Strenuously negotiating the indemnities in a straight-forward debt financing, documented along LMA lines, is rarely going to be that productive. In transactions requiring more extensive risk allocation, such as asset financings, there is more room for debate over the indemnities. With any indemnity, the protection its beneficiary seeks and what a judge awards can differ widely. Alexander Hewitt looks at two of the (many) areas where an indemnity may not give the protection you might expect and at a recent case illustrating this problem. He concludes that the remedy is often in the drafting.

Indemnity claim v. Breach of contract action

Parties often hope an indemnity will give them greater protection than a breach of contract claim. A damages award for a breach of contract, for example, is one-off and final. There is no going back for more if further losses flow from the original breach. But a well drafted indemnity can give the right to claim repeatedly as new losses arise from the original breach.

There are at least two common situations, however, in which an indemnity may not deliver superior recoveries over a breach of contract action. These are where the court applies the breach of contract rules on mitigation and remoteness of loss to an indemnity claim.

Mitigation

Parties often hope having an indemnity means having no duty to mitigate; that they will receive "pound-for-pound recovery" for all losses, without needing to try to contain them. If a judge construes an indemnity as creating a claim in debt, it is very likely its beneficiary will have no duty to mitigate. But if the judge decides the indemnified claim is for damages, it is likely there is a duty to mitigate. Surprisingly, it is not always clear whether a claim under a finance document is for debt or damages.

The indemnity could say its beneficiary need not mitigate some losses (where the deal is for a complete risk transfer). Among other things, this probably requires very clear and emphatic drafting to be enforceable. More commonly, the indemnity might impose a specific, limited duty to mitigate. There is no such thing as judge-proof drafting, but excluding or limiting any duty to mitigate will often be safer than assuming there is none just because the claim is under an indemnity.

A specific, limited duty to mitigate may also suit the indemnifier. The common law duty to mitigate is fairly light. It rarely requires sophisticated or risky action. So, where sophisticated action by the beneficiary might be needed to reduce the indemnifier's exposure under its indemnity, both the indemnifier and the beneficiary may gain from an agreed, limited duty to take or explore specific, sophisticated action.

Remoteness

An indemnity claim may also not give better recoveries than a breach of contract action if the court, in effect, applies the breach of contract rule that some losses are too remote to come within the indemnity. This will cut off losses that are neither direct, nor natural and probable consequences of the indemnified breach – judged as at the date of contracting.

The Eurus and Pindell cases

The Court of Appeal applied the contractual remoteness rules to a claim under an indemnity for breach of a charter of a ship in The Eurus [1998] 1 Lloyd's Rep 351. Recently, in Pindell v. AirAsia [2010] EWHC 2516, the High Court used similar reasoning to block an aircraft lessor's claim for loss of a very profitable sale of its aircraft. The loss flowed from a lessee's late return of an aircraft in breach of its lease. The indemnity promised protection against "any losses". The judge, in effect, applied the contractual remoteness rule to find that "any losses" did not include this loss.

Drafting indemnities

An indemnity that:

  • had spelt out all losses it was to cover;
  • did so in clear, coherent, unambiguous and detailed terms; and
  • was not too loose, chaotic, abstract or brief,

could have dramatically improved recoveries in both the Eurus and Pindell cases. This is clear from the judgments in those cases and from the general law of damages. It is not always possible or desirable to draft to this standard. And no client is going to thank their (deluded) lawyer for trying to produce "perfect" documents. When, however, parties need a high degree of certainty that their indemnities allocate risks in line with the commercial deal, there is no substitute for putting in work on the drafting.