Practical Law

It is very difficult to procure a construction or engineering project in a city like London without encountering at least one third party with potentially “at risk” assets. Typically, these third parties want their assets protected, measures taken to mitigate the risk of damage and insurance-backed compensation arrangements put in place to cover any conseqeuntial costs or losses should damage occur.

As a result, many third parties (especially statutory undertakers) have finely tuned asset protection agreements (APAs), which usually require compensation for their costs and losses to be on an indemnity basis. 

A client of mine (I’ll call him Mr Bump) is procuring a large construction project in west London, adjacent to assets that are owned and operated by a major statutory undertaker (Mr Worry). Asked to sign Mr Worry’s standard APA, he notices a requirement to indemnify Mr Worry against certain losses. He asks me what an indemnity is and what are the consequences of signing up to this indemnity.

What is an indemnity?

An indemnity is best described as a contractual arrangement under which one person agrees to compensate another person for a specific loss. For example, if Mr Bump damages Mr Worry’s assets, this could be the cost that Mr Worry incurs in repairing the damage, together with the associated financial losses.

I explained to Mr Bump that indemnities which extend beyond the usual losses arising from personal injury or death and damage to third party property are potentially onerous and should be avoided if possible. Most public liability insurance policies will only respond to losses flowing from physical damage, and only then to the extent that such losses would be recoverable at common law. Moreover, such indemnities can be very difficult to pass down to a well-advised contractor.

What are the key differences between a claim under an indemnity and a claim for breach of contract?

In the absence of an indemnity, if Mr Bump damages Mr Worry’s property then Mr Bump may be liable on a contractual basis for some or all of the losses that Mr Worry incurs as a result. However, this will be subject to long-established common law rules on recovering damages for breach of contract, including remoteness and mitigation. These seek, as a matter of judicial policy, to balance the interests of Mr Worry (by ensuring he is appropriately compensated for any losses that he suffers) with those of Mr Bump (by ensuring that he is not exposed to indeterminate and unlimited losses).

A claim under an indemnity is often promoted as being more advantageous than an ordinary breach of contract claim because the common law rules of remoteness and mitigation do not apply. In other words, the claimant will not need to prove that its losses were foreseeable and could not have been avoided. However, this is not always the case and whether or not these common law rules apply depends on the wording of the indemnity itself and whether a claim made under it can be categorised as a debt or a damages claim. If it is the latter, the rules of remoteness and mitigation will apply, but if it is the former they won’t. Unfortunately for Mr Bump, the indemnities in Mr Worry’s APA are drafted to give rise to a debt, rather than a claim for damages.

Another key difference between a claim in contract and a claim under an indemnity is the point from which the applicable statutory limitation period starts running. Under a normal claim for breach of contract, the limitation period runs from the date of the breach that gives rise to the loss. However, in the case of an indemnity the limitation period runs from the date when the indemnified loss is established, which could be much later.

What features of an indemnity are more likely to mean that it is construed as a “damages” claim?

For obvious reasons, the indemnifier will want the indemnity to be characterised as a claim for damages for breach of contract. How can Mr Bump achieve this in the context of Mr Worry’s APA? He could:

• Look to restrict the scope of the indemnity to losses that have been “reasonably” incurred by Mr Worry or, where the indemnity applies to claims made against Mr Worry by a third party, to losses that are “legally sustainable”. If Mr Worry is required to prove his losses or demonstrate that they have been reasonably incurred, a court is more likely to view his claim as one for damages than a debt.
• Try to ensure that claims under the indemnity are triggered only if Mr Bump breaches one of his obligations or warranties under the APA itself, rather than the occurrence of a specific external trigger event.
• Include an express requirement for Mr Worry to mitigate the losses covered by the indemnity.
• Include an express limitation period in the APA, bringing it into line with that for a breach of contract. However, as I explain to Mr Bump, in his case the limitation period is perhaps of less concern given that damage to Mr Worry’s assets is most likely to arise during the construction period.
• Exclude or limit his liability for certain categories of loss (for example, indirect and consequential loss or loss of profit). This would reflect the position that otherwise applies at common law.

Final thoughts

As with all provisions of this nature, the devil is in the detail. The precise extent and scope of any specific indemnity is a matter of contractual interpretation. So perhaps the most important tip for drafting and negotiating an effective indemnity clauses is to tailor it to the particular circumstances of the parties. This may sound obvious but there is a tendency, particularly in the context of APAs, for the party giving the indemnity to think that it is set in stone and not negotiable.

If you are relying on an indemnity don’t simply assume that it will protect you in all circumstances. Also take account of the capacity of the party giving the indemnity to meet it. A broadly worded indemnity clause will be worthless if the party giving it does not have the financial resources to make good on its promise.

Similarly, the party giving the indemnity should consider how it will fund its promise and whether it needs protection through insurance or some other arrangement.