and mitigation:
1. Clear drafting
Draft the clause so that it clearly states it is an indemnity. Do not rely solely on the words "responsible for", "directly or indirectly" or "all consequences" to exclude the rules of remoteness. Rather, state that the rules of remoteness are excluded or make sure that all conceivable losses are covered by the indemnity whether or not they are in the reasonable contemplation of the parties.
To avoid any arguments that the losses are not in the reasonable contemplation of the parties, these could also be set out specifically. However, when listing any categories of loss, care must be taken to ensure that other categories of loss are not excluded by their omission by inserting a general "sweeper provision" at the end of the list. However, this sweeper should be drafted so that any further categories of loss are not limited to the same categories of loss as those listed before it.
2. Commercial purpose
Set out the commercial purpose behind the indemnity. For example, an indemnity covering the risk of loss or damage to a set of works prior to practical completion may sit best with the indemnified party because it can insure the risk or is best placed to manage the risk (e.g. by having control of the site).
3. Whole contract approach
The contract must be read and considered as a whole, so avoid inconsistencies in the usage of the word "indemnity" between those which are akin to damages claims and those which are intended to be classic indemnities. This will avoid the risk of an intended classic indemnity being downgraded by the courts to a claim for damages in tort or for breach of contract.
4. Business common sense
Ensure that the indemnity is consistent with business common sense appropriate to the type of contract in question. If there are conflicting interpretations and one is inconsistent with business common sense, the courts may use that as a factor in deciding that the other interpretation prevails.
Mitigating the impact of indemnities for the indemnifier
An indemnifier could in return consider taking any of the following steps to mitigate the impact of an indemnity it has given:
1. Insert caps on liability
Agree both an overall cap and a sub-cap on the indemnity where possible. If capping the indemnity only, the indemnifier should ensure that its general liability in relation to the same losses is also capped at a similar amount.
2. Restrict categories of loss
Limit the categories of loss that may be recovered under an indemnity. For example, by excluding loss of profit and other consequential losses where possible. Also ensure that the indemnity only relates to the actual liabilities of the indemnified party, not just the sum an adjudicator, court or arbitrator may award.
3. Exclude negligence
Limit the scope of the indemnity to breaches of contract only by excluding negligence. Also resist any attempts by the indemnified party to insert a right to claim under the indemnity for damage or loss suffered by its own negligence, which is not normally permissible unless express words are included to this effect.
4. Conditions precedent
Insert notice requirements as conditions precedent to the indemnified party's entitlement to claim for losses under the indemnity.
5. Duty to mitigate
Place on obligation on the indemnified party to mitigate the losses it is able to claim for under the indemnity.
6. Conduct of claims
Make sure there are rights to receive notice of any third party claims covered by the indemnity and to take conduct of any defence proceedings and/or approve any settlements. These exist in the FIDIC standard form, but would need to be added to the JCT and NEC3 standard forms.
Conclusion
The potential repercussions of a classic indemnity are serious. To avoid disagreements over the rules of remoteness and mitigation which, if pursued in the courts, may have unexpected results, parties should be minded to agree in advance the liabilities and losses that they intend the indemnity to cover, and make sure the drafting reflects these clearly.
