An indemnity is simply a promise to hold a person harmless in relation to the occurrence of a particular event. They are used in contracts to allocate the risk of loss or damage which flows from certain events, and are often linked to acts or omissions of the indemnifying party.
Indemnities are often drafted with insurances in mind. They are often included in contracts to allocate the risk of certain events to a particular party, on the basis that the indemnifier will obtain insurance to cover its liability under the indemnity. Indeed, many contracts contain provisions which specifically require the indemnifier to effect insurance policies covering its liability under the indemnity, particularly where the indemnifier might not otherwise have the cash flow required to honour its obligations under the indemnity.
Some general principles and distinguishing features
The principles relating to the enforceability of indemnities are no different from the principles relating to the enforceability of contractual promises generally. That said, there are some aspects of an indemnity which distinguish it from other forms of contractual promises. These distinguishing features are best illustrated by comparing a contracting party's ordinary right to recover damages for breach of contract, with an indemnified party's right to be indemnified for any damages it incurs as a result of a breach of contract by the indemnifying party. The distinguishing features are:
No concept of remoteness: The concept of remoteness of damage and the rule in Hadley v Baxendale (1854) 9 Ex 341 do not ordinarily apply in respect of loss or damage which is recoverable under an indemnity. In other words, the liability of an indemnifier will extend loss suffered by the indemnified party which would be too remote to be recoverable as damages for breach of contract. Put another way, loss which does not flow according to the usual course of things, and which was not contemplated by the parties at the time the contract was entered into, will be recoverable under an indemnity provided the words of the indemnity cover the loss.
No obligation to mitigate: The requirement to mitigate loss which applies to a plaintiff who suffers loss as a result of a breach of contract, does not apply to a party claiming under an indemnity unless the terms of the indemnity expressly require this. This is because the obligation to mitigate is relevant only in relation to breaches of contract and, with an indemnity, the relevant breach of contract is the refusal to indemnify. It is difficult to conceive of a situation where in relation to the breach constituted by the refusal to indemnify, there could be a relevant failure to mitigate loss. That said, there is authority for the proposition that, at least in relation to indemnities against liabilities to third parties, the liability to the third party must be reasonably incurred.
In other words, if an indemnified party were to settle a third party claim which had no legal basis without the consent of the party providing the indemnity, the indemnified party would not be entitled to recover the amount which it has agreed to pay to the third party on the basis that such liability was not reasonably incurred.
This implied limitation of reasonableness is also consistent with the authority that indemnity clauses are to be strictly construed and, for example, do not ordinarily extend to cover the consequences of a party's own negligence (Walters v Whessoe Ltd  1 WLR 1056).
In other words, while there is no duty to mitigate (unless the terms of the indemnity expressly require this) the indemnity will be construed strictly so as to extend only to costs and liabilities reasonably incurred.
The point to take away here is that, when acting for a party giving an indemnity, consideration should be given to including a requirement in the indemnity that the indemnified party be required to take reasonable steps to mitigate its loss.
Extended limitation period: An indemnity can have the practical effect of extending the limitation period which would ordinarily apply in relation to the event giving rise to a liability under an indemnity. For example, if a contractor fails to fulfill a particular obligation under a contract, the statutory six year limitation period within which the principal can bring an action for breach of the contract runs from the time of the breach. If, however, the contract also contains an indemnity from the contractor indemnifying the principal for losses incurred as a result of the contractor's breach, the principal can bring a claim under the indemnity whilst ever the indemnity remains on foot. Also, if the principal makes a claim under the indemnity and the contractor fails to pay, the six year period within which the principal can bring a claim for the breach of contract constituted by the refusal to indemnify runs from the time of that refusal, which may be long after the date of the original breach which gave rise to a liability under the indemnity.
Ongoing losses: A claim under an indemnity in respect of losses incurred by the indemnified party to that date does not preclude the indemnified party from subsequently bringing a further claim under the indemnity in respect of subsequent or ongoing losses. This situation can be contrasted to that which arises under the res judicata principle which only allows a party to bring proceedings claiming damages in respect of a particular breach of contract once, even if that party subsequently suffers further loss arising out of the same breach after the proceedings have been concluded.
Under an indemnity, a separate cause of action arises with each refusal to indemnify.
For the above reasons, indemnities for breach of contract are less common than, say, indemnities for property damage or personal injury resulting from a contractor's activities.
Another general principle which needs to be borne in mind when drafting and interpreting indemnities is the principle from Andar Transport Pty Ltd v Brambles Pty Ltd (2004) 217 CLR 424 which requires any ambiguity in an indemnity clause to be construed in favour of the person providing the indemnity. This principle is illustrated by the recent NSW Supreme Court decision in F&D Normoyle Pty Ltd v Transfield Pty Ltd (2005) NSWCA 193.
In that case, Transfield Pty Ltd and Bouygues SA (the "Joint Venture") was the main contractor for the Sydney Airport domestic terminal railway station. The Joint Venture engaged Chadwick Building Systems Pty Ltd under a subcontract to supply and install gyprock ceilings at the site.
An employee of Chadwick who was working at the site under Chadwick's direction sustained injuries when he tripped over some pipes and claimed damages from the Joint Venture. The court held that the Joint Venture was liable to the employee for breach of statutory duty under certain OH&S regulations.
The Joint Venture in turn made a claim under an indemnity in its subcontract with Chadwick which required Chadwick to indemnify the Joint Venture against any claims arising as a result of any "act, neglect or default" of Chadwick.
Justice Ipp (with Justice McColl agreeing) held that the reference to "act" should be read eiusdem generis (ie. in conjunction) with the words "neglect or default", both of which connote a breach of a legal duty. Accordingly, Justice Ipp held that the reference to "act" should be similarly read as an act involving a breach of legal duty rather than a "fault free" act. Justice Ipp said that the clause was at the very least ambiguous and that, on the authority of Andar, should be construed in favour of Chadwick.
As the employee's injuries were not caused by an act or omission of Chadwick which amounted to negligence or breach of contract or breach of statutory duty by Chadwick, the majority held that indemnity did not apply.
Justice Bryson, on the other hand, held that the indemnity was not ambiguous and that the reference to "act" should be given its ordinary and natural meaning which is neutral as to fault or breach of duty. He said the parties should be taken to use the word to have contributed some additional meaning and not to have included it to no purpose. Accordingly, he held that Joint Venture was entitled to be indemnified.
Drafting tip: Use the phrase "act or omission" for maximum coverage, and be very careful when adding in extra words such as default or neglect which might cause the words "act or omission" to be read narrowly.