Indemnities remain a common feature of commercial contracts. Although they are often treated as a practical way to allocate risk, the protection they provide turns entirely on the words the parties choose and how those words operate within the contract as a whole. Recent cases provide a useful reminder of how indemnities are interpreted by the courts and why precise drafting can reduce the risk of later arguments.
Buyer beware!
In a business purchase, the principle of ‘buyer beware’ applies. Generally, neither common law nor statute gives a buyer comprehensive protection in relation to the assets and liabilities of the target business. The buyer’s protection must, therefore, come from the acquisition contract. Those contractual protections are usually heavily negotiated and will depend on the parties’ respective bargaining strength. Where a buyer identifies a specific area of concern in the target business, one of the most robust forms of protection it can seek is a contractual indemnity.
What is an indemnity?
An indemnity is a contractual promise by one party to reimburse another for loss or liability falling within the scope of the indemnified matters. In an acquisition context, this may include liabilities connected with pre-completion events or circumstances, even if the claim is made or the loss suffered after completion. Depending on its terms, an indemnity can shift the relevant risk from the buyer to the seller.
When compared to a buyer’s other main form of contractual protection – warranties – indemnities have several key advantages:
- to bring a successful breach of warranty claim, the buyer must prove that there has been a breach of warranty, that the breach has caused a reduction in the value of the business, and that the amount of that loss exceeds any limitation thresholds agreed between the parties. In the case of an indemnity, the buyer will usually need to prove only that it has suffered loss falling within the scope of the agreed indemnity, and will then be able to claim for that loss;
- in the case of a warranty, the buyer has a common law duty to mitigate its losses. The position is less clear as to whether such a duty arises in the case of an indemnity, particularly where a court construes the indemnity as giving rise to a debt claim;
- disclosures made by a seller will generally reduce or prevent a buyer’s recovery under the warranties, but should not affect recovery under a properly drafted indemnity; and
- the buyer’s knowledge will often prevent recovery under a warranty, but not under an indemnity.
Drafting tips
Recent cases continue to provide useful guidance on how courts are likely to interpret indemnities and on the issues that Recent cases continue to provide useful guidance on how courts are likely to interpret indemnities and on the issues that parties should consider when drafting them.
The starting point is that an indemnity is a contractual promise. The court will interpret that promise using the ordinary principles of contractual interpretation. It will consider the words used, the contract as a whole, the commercial context and business common sense. It will not, however, rewrite a clear bargain because one party later considers the wording to be too narrow, too wide or commercially unattractive.
The following points are particularly important when drafting or negotiating an indemnity.
- Be clear about the trigger for liability: Both parties to the indemnity need clarity on which events trigger payment. This means that the indemnity should identify exactly what must happen before the paying party becomes liable. If the indemnity is intended to apply only where there is a third-party claim, complaint, notice or formal demand, say so. If it should also apply where the receiving party self-reports, pays a regulator, incurs investigation costs or takes protective action, that should also be stated expressly.
- Define the losses with care: When considering the types of loss to be covered by the indemnity, it is good practice to list the principal categories of loss, focusing on what is likely to happen, and then include a sweeper such as “all other losses or liabilities”. The clause should make clear that any list of losses is not exhaustive. Broad words such as “arising out of” or “in connection with” can be useful, but they are not unlimited. If the indemnity is intended to cover enforcement costs or other ancillary matters, those matters should be expressly identified.
- Think about the position of the indemnity in the contract: A clause that appears within a specific event of default, claim process or remedial regime may be read as limited by that context. If the indemnity is intended to have wider effect, or to override other liability provisions, the drafting should say so clearly and should cross-refer to any related provisions.
- Identify the relevant period: If the indemnity is intended to cover pre-signing matters, the period between signing and completion, or post-completion events linked to a pre-completion issue, the clause should say so. This is particularly important in acquisition documents where warranties and indemnities may apply to different periods.
- Decide whether other remedies are preserved or excluded: An indemnity does not automatically prevent a party from bringing other claims, such as warranty claims or claims for breach of contract. If the indemnity is intended to be the sole remedy, that should be stated expressly. If other rights should remain available, the clause should say that the indemnity is without prejudice to those rights.
- Consider mitigation and remoteness: The contract should state whether the receiving party must mitigate its losses and whether the usual rules on remoteness apply. If the receiving party wants full recovery for specified losses, it may be safer to include an express provision disapplying those rules, to the extent the parties intend that result and it is appropriate in the context.
- Bring unusual requirements to the other party’s attention: If an indemnity is included in standard terms incorporated by reference and contains onerous or unusual requirements (such as a “pay first” obligation), the party relying on it should make sure that the indemnity is clearly brought to the other party’s attention. However, in business-to-business contracts between parties of equal bargaining power, the threshold for a term being considered too onerous is high.
Comment
Recent decisions indicate that courts will usually hold commercial parties to the words they have used. An indemnity can be a powerful form of protection, but only if it reflects the risk the parties intended to allocate. The safest approach is to identify the commercial purpose of the indemnity, define the trigger and losses precisely, and make clear how the indemnity interacts with the rest of the contract.