Indemnity clauses are known to be frequent sources of commercial disputes. Litigators Andrew Bernstein, Sarah Whitmore and Chris Hunter walk through indemnity essentials and what to watch for when negotiating agreements.
underlying principles of indemnities in contracting
Andrew Bernstein (00:07): Hi, everybody. I'm Andrew Bernstein from Torys' Litigation Department, and this is the first in our Commercial Disputes video series. So we're going to have different members of the Litigation Group come and talk to you about different parts of the commercial dispute. Today, I'm here with my colleagues Sarah Whitmore and Chris Hunter, to talk about indemnity clauses in commercial agreements, which are often front and center in commercial litigation disputes. Chris, what is an "indemnity"?
Chris Hunter (00:36): Well, Andrew, at its most basic level and indemnity is an obligation in a contract requiring a party to compensate for certain types of losses upon the occurrence or non-occurrence of an event, typically a breach of contract, and it can be in favour of a party to the contract or it can be in favour of a non-party, which is what we call third-party indemnities.
Andrew Bernstein (00:57): Okay, and Sarah, why do parties include indemnities in their agreements?
Sarah Whitmore (01:01): It's a good question. A party who breaches a contract isn't always liable for all of the losses that then flow to the innocent party or to third parties to the contract. In the seminal case that you might remember from law school called Hadley and Baxendale, the courts have recognized that parties are only liable for damages that reasonably flow from the breach. We often refer to these as direct damages. So reasonable damages are those that the parties had in their contemplation at the time of the breach or at the time that the contract was formed. The courts do also recognize that parties are entitled to modify the common law rule. So parties are entitled to put in their agreement that if an act or a non-act occurs that they may be liable for greater than the common law rule of damages. Parties can also exclude certain damages. And these clauses are referred to as indemnities and they modify the "rule of reasonableness". So, for example, if we had an agreement and there was a seller who had to obtain a permit before closing and they failed to obtain the permit, the buyer would ordinarily only be entitled to the damages that would directly flow from that breach. They might not be entitled to things like the inability to obtain financing and losses that might result from that inability, but if there was an indemnity in the agreement that provided that all losses or damage that flowed from the inability to obtain the permit in advance of closing, then Party B, the buyer, would be entitled to those losses.
Andrew Bernstein (02:32): And are there limits to what a party can include in an indemnity? What are the scope of damages?
Chris Hunter (02:39): Generally speaking, no. Provided they're expressly specified in the agreement, and there are, as you know Andrew, a myriad of terms we tend to see in these agreements. But there are at law five categories of damages. The first is "direct damages", which are reasonably foreseeable consequences of an event, namely a breach. "Indirect damages", which is damages that result but aren't necessarily reasonably foreseeable or at least directly traceable to the event. What are called "consequential or special damages", which are consequences that are foreseeable as a result of some special circumstance or knowledge known to the other party. "Incidental damages" which are costs incurred mitigating losses and "punitive or exemplary damages", which is a tort concept designed to award damages going beyond what's necessary to compensate a party for its losses, strictly speaking, under the contract. That's something we see less commonly in many contractual cases. But as Sarah says, the basic rule at common law is that only direct, and in some cases, special damages are recoverable. As a result, it's really important that you specify specifically what kinds of damages will or will not be available when an indemnity is triggered. That's particularly true because we've seen in cases when you are trying to depart from the common law rule in the absence of express and plain language regarding what damages are or aren't available, courts are going to be inherently concerned with what's reasonable, particularly for example, if the loss is in some way already potentially accounted for in the purchase price under the agreement or if it's the result of some sort of self-inflicted harm. And for that reason, there are two other kinds of damages or at least references we commonly see in these clauses. The first is "lost profits". Now, lost profits could be direct, they could be special or they could be indirect damages depending on the specific circumstances you're dealing with in a case. But it's precisely because of that, that it's important that you specify in your indemnity whether they'll be recoverable or not if the indemnity is triggered.
Chris Hunter (04:55): The other one we see is "diminution in value". And this is something we see in particular frequently in the M&A context. Where the major harm that will be suffered is the loss in value or the difference in value between the company as it was represented and the company actually purchased. And so the more specific you can be in your indemnity clause, whether that's loss of goodwill, lost profits, even mental distress, the more likely it is that the court will either award or refuse to award those types of damages depending on what your indemnity says.
Andrew Bernstein (05:28): So basically, you should tell the court what you want and don't leave it to their discretion.
Chris Hunter (05:32): Exactly.
Andrew Bernstein (05:33): Sarah, if you are the beneficiary of an indemnity and you get sued by a third party, what should you do?
Sarah Whitmore (05:41): So if you're sued by a third party to the contract, that's a third-party claim. What we refer to as a third-party claim. You want to check the provisions in your indemnity. Indemnities often set out a procedure that you'll need to follow. So first you'll want to make sure that third party claims are covered. They most often are. And then you'll want to check to see if there are timelines that you need to follow. So sometimes you need to notify the indemnifying party within a certain time frame that you have a claim, and you need to make sure you follow those steps. They're not hard and fast rules, but it will be important that you show the court you've acted reasonably and you've acted within those timelines. Next, you'll want to check survival periods for your representations and warranties, because often the claim that will be made against you by the third party will arise out of either a representation or a warranty that the breaching party had made. And you'll want to make sure that those have survived and that guarantee is still in place. That's different than a limitation period. The limitation period sets out the amount of time by which that third party needed to bring their claim. And the survival period tells you how long did that promise last. So once you've checked those things, you'll want to also see whether or not you have control over the claims, so whether you should be defending and bringing the action, or whether the indemnifying party has the right to do so. And that is often set out in the clause, and it will specify certain circumstances or exceptions to the rule that ordinarily the indemnifying party does have the right to take defense and to take charge of the claim. Circumstances or common exceptions to that rule occur where the third party is a supplier or a frequent customer of the indemnified party and there might be a business reason why the parties have agreed that in that case, the indemnified party will take charge of the claim. Another example might be where the indemnifying party denies liability, and they say that the indemnity doesn't apply. And so in those circumstances, the indemnified party might again have the right to take charge of the claim. The other thing you want to check is whether or not you need to—if you are the indemnified party and you are taking carriage of the claim—do you need to communicate with the indemnifying party about settlement or about certain steps that have to occur in the litigation? Because there are certain clauses that specify that before you enter into settlement discussions or before you take material steps in the litigation, the indemnifying party has a right to either participate in those discussions, evaluate the settlement, or otherwise be a party to those conversations.
Andrew Bernstein (08:31): And I will say that those clauses can cause some real problems. And what I often recommend to our colleagues who are in the contract drafting business is that they provide some kind of negative option mechanism where if somebody says nothing within 30 days, they're deemed to consent, because otherwise you get these situations where you send out a proposed settlement to your indemnifying party, and they just don't respond and you don't know what you're supposed to do. Chris, could an indemnity work the other way around and allow an indemnifying party to sue a third party through the indemnified party?
Chris Hunter (09:05): Yes. So that's called subrogation, and it's particularly common in the insurance context. We could probably do a whole video on subrogation, but the two things I'd say in general about that first, again, it would have to be expressed in the terms of your indemnity And second of all, what's important, at least from the perspective of the indemnified party, is to make sure that there are sufficient protections and exclusions built into it so that you're not undermining the fundamental purpose of the indemnity. For example, you'd commonly see a requirement that the indemnifying party pay the indemnified party its claim in full, so that the indemnified party isn't sitting around waiting for the subrogated litigation to resolve before it's made whole.
Andrew Bernstein (09:45): Interesting. Okay, well thank you very much, Sarah and Chris. Great to have you here as the debut of this commercial litigation video series. And stay tuned viewers for the next in the series. Thanks.
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