Indemnities for breach of contract - Do they do what you think they do?

The inclusion of an indemnity covering breach of contract has become increasingly common in modern construction contracts. There are two perceived key benefits of including this sort of indemnity:

• it allows for the recovery of loss as a debt as opposed to a traditional claim in damages; and
• all losses are able to be recovered including remote loss.

In this article we'll examine what type of obligation arises under an indemnity clause and whether these two perceived benefits do in fact exist.

What type of obligation arises under an indemnity clause?

The case law suggests that courts have been inconsistent in the way that they have interpreted indemnity clauses and the obligations arising under those clauses. There appears to be two alternative obligations that may arise under an indemnity clause:

• Preventing loss: An obligation to indemnify another party has been interpreted by some courts as giving rise to an obligation to prevent the loss or harm covered by the indemnity from occurring (for example, Firma C-Trade SA v Newcastle P & I Assn (The Fanti) [1991] 2 AC 1). In other words, it gives rise to an obligation to prevent something from happening rather than a mere obligation to compensate for loss or harm suffered. If an indemnity clause is interpreted in this way, the indemnifier will be in breach of contract if the relevant loss or harm is suffered and will be liable to pay damages for breach of contract to the indemnified party. Therefore, the indemnified party’s remedy under the indemnity will be a claim in damages for breach of contract.
• Making good: Some courts have interpreted an indemnity as only giving rise to an obligation on the indemnifier to compensate the indemnified party (for example, Caledonia North Sea Limited v British Telecommunications Plc (The Piper Alpha) [2002] 1 Lloyd's Rep 553). In other words, the indemnifier only has an obligation to make good the loss or harm suffered and does not have any obligation to prevent it from occurring – it will not be in breach of contract if the indemnified party suffers loss that is covered by the indemnity. If an indemnity clause is interpreted in this way, the indemnified party will have a claim under the contract for the sum payable under the indemnity (ie. an action for the recovery of a debt) as opposed to a claim for damages for breach of contract.

Perceived benefits of including an indemnity for breach of contract

It is commonly perceived that a claim under an indemnity is a claim for a debt as opposed to a claim for damages for breach of contract. A claim in debt provides the indemnified party with some substantive and procedural advantages that do not apply to a claim for damages for breach of contract. For example:

• in an action for the recovery of a debt, the plaintiff only needs to establish that the event triggering the obligation to pay the sum sought has occurred. In an action for damages for breach of contract, it is up to the plaintiff to establish that both a breach of contract has occurred and that the damages being claimed have, in fact, been suffered, which may require expert evidence to be adduced; and
• in an action for damages for breach of contract, the plaintiff will not be able to recover loss to the extent that it has not taken reasonable steps to mitigate its loss. It will also not be able to recover loss that the law considers to be too remote. These rules of mitigation and remoteness do not apply to an action for the recovery of a debt.

These advantages will only be available if an indemnity is interpreted as an obligation to make good as opposed to an obligation to prevent loss. Therefore, one of the perceived benefits of including an indemnity for breach of contract will not exist in all circumstances and will depend on how the indemnity is interpreted by a court.

Recovering "all losses" under an indemnity

It is also commonly perceived that an indemnity for breach of contract allows all losses to be recovered including remote loss. Again, this will depend on how the indemnity is interpreted. If it is construed as an obligation to prevent loss, recovery of loss under an indemnity will be no different to any other claim for damages for breach of contract and will be subject to the rules relating to remoteness of damage. In other words, the indemnified party will not be able to recover any losses that the law considers to be too remote.

Even if an indemnity is interpreted as an obligation to only make good (and not an obligation to prevent loss), not all loss will necessarily be recoverable by the indemnified party. In construing such indemnities, courts have generally imposed some limitations on the loss that may be recoverable. Those limitations were considered in the case of Total Transport Corporation v Arcadia Petroleum Ltd (The Eurus) [1996] 2 Lloyd's Rep 408, the key points being:

• a claim for an indemnity requires an unbroken chain of causation between whatever it is that the indemnity sets up as the origin of the indemnity and the loss which is claimed;
• causation is used by the law to limit the scope of indemnities and questions of construction cannot be avoided, which inevitably involves reference to the reasonable contemplation of the parties;
• the law has been concerned to examine critically the notion that the indemnifier is liable for all loss consequent on the stipulated condition, and this is so even where the indemnity clause expressly refers to “all consequences”. It is not in fact “all” consequences that are the subject matter of an indemnity – it is only consequences that are proximately caused that are covered;
• without express language, an indemnity will not cover consequences caused or contributed to by the negligence of the party in whose favour the indemnity is given; and
• where the indemnity is triggered by a breach of contract, the indemnity, subject to any contrary provision, only covers foreseeable consequences caused by that trigger.

The Total Transport decision shows that even though the rules of remoteness of damage do not generally apply to an indemnity that is construed as an obligation to make good, the rules of construction and test of causation are likely to be used by courts to limit recovery. Accordingly, very clear language is required if losses that are otherwise considered to be remote are to be recovered under an indemnity. This is particularly important in the case of an indemnity that extends to breach of contract. Therefore, without very clear language, an indemnity for breach of contract is unlikely to provide greater protection in respect of recovery of loss to an indemnified party than an ordinary claim in damages for breach of contract.

Implications and drafting suggestions

To draft an indemnity that is intended to provide the two key benefits avoid:

• using the terms “indemnify” and “hold harmless” as they are more likely to result in the indemnity being interpreted as an obligation to prevent loss. The indemnity is more likely to be interpreted as an obligation to make good if terms such as “make good”, “compensate” or “pay on demand” are used (Nuncio D'Angelo, 'The Indemnity: It's All in the Drafting', (2007) 35 Australian Business Law Review 93); and
• avoid relying on the use of terms such as “all losses” or “all damages” to recover loss or damage that may be remote – ensure that the drafting is very specific on what losses and damages are intended to be covered by the indemnity. It needs to be clear that the indemnity is not limited to loss and damage that would be recoverable under an ordinary claim for breach of contract.

Thanks to Urszula Altson for her help in writing this article.