Many contracts contain clauses that ‘warrant’ the existence of something or ‘indemnify’ a party for losses. It can be confusing to identify what the difference between these obligations are and what that means for your business.
In this article we will look at the theoretical differences between warranties and indemnities, and what the practical distinction is for your business.
The theoretical differences
At least in theory, there is a substantial difference between warranties and indemnities.
Warranties
A warranty is a statement that acts as an assurance from one party to another as to the existence or non-existence of something. An example of this would be a party warranting that a good will be free from defects for a set period of time or that services will be delivered with due care and skill.
The theory is that a warranty covers a risk that is unknown as at the time of the contract being executed. In our examples above, there is no way of knowing if the product will be free from defects for the warranty period as that period has yet to pass and the services have yet to be delivered so you cannot know if they have been delivered with due care and skill.
There is also a line of reasoning that if a party knows that a warranty has been breached by the other party when they sign the contract then they cannot rely on that breach as a breach of contract, although there is limited jurisprudence on this issue.
The remedy for a breach of a warranty is to put the party in the position as if the warranty was true. Using our examples above, this would mean that any defects are repaired or a replacement product is supplied during the warranty period for the first warranty and that the services have to be redelivered or the cost of any issues with the services being rectified for the second warranty.
A breach of warranty is a claim for unliquidated damages, which is another way of saying that the court is required to quantify the damage or loss suffered. This assessment would be subject to the contractual principles from Hadley v Baxendale (1854) 9 Ex 341.
These principles require that the loss either arise from the usual course of things or that the loss was in the contemplation of both parties at the time the contract was signed. There is also a general duty for parties to mitigate loss that they suffer due to breach of contract.
The total effect of the above principles is that parties regularly cannot recover all loss suffered due to a breach of contract.
Indemnities
In contrast to a warranty, an indemnity is a promise to compensate a party should an event occur, and a loss is incurred. An example of an indemnity would be a party indemnifying (indemnifying party) the other party (indemnified party) from any claims brought against the indemnified party by a third party based on intellectual property infringement by the supplied product or service.
An indemnity is only activated by the indemnified party sustaining an actual loss. This means that the indemnifying party does not have to pay the indemnified party until the indemnified party pays money (or equivalent) to a third party.
In contrast to a warranty, the breach of an indemnity has been characterised as an action in debt or an action for liquidated damages. This means that the court is not required to quantify the damage or loss suffered as the remedy under an indemnity is the total loss suffered. This loss would also not subject to the foreseeability and remoteness principles from Hadley v Baxendale.
It is unclear if the duty to mitigate also applies to indemnities, but there is a line of reasoning that an indemnified party cannot recover the entirety of a loss if they have overpaid in settling the matter. This would be equivalent to a duty to mitigate.
It should be noted that many indemnity clauses provide the indemnifying party the right to run and settle any dispute that would be the subject of the indemnity clause. The question of overpayment would be removed if the indemnifying party did negotiate the settlement.
In essence, an indemnity is a duty to pay for a loss that is breached if that amount is not paid. This means that any breach of an indemnity is about the indemnified party proving that the loss is subject to the indemnity but is not about proving the actual quantum of the loss. The indemnifying party could argue that the loss was an overpayment but would otherwise not be allowed to challenge the quantum of loss if it is an indemnified loss.
The differences
The theoretical differences between an indemnity and a warranty appear to be that:
- an indemnity is an action for a set sum of money and is not subject to the principles of Hadley v Baxendale or general arguments around the damages;
- an indemnity can only be relied on if actual loss is suffered, whereas a warranty can be relied on once the warranty is breached; and
- the duty to mitigate might not apply, or might be limited, for indemnities.
In practice, it is likely that these differences are relatively minor.
Indemnities are interpreted using a strict construction approach. This means that each indemnity must be interpreted on an individual level and not based on general principles around what an indemnity is. It also means that the specific terms used are vitally important as the duty to ‘make good’ is not the same as the duty to cover ‘all losses’. The drafting of indemnities is therefore vital to ensure that the indemnity covers the losses that it is intended to cover and HWL Ebsworth can help you with this.
It should be noted that indemnities are often drafted in such a way that there is a contractual duty to mitigate and to limit the losses covered by that indemnity. This can be seen as artificially inputting some of the principles around assessing damages for breach of contract.
This means that indemnities can cover a larger quantum of damages and be easier to litigate, but the reality is that most of the time the difference in quantum will be minor if the indemnity has been carefully drafted.
Next steps
In summary, indemnities and warranties differ slightly but can be drafted in such a way to minimise those differences or to maximise those differences.
HWL Ebsworth’s IP and IT teams have extensive experience in advising businesses regarding commercial contracts. If you are concerned about warranties or indemnities, please contact us for further information on how we can assist you.
This article was written by Luke Dale, Partner, Max Soulsby, Solicitor and Carmen Marino, Law Clerk.
