FREE SAMPLE from ‘Stephens on Contractual Indemnities’ by Richard Stephens

CHAPTER ONE – WHAT IS AN INDEMNITY?

“… In English law an indemnity is a promise to prevent the indemnified person from suffering loss (damnum): see e.g. Firma C-Trade SA v Newcastle Protection and Indemnity Association (The “Fanti” and “The Padre Island”) [1991] 2 AC 1, 35 (Lord Goff). …” [1]

The subtitle of this Chapter could usefully be, “what is not an indemnity?”

Introduction

There used to be but one indemnity in most commercial agreements and it was the IPR (intellectual property rights) indemnity. It provides, in a sense, protection for both parties and is a good example of an indemnity. It is a commonplace in e.g. software licences and many other types of agreement. For the licensee, it provides peace of mind, an assurance that, if a third party should emerge to claim rights in the IPR which have been licensed to that licensee, then the licensor will be responsible for that claim. For the licensor, it also provides peace of mind: if the licensor is licensing its own IPR, it wants to make sure that it is the one dealing with allegations of infringement, not anyone else. Indeed, the licensor may well be in the best place to defend any such allegation of infringement. It is perhaps a rare example of where an indemnity has benefits for both parties and is a sensible allocation of risk, as was observed by Arnold J in Codemasters v Automobile Club de l’Ouest [2009] EWHC 2361 (Ch):

“Not only is such an indemnity commonplace, but also there are good reasons why parties agree to such indemnities. Generally speaking, the licensor of intellectual property rights will be in a better position to assess whether the exploitation will infringe third party intellectual property rights. This is particularly true in the field of copyright. To a lesser extent, it is true of trade marks also. Furthermore, in terms of allocation of risk, generally speaking it will be commercially more acceptable for the risk of a claim of infringement by a third party to be borne by the licensor than by the licensee.”

Of course, whether an individual IPR indemnity actually achieves those aims will depend on the precise drafting: it is the aim of this book to look at indemnities and how the courts apply them so as to be able to answer that question.

While there is some reference in these pages to the treatment of an indemnity in the world of insurance, this is kept to a minimum as insurance law responds to different challenges. For example, contractual indemnities do not require any duty of disclosure by the indemnified to the indemnifier, unlike the duty of disclosure owed by an insured to the insurer. Furthermore, insurance is often about extreme events that are not realistically contemplated as likely to happen (such as a disastrous fire burning down a factory) whereas a contractual indemnity may be for an event that is very much on the indemnified’s mind (such as an indemnity against losses caused by the indemnifier’s breach of contract). So, while they are similar, they are by no means identical, and the focus of this book is on those indemnities that appear in ordinary commercial contracts between businesses.

The other question addressed by this book is whether an indemnity in other commercial contexts has the same hallmarks of being a sensible allocation of risk as with the IPR indemnity. This is because, in recent years, the contractual indemnity has become a much loved tool of the commercial lawyer and has gone way beyond the IPR indemnity. Indemnity provisions are more or less ubiquitous now and appear scattered throughout most modern commercial contracts. Whether they survive the drafting into the final signed version is a different question as indemnities have attracted an aura of fear among lawyers asked to review contracts. Having said which, if those insisting on including indemnities in commercial contracts knew just how devoid of underlying principle they were, it might start some debate about the value of including them in the first place.

Terminology

As indemnities have become common in commercial contracts, so certain language, certain formulae, have also become common in commercial contracts. Indeed, some expressions have become “hallowed” by usage, such that it seems inconceivable that an indemnity should not contain them e.g.

“Defend and hold harmless”

“Save and hold harmless”

“Indemnify and keep indemnified”

Indeed, we see combinations of these expressions using elements drawn from each of them, such as “defend, save and hold harmless” and sometimes a clause will use all of these elements in one long, inelegant expression.

However, research in most legal dictionaries and textbooks to do with contract or commercial law will not yield any clue as to the meaning of such expressions. Let us therefore look at the formula “hold harmless”: it is very common and will be seen in just about any indemnity provision, but what exactly does it mean?

A Canadian case throws some light on this question. In Salmon River Logging v Burt Bros. [1953] 2 SCR 117, Burt Bros. supplied trucks and personnel to operate them in Salmon River’s logging yard. One of the trucks was standing idle by a spar tree (a tree used as a sort of crane). A workman working for Salmon River was yarding a log which caused the spar tree to collapse on the truck causing damage to it. Salmon River could not deny the negligent act but relied on clause 3 in the contract which provided that Burt Bros

“… will indemnify and save harmless [Salmon River] from any claims or damage that may occur arising out of the use or operation of the said trucks for the term of the within contract.”

The Supreme Court of Canada held that the clause did not cover negligence by Salmon River: the truck was standing idle at the time of the accident and the accident had nothing to do with the operation of the truck. Salmon River was therefore liable to Burt Bros for its negligence in damaging the truck[2]. Rand J said this,

“We do not ‘indemnify and save harmless’ from or against our own claims … [T]his familiar phrase must be given its well established meaning. To indemnify and save harmless is to protect one person against action in the nature of claims made or proceedings taken against him by a third person.”

Before the reader leaps to the conclusion that “indemnify and save harmless” has this fixed judicial understanding, let us now look at what the UK Supreme Court made of very similar wording in Farstad Supply v Enviroco (The Far Service) [2010] UKSC 18[3]. In that case, the vessel “Far Service” was owned by Farstad and chartered to a third party, Asco. Asco had engaged Enviroco to clean out some of the Far Service’s tanks. Following Asco’s instructions, the master of the vessel started the engines just as an employee of Enviroco opened a valve which allowed oil to enter the engine room. The oil ignited due to the heat of the engine causing substantial damage. For the purposes of the action, it was assumed that Asco had been negligent.

Clause 33.5 of the charterparty provided that Farstad would

“defend, indemnify and hold harmless [Asco] from and against any and all claims, demands, liabilities, proceedings and causes of action resulting from loss or damage in relation to the Vessel (including total loss) or property of the Owner … irrespective of the cause of loss or damage, including where such loss or damage is caused by, or contributed to, by the negligence of [Asco].”

The question before the court was whether the expression “defend, indemnify and hold harmless” could cover Asco’s negligence: this was an action as between two parties to a contract. The court rejected the idea that such a clause was only aimed at giving protection against third party claims. As Lord Clarke put it,

“… in this charterparty the expression ‘defend, indemnify and hold harmless’ is wide enough both to provide a defence for one party to claims made by the other party and to provide an indemnity in respect of the claims of third parties.”

It will be seen from these two cases that two very senior courts have come to diametrically opposite views as to the meaning of one of the most basic expressions used in drafting indemnities.

The same can be said about “keep indemnified”: lawyers frequently use this expression, but it has no fixed meaning, no line of case-law supporting any settled understanding of the term.

The mystery is that lawyers keep on using these expressions.

It goes wider than that. There is no standard terminology associated with indemnity drafting, so one can see in contracts and judgments the following pairings:

Indemnifier and indemnified

Indemnifier and indemnifiee

Indemnifying party and indemnified party

Indemnitor and indemnitee

Of course, if desired, one can also mix and match terms taken from different pairings or one could even take terms from the related spheres of guarantees and international trade:

Guarantor

Surety

Beneficiary or creditor

Debtor or principal debtor

The reality is that there is no fixed terminology, no general agreement or understanding even regarding what the parties to an indemnity should be called. This book will proceed by talking about an “indemnifier” on the one hand and an “indemnified” on the other in the interests of brevity and consistency. Where an indemnity is offered against the non-performance of some third party contract, that third party will be called a “debtor”, as in cases relating to guarantees, and the third party contract will be referred to as the “underlying debt”.

As to what indemnities themselves mean, it is the aim of this book to elucidate their meaning and effect.

The emergence of indemnities

It is perhaps strange that there is a dearth of agreement on terminology as the indemnity is by no means a modern creation of the law or of lawyers. There are statutes which make use of the concept e.g.

Partnership Act 1890 section 24(2) – a firm must indemnify a partner in respect of payments and liabilities incurred in the ordinary course of business or necessarily done to preserve the firm’s business or property

Companies Act 2006 section 767(3) – the directors must indemnify a party to a transaction suffering loss as a result of trading in breach of section 761 (requirements as to minimum share capital)

Even without statutes, some relationships have been found to create a right to indemnity under the common law e.g.

An accommodation party to a bill of exchange is entitled to be indemnified by the party accommodated

An agent is entitled to indemnity from the principal against liabilities reasonably incurred in the performance of the contract of agency

An employee is similarly entitled to indemnity from an employer

The courts of Equity have also made use of the concept e.g.

A personal representative is entitled to indemnity out of the estate for expenses properly incurred

A trustee may be entitled to indemnity from co-trustees

Cases on some of these areas go back many, many years: the indemnity is by no means a modern invention.

When is an indemnity not an indemnity?
When it is a guarantee …

Unfortunately, it is not possible to discuss indemnities without venturing into the thorny subject of how an indemnity differs from a guarantee. An introduction to the distinction can be seen in Yeoman Credit Ltd v Latter [1961] 1 WLR 828 where Harman LJ said that the distinction between a guarantee and an indemnity was,

“… a most barren controversy. It dates back … to the Statute of Frauds, 1677, and has raised many hair-splitting distinctions of exactly that kind which brings the law into hatred, ridicule and contempt by the public … and the decided cases on the subject are hardly to be reconciled.”

Holroyd Pearce LJ in his judgment in the same case gave a beautifully simple summary of the distinction which perhaps belies the enormous amount of litigation on the subject both before and since his judgment,

“An indemnity is a contract by one party to keep the other harmless against loss, but a contract of guarantee is a contract to answer for the debt, default or miscarriage of another who is to be primarily liable to the promisee.”

The mention of the Statute of Frauds 1677 above means we must look at what it says, using the quaint language and spelling to be found in the online version at legislation.gov.uk,

“IV No Action against Executors, &c. upon a special Promise, or upon any Agreement, or Contract for Sale of Lands, &c. unless Agreement, &c. be in Writing and signed.

Noe Action shall be brought . . . whereby to charge the Defendant upon any speciall promise to answere for the debt default or miscarriages of another person . . . unlesse the Agreement upon which such Action shall be brought or some Memorandum or Note thereof shall be in Writeing and signed by the partie to be charged therewith or some other person thereunto by him lawfully authorized.”

In general, the essence of a guarantee is that it is a secondary obligation, coextensive with the underlying debt being guaranteed, and is brought into play when the debtor defaults. This is what is meant in the 1677 Act by “answering for” a third party’s “debts, defaults or miscarriages”. If the debtor fails to pay £100 as required by a contract, then the guarantor of that debt becomes liable instead for £100.

As against which, an indemnity is a primary obligation, compensating the indemnified for defined losses or expenses described in the indemnity and the indemnity can become payable even without a third party’s default, all depending on how the indemnity is worded.

One consequence of the distinction between a guarantee and an indemnity, and one which is the cause of most of the problems, is that a guarantee falling within the 1677 Act has to be in writing and signed. We can dispose fairly swiftly of the requirement of what constitutes writing and signature as the courts in recent times take a fairly expansive approach to this requirement, as shown in Golden Ocean v Salgaocar [2012] EWCA Civ 265. There was a ten year charterparty and Golden Ocean alleged that the other party had repudiated it causing US$54m of loss. Golden Ocean alleged that Salgaocar was the guarantor. In fact, the alleged guarantee was not to be found in a formal contract of guarantee, but rather in a chain of emails. The Court of Appeal made short shrift of the issue: an agreement of guarantee was not a special class of contract but was subject to the normal rules applying to contracts generally. This meant that a contract of guarantee could be found in a sequence of negotiating emails just as is the case with any commercial contract. As to signature, then this could be an electronic signature, or the first name, initials or perhaps just a nickname applied to an email (provided that it was clear as to the identity of the individual said to be “signing” the email).

But there has to be writing, and there has to be a signature, and these are the points which have bedevilled commercial parties who end up litigating in this area. Some examples will illustrate the point, if not make it clear.

In Actionstrength v International Glass Engineering Limited [2003] UKHL 17, Actionstrength provided labour only services to help build a unit for St Gobain under a contract with IGEL. Debt built up due to non-payment by IGEL. Actionstrength became more and more concerned at the non-payment and, at a meeting of senior representatives of all three parties, St Gobain orally agreed to ensure Actionstrength got paid. IGEL in fact went into insolvency owing Actionstrength around £1.3m. Actionstrength argued that the oral statement made by St Gobain amounted to some sort of estoppel which could circumvent the Statute of Frauds. The Court of Appeal had described this argument as “absolutely hopeless” and the House of Lords upheld that decision. The selfsame words could not be at the same time both an unenforceable guarantee and an estoppel overriding the statute.

For those interested, the judgment of the House of Lords contains an interesting history of the Statute of Frauds 1677, both in its original form and in its present, considerably truncated, form[4]. There is also consideration of the value of maintaining the requirement of writing and of the reports of the Law Commission on the subject. It is a difficult question: in a very real sense, a guarantee performs the same commercial function as an indemnity – it gives one party the assurance that it will get paid. We will look at this distinction again shortly when considering whether certain defences applicable to guarantees extend also to indemnities.

In Pitts v Jones [2007] EWCA Civ 1301, Pitts was an employee and minority shareholder in a company majority owned by Jones. Jones wanted to sell the shares in the company to a third party and reached a provisional agreement to do so. Jones told Pitts about this, the latter assuming that he would be paid cash for his shares. In fact the purchaser proposed to pay in instalments. Pitts was not happy about this proposal and, at an EGM called to deal with the matter, Jones orally assured Pitts that he would pay if the purchaser did not. The sale went through but the purchaser went into insolvency. Pitts sued Jones on his oral promise.

The Court of Appeal said that a guarantee was a type of indemnity, and that the term “merely connotes the right of one party to look to another [to] satisfy his losses and may arise under a contract (for example under a contract of insurance) or by operation of law”. The Court of Appeal out of these facts identified two separate transactions: firstly, there was the sale of Jones’ shares to the purchaser and, secondly, there was Pitts’ sale of his shares to the purchaser. Jones’ oral assurance to Pitts was part of this second and separate transaction and could not be seen as part of a larger unitary transaction. This being so, Jones’ oral assurance was a guarantee within the 1677 Act and therefore unenforceable without writing.

A very recent example can be found in the case of Abbhi v Slade [2019] EWCA Civ 2175. Abbhi was funding his father-in-law’s (Singh’s) inheritance litigation. He was conscious of the risks of being found to be a third party funder of litigation and so was providing funds to Singh who then in turn paid for legal representation. Shortly before trial, a new solicitor was appointed to represent Singh, one Slade. Abbhi met Slade at a meeting without the presence of Singh. During that meeting, Abbhi agreed that he would pay Slade but would do so by putting Singh in funds so that Singh would be able to pay Slade. The engagement letter was entered into as between Singh and Slade, Abbhi was not mentioned. Singh went on to lose his case and died insolvent, owing Slade some £317,000 (of which some £250,000 consisted of unpaid counsels’ fees). Abbhi meanwhile had stopped paying Singh. Was this a guarantee (oral – unenforceable) or an indemnity (potentially enforceable)?

The Court of Appeal found that,

“[t]he critical question which determines whether a contract is one of guarantee within section 4 of the Statute of Frauds is not that the promise is to pay another’s debt but … whether that promise is to pay if the other does not pay, in which case it is within the Statute of Frauds or whether it is a promise to put the claimant in funds in any event, in which case it is outside the Statute of Frauds.”

In this case, Abbhi had assumed a primary obligation to make payments to Singh in any event, as the underlying agreement was to pay Slade’s bills by the circuitous route of putting Singh in funds, meaning that payment was not dependent on Singh defaulting. The oral agreement was therefore enforceable.

Even from these cases, it can be seen that hair-splitting distinctions can be the basis for determining whether a particular agreement is classed as a guarantee (no signature: unenforceable) or an indemnity (potentially enforceable without signature). There are many, many more in the same vein. Indeed, going back to the lament of Harman LJ in Yeoman Credit Ltd v Latter [1961] 1 WLR 828 quoted above (“a most barren controversy”), judges find themselves having to deal with ever more convoluted factual scenarios and seeking to discern either a primary or a secondary obligation. For present purposes, in a book aimed at describing contractual indemnities, it is not necessary to give further examples of this distinction.

Practice point

For the ordinary practising lawyer’s purposes, it suffices to say that if, during a meeting, a party says anything to the effect that he will pay if someone else does not, however it is phrased and whatever the exact proposed contractual structure, just bear in mind that this promise almost certainly needs to be reduced to writing and signed by the potentially paying party to make it enforceable.

What else distinguishes a guarantee from an indemnity?

Guarantees benefit from various defences that have been applied for many years by the courts although there is nothing expressly in the Statute of Frauds dealing with such defences. The origins of these various defences are obscure, probably based on eighteenth and nineteenth century judges being reluctant to make individuals liable under a guarantee, which had become a much used instrument both in trade and domestic arrangements, and thereby demonstrating a paternalistic approach to the law in order to protect the vulnerable.

To take one example which bulks large in any consideration of guarantees (and just possibly, indemnities – see below), a rule emerged which became known as…

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[1] per Leggatt LJ in Minera Las Bambas v Glencore [2019] EWCA Civ 972

[2] The judges variously relied on principles deriving from Canada Steamship and contra proferentem: we will see in a later chapter whether these principles are still live in the context of indemnities.

[3] In fact on appeal from the Scottish courts.

[4] Originally, other transactions which required writing included contracts entered into in contemplation of marriage, for example.