12 November 2014

Indemnity note for contractors and consultants

Julie Teal
Partner | UK

1. The fundamentals – What is an indemnity?

1.1 An indemnity is a promise by one party, the contractor, to reimburse the other (a 'beneficiary' (such as the employer)) for loss or damage sustained by the beneficiary in respect of a particular risk/matter.

1.2 It can include loss directly incurred by the beneficiary as well as losses incurred by reason of the beneficiary's liability to third parties, for example, under third party agreements.

2. An 'indemnity' is not the same as a 'warranty' – why is this important?

2.1 *A warranty in a contract is a statement:
(a) This statement is given by the contractor to an employer as an assurance in respect of a matter in the contract. For example, the contractor undertakes to design the works using a particular standard of skill and care, or agrees not to use certain prohibited products.

2.2 *What happens when a warranty is breached by a contractor?

  • The pay-out by the contractor is subject to certain rules: If breached a 'warranty' gives rise to a right to sue for damages for breach of contract.

(b) The employer will need to establish a causal link between the contractor's breach and the loss the employer has suffered. Then it will need to show that the loss was not too remote (that the loss arose naturally from a breach and was in the reasonable contemplation of both parties). Finally, that it was careful not to incur additional costs (i.e. mitigation is needed).

( c ) A claim for breach of contract runs from the date of breach. This is important, see below, as to why.

2.3 What happens if the beneficiary calls on the indemnity?

(a) The contractor may have just given the employer a blank cheque: an indemnity allows a beneficiary to recover the amount necessary to make good the liability or defect (i.e. this can lead to a debt claim).

(b) The beneficiary will not have to show that it has in fact suffered the loss as a result of the liability / defect. Although, this is arguable (see last section on 'court practice').

( c ) A claim under an indemnity starts to run from the date the indemnified loss is established. This can be later than under a breach of contract claim. So, the employer can have more time to bring an indemnity claim.

3. If agreeing an indemnity, clear wording is needed

3.1 An indemnity will be given its 'natural and ordinary' meaning. When interpreting a contractual indemnity clause, the court will consider its meaning from the point of view of a reasonable person. The document's interpretation will therefore depend on what a reasonable person would consider at the time the indemnity was agreed, if it along with the other party to the contract had the same background information reasonably available to them.

4. Risk limiting considerations

4.1 Who is the 'beneficiary'? Consider whether this includes just one entity or other third parties such as a subsidiary. If this is a widely defined term, then a contractor's exposure through the indemnity is widened. For example, assignees may also benefit, or named beneficiaries of third party rights.

4.2 What document is the indemnity going into? Consider carefully if an indemnity is needed at all, and whether the beneficiary can simply rely on the contractual warranties.

4.3 What does the indemnity cover?

(a) Consider the type of losses that the indemnity covers, and its scope:

(i) The categories of loss should not cover 'indirect and consequential losses'. For example, this can extend to indemnifying the beneficiary for loss of rental income, loss of business etc. Loss of profit is generally considered to be a 'direct loss' and so recoverable.

(ii) The following is an unlimited indemnity and should not be accepted by a contractor, as the types of loss referred to in it are comprehensive. An unlimited indemnity should only be used if it is commercially agreed that a particular kind of risk can only be controlled by the contractor:

'The contractor shall indemnify the employer against all liabilities, costs, expenses, damages and losses (including but not limited to any direct, indirect or consequential losses, loss of profit, loss of reputation and all interest, penalties and legal costs (calculated on a full indemnity basis) and all other professional costs and expenses) suffered or incurred by the employer …'

(iii) Carefully consider the wording 'legal costs (calculated on a full indemnity basis)', as this will allow the beneficiary to also recover costs and expenses in connection with the enforcement of the agreement (containing the indemnity provision), such as the building contract that the contractor has entered into. This is a step too far, as the courts will usually consider in proceedings how the costs will be borne.

(iv) Do challenge 'boiler plate' clauses in the contract which seek to extend the categories of loss. Standard wording of such type can read: 'any words following the terms including, include, in particular or any similar expression shall be construed as illustrative and shall not limit the sense of the words or term preceding those terms'.

(b) Consider carefully the risks that the indemnity will cover:

(i) An indemnity should not extend to 'any breach of a warranty'. As explained above, a breach of warranty leads to a damages claim, and should not fall under an indemnity.

(ii) Avoid also wording which extends the indemnity to 'the Contractor's breach or negligent performance or non-performance of the agreement', as this again extends the indemnity to breach of warranty claims.

(iii) The indemnity should not extend to cover 'enforcement costs' of the beneficiary. This is usually determined by the courts.

(iv) Consider carefully an indemnity in relation to intellectual property rights – can the contractor provide such an indemnity?

(v) The indemnity should not cover the beneficiary's (i.e. the employer's) loss due to its own negligence. For example, a contractor should resist indemnifying the beneficiary for losses on site caused by the employer, even if they arise out of the works undertaken by the contractor.

( c ) Drafting matters (as discussed in the courts):

(i) 'Insofar as' does not mean 'to the extent that'. In fact means, 'if', if it is used in an indemnity.

(ii) 'Hold harmless' wording is akin to a breach of contract claim, as the contractor has failed to hold the beneficiary harmless against such loss. This is a 'statement' that the contractor was unable to meet, so an indemnity that includes such wording may be dealt with as a breach of contract claim. As a contractor you may wish to accept this wording if you are providing the indemnity. However, if you are the recipient, i.e. a beneficiary of an indemnity, suggest 'promise to pay' wording which is more akin to an indemnity.

(d) Assignment – A contractor must consider if it wants the indemnity it provides to benefit an assignee under the contract.

(e) Tax – The concept of indemnification suggests that the beneficiary is paid the tax on the indemnity payment. If this is not the case, then the contractor must negotiate clear wording to recognise that such 'gross-up' will not apply.

(f) Double whammy / third party agreements – A contractor is often required to have regard to the employer's obligations under a superior agreement. An indemnity is included to ensure that the employer does not breach its obligations under a superior agreement, due to the contractor's fault. A contractor must review these provisions carefully, especially if the superior agreement also includes indemnities. The end result could be a double exposure.

5. Safeguards and other points to consider

(a) Conditions precedent for the indemnity to apply – a contractor might consider negotiating a mechanism to provide control over the conduct of third party claims against which the contractor is to indemnify the beneficiary or the beneficiary will need to follow a specific procedure on receipt of a third party claim. For example, this is relevant to intellectual property claims.

(b) Exclusion clause – such clauses seek to exempt the contractor from certain types of liability. These need to be drafted carefully, as they can be subject to a test of reasonableness under the Unfair Contract Terms Act 1977 (UCTA).

( c ) Limitation clause –

(i) A cap on liability allows a contractor to limit its liability. For an indemnity to fall within this cap suggest using clear wording:

'Notwithstanding anything contrary contained in the contract and without prejudice to any provision in this contract whereby liability is excluded or limited to a lesser amount, the liability of X under or in connection with this contract (including any liability arising out of the indemnity at clause [ ] and [any other indemnity]) whether in contract or in tort, in negligence, for breach of statutory duty or otherwise shall not exceed [£[ ]] in the aggregate.'

(ii) Include a limitation period clause (which will then also apply to an indemnity) that seeks to deal with all contractual claims under the contract, for example, no claims proceedings shall be issued following the date that is 6 or 12 years from the date of practical completion of the works.

(d) Indemnity and UCTA – if a contractor agrees to indemnify the beneficiary for the beneficiary's own negligence in performing the contract, this can be valid (subject to the requirements of UCTA), but the courts will require clear drafting. UCTA may benefit the contractor as the provisions will be analysed through the lenses of a 'reasonableness' test.

(e) Mitigation – an indemnity arguably does not require the beneficiary to mitigate its losses. Therefore, a contractor should request that an express duty for the employer to mitigate such losses is included in the contract.

(f) Knock for knock indemnities – more common in the energy sector 'turnkey' contracts are knock for knock indemnities, by which each party agrees to indemnify the other for its own property damage, injury/death within its workforce etc. A party can also undertake to assume the risk of its own consequential loss, as well as the other party's own negligence or breach of statutory duty. Clear wording is required here, as discussed above. A contractor must consider if circumstances require such indemnities for a specific project. Obviously, these indemnities are sector specific and usually called for under contracts where each party is most comfortable (and best placed) to manage its own risk.

(g) Court practice – (governed by case law):

(i) It is often suggested that causation, remoteness rules and mitigation may not apply to an indemnity, but the courts have considered otherwise. For example, causation may become important if the loss is due to the beneficiary's action or fault. The resulting loss may not be recoverable under the indemnity. Whether or not an indemnity provision will be subject to such rules of 'damages for breach of contract' will be fact specific.

(ii) The courts expect the type/variety of losses to be clearly set out. For example, if the indemnity is to cover losses that are not foreseeable, clear language is needed. If the 'type of loss' is unclear the loss can be seen to be too remote and irrecoverable.

(iii) If there is no clear mechanism in the contract to establish the amount to be paid out if a claim is made under an indemnity, the court is more likely to see this as a damages claim for breach of contract.

(iv) If the indemnity is by reference to an obligation in the contract, instead of an external trigger, it is more likely that the court will see this as a breach of contract claim.

(v) The court can consider an indemnity that requires payment of a fixed sum of money for a breach of a warranty to be a liquidated damages provision and subject to the rules on penalty clauses. These rules can assist a contractor by declaring that the indemnity provision is unenforceable.

(h) Consider also pass down issues – can the contractor pass on the risk assumed under an indemnity to a subcontractor?

(i) Always ask your insurers to approve an indemnity clause and, where necessary, seek legal advice.

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