Inappropriate use of indemnities

Too many contracts include indemnities.  IP Draughts has noticed a increasing trend to include indemnities in commercial contracts, in recent years.

First, we need to distinguish between two types of indemnity.  Take the example of a contract between A and B, under which A is engaged to manufacture a pharmaceutical drug for B, to B’s specification, which B will use in human clinical trials.

A third party indemnity allocates responsibility between A and B for dealing with third party claims or liability.  In the present example, a patient might be injured by the drug.  The manufacturing contract may provide that, if a patient brings a claim in respect of that injury:

(a) if the injury arose because the drug was inherently toxic or harmful, B will indemnify A against the patient’s claim; or

(b) if the injury arose because A introduced some contaminent into the drug during the manufacturing process, or otherwise failed to make the drug to B’s specification, A will indemnify B against the patient’s claim.

Third party indemnities can be contrasted with an inter-party indemnity, e.g. where A indemnifies B against any loss or damage suffered by B, if A fails to perform its obligations under the agreement or is in breach of a contractual warranty.  In the present example, if A fails to deliver the drug by the contractual delivery date, B may have a claim against A for any losses suffered by B arising from that breach.  The contract may provide that A will indemnify B against such losses.

IP Draughts is happy to see third-party indemnities in contracts such as the manufacturing contract described above.  Our concern relates to the over-use of inter-party indemnities.

In the past, a conventional response among English lawyers would have been to query the need for inter-party indemnities.  If A is in breach of contract, B will have remedies under the general law of contract.  There is no need for an indemnity as well.

From A’s perspective, an indemnity in this situation is unattractive.  Depending on how the indemnity is worded, it may remove some of the protections given by general contract law to the party in breach.  Under general contract law principles, B would have to demonstrate that the loss suffered is not too remote from the breach, and B would have to mitigate his loss.  These protections may be swept away by the indemnity (although there is some case law to suggest that mitigation of loss may still be required).

If B’s objective is simply to maximise its legal position, then an indemnity may be attractive.  However, if parties are negotiating on the basis of trying to reach a “reasonable” position, an indemnity may be considered rather one-sided.

IP Draughts believes that the trend towards increasing use of inter-party indemnities has come from the US, where different legal rules operate.  US lawyers have told us that, if a winning party in contract litigation is to recover its legal costs, an indemnity is required.  This is because the courts in the US do not generally award a winning party its legal costs.  English law in this area is very different; usually the winning party is awarded some or all of its legal costs.

If there is a good reason to include an inter-party indemnity in a contract, then it should be included.  However, we have negotiated contracts prepared by the other party, where it appeared that an indemnity was included merely because it formed part of the template agreement on which the draft contract was based, and where the other party had no convincing reason for including the provision.

Our general approach is: if there is no clear reason for including an indemnity, it probably shouldn’t be there.

3 Comments

Filed under Contract drafting

3 responses to “Inappropriate use of indemnities

  1. In principle Canada uses the English costs-follow-the-cause rule, but in practice the assessment is restrictive, and my understanding (I am an academic, so I don’t have direct knowledge) is that costs awarded typically amount to around 20% of actual costs. I am curious as to what costs scale parties choose for themselves. If the contract includes a clause allowing the prevailing party to recover its attorney’s fees, does this mean 100% of actual costs? If not, what is the mechanism for assessment of costs?

    • Christopher Whent

      Ay, there’s the rub. In all US jurisdictions I have experience of, the court reserves to itself the right to determine any attorney’s fee. Thus, at the extreme, in New York, although in an action for money only plaintiff can enter a default before the clerk, any attorney fee portion, no matter how nominal, means that the default has to go before a judge.

      That said, absent special circumstances, I would be surprised that a “typical” judge would risk appeal by denying 80% of costs actually incurred and verified.

      Incidentally, on the matter of attorney fees, I was recently counsel on an infringement action brought in both New York and Germany. The matter was settled worldwide in conference before the court in New York, and it was agreed, typically, that both sides would bear their own costs. However, when it came time to file the settlement with the German court, we learned that counsel cannot in accordance with German law, in essence waive a fee, and that the fee will be determined by the court. Furthermore, the amount of the fee is a function of the amount of the claim, as I understand it, and not of the time spent. Given that we had been active with inter alia motion practice in New York, and the Berlin action did not proceed beyond the pleading stage, even German counsel was embarrassed by the result. While the circumstances were unusual, I share the anecdote lest other find themselves in a similar litigation posture.

  2. Christopher Whent

    A kind of Gresham’s Law is clearly operating, with bad drafting driving out good. This has been an issue for me for more than 30 years. Specializing in entertainment related law, and dealing frequently with lawyers who do only transactional work and do not have the wit to consult with a litigator when drafting contracts, I am constantly confronted with indemnity provisions that are not expressly limited to third party claims inconsistent with a party’s representations, but which seek to indemnify against “breaches of covenants and agreements” (yes, indeed, the duplication is typical).

    The New York Court of Appeals has addressed the issue of extending indemnification clauses to claims between contracting parties in Hooper Assocs v AGS Computers, ruling that such a claim will only be allowed where it is “unmistakably clear” that the clause was intended to extend to such claims.

    The “American Rule” on attorney’s fees is something of a red herring. As a former judge of the Court of appeals wrote in an article last year:

    “The surest way to avoid such disputes is for transactional counsel to address the issue head-on when negotiating contracts. A simple statement, either in the indemnification clause or in a separate attorney’s fee clause, that in any dispute between the contracting parties, the prevailing party shall be entitled to recover its legal fees, costs and expenses from the other party, should with rare exception satisfy the Hooper standard.”

    My templates expressly limit indemnification to third party claims and (unless the client prefers otherwise) include a separate clause permitting a prevailing party to recover its attorney’s fees.

    I suspect that the fact that litigants continue to try to extend indemnification to disputes between the parties is an attempt after the fact of a dispute having arisen to rectify poor drafting of the original contract.

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