By Fatima Alsebai
When one party is in breach of contract or fails to perform its obligation, what are the rights of the parties? How to dealing with the possibility of breach or the potential losses in your contract? What are the differences between indemnity and liquidated damages clauses? And how to draft them in your contract? These questions form the focus of this Article.
The normal remedy of the injured party is to obtain monetary compensation in the form of damages for the breach.Damages are money paid by one party to another, intended to restore the party who has suffered loss to the same financial position he would have been in, had the contract been properly performed. Contractual damages, thus, look forward to the post-contractual position (unlike tortious damages, which look backward to the pre-tort position).
There are several types of damages. Compensatory damages: compensate for all of the damage suffered and therefore place the victim in the position in which he would have been had he not suffered the damage, by reasoning retrospectively. Incidental damages: compensate for those losses which the claimant incurs after the breach has come to his notice (e.g. the administrative costs of buying a substitute, the cost of returning defective goods); consequential damages: compensate for the foreseeable consequences of the breach, may be loss of profits (e.g. reliance loss). However, there can also be further harm, such as personal injury or damage to property; nominal damages: are awarded if the actual amount cannot be shown, there are no actual damages, or a causal connection between the breach and the loss sustained cannot be shown; and finally, Punitive damages: are less common and are granted as a way to punish the parties that have breached a contract agreement in a civil action, in which criminal sanctions are of course unavailable. They are proper in cases in which the defendant has acted willfully and maliciously and are thought to deter others from acting similarly. Liquidated damages: The parties to the contract may stipulate a sum which shall be paid by a party in breach of contract to the innocent party, in advance of any breach of contract, which will be highlighted in detail below.
Damages, in common law countries, mainly England, can be compensated in one of three ways:
loss of expectation (to put the claimant in the same position as if the contract had been performed)
Reliance loss (the cost to the claimant of relying on the contract)
Restitution (benefits obtained by the defendant under the contract) Where a bargain is made, and the price paid, but the defendant fails to deliver the goods, the claimant is entitled to recover the price paid, plus interest thereon.
In all cases, the claimant must to do his utmost not to increase the amount of damage done, which is called “duty of mitigation” that means the court will not award damages for loss which has been caused by the innocent party’s failure to take reasonable steps to mitigate his loss - although the defendant must prove such failure. However, incidentally, this rule normally does not apply in relation to enforceable liquidated damages clauses.
However, the compensation, in civil law countries, will often include the loss sustained by the creditor and the profit foregone. It is worth noting that moral or reputational damages are recoverable as well, under Civil Codes.
Differences between indemnity and damages:
Indemnity and damages are closely related, but major differences are that:
The major point of difference between Damages and Indemnity is that Indemnity can be claimed for loss arising out of action of a third party whereas damages can only be claimed for loss arising out of the actions of the parties to the contract upon breach of contract.
Another difference between damages and indemnity is that damages can only be claimed for breach of contract whereas in the case of indemnity a breach of contract does not have to take place. Indemnity may be claimed for loss caused by action of a third party which may not necessarily result from the breach of contract
The main principle behind indemnity is to put a person back into the place he was before the loss occurred. Hence when a person is indemnified he will never make a profit or a loss out of it, he will be restored to his original position.
‘Liquidated damage’ clause in a contract: ("LD Provisions"):
Even though civil law and common law legal systems are gradually assimilating regarding major issues of contract law, there is still no uniformity to the legal concept of liquidated damages. However, Liquidated damages clauses serve the function of saving time and resources for the Parties to a contract by explicitly stipulating a clause into a contract that, if a breach occurs, the one who committed the breach shall pay to the other a fixed sum of money, the amount so agreed upon is called liquidated damages.
As long as the sum payable reflects the innocent party’s legitimate interests in ensuring the contract is performed. A “liquidated damages” clause of this type, thus, enables a party to know his liability in advance of any breach. However, to be enforceable, liquidate damages must be reasonable measure of estimated damage. Liquidated damages clauses are most commonly used in construction, information technology development, and other contracts
Liquidated damages clauses and penalty:
In common law countries, mainly England and United States, where it has originated, it is not enforceable if its’ purpose is to penalize the other party, rather than compensate the breach for the aggrieved party, in that case it is considered that the clause is actually penal in nature.
In Dunlop Pneumatic Tyre Co Ltd v New Garage & Motor Co Ltd [1915] AC 79, the House of Lords decided that a liquidated damages clause would be considered a penalty and therefore unenforceable, where the sum to be paid by the defendant was “extravagant and unconscionable in amount in comparison with the greatest loss that could conceivably be provided to have followed from the breach”.
However, in civil law legal system penalizing function of agreed damages is permitted, nevertheless the court has the right to alter the sum stipulated if it is disproportionate to the actual loss.
Furthermore, good faith, fairness and reasonableness are all important factors to keep in mind when negotiating, drafting and administering the LD Provisions.
Where the parties to a contract are in dispute whether a payment clause in a contract is a genuine liquidated damages clause or a dishonest penalty clause, what test has been used to settle the issue in the English law?
The test can be explained as follows:
a) Whether the clause is “a secondary obligation which imposes harm on the breaching party out of all proportion to any legitimate interest of the injured party in the enforcement of the primary obligation.
b) Whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable.
c) The traditional test based on a comparison between the stipulated amount and the greatest loss that could be proven to have been caused by breach of the relevant primary obligation.
Drafting the liquidated damages clause:
1- Understandably, if your contract governing by the common law, words implying of penalty shall not be used. Certainly, don't use “penalty" or "penalize." and, it may be better to avoid “forfeit" -"forfeiture" or "fine", they may be detrimental.
2- Make sure that the damages stipulated will fall within the range between the upper and lower limits of potential actual damages foreseeable at the time of the making of the contract. Otherwise, in the common law the provision is likely to be held to be invalid as prescribing a penalty. Nevertheless, in civil law countries the court may often decrease the agreed amount if the obligor party proves that the calculation is exaggerated. Therefore this amount has to be reasonable in light of the circumstances, and the amount imposed will generally be a fair estimate of actual damages associated with the specified breaches.
3- Setting out too small amount when representing party in whose favor the liquidated-damages provision runs would be disadvantageous. Because if it is valid, that is all he will ever get even though it turns out that the damages actually sustained and provable are much greater. I.e. where the damages exceed the agreed amount of liquidated damages, he may not claim a higher amount.
4- Furthermore, treat each potential breach separately and precisely, if more than one is to be provided for. So don't provide a single sum or measure of damages for breaches of two or more covenants.
‘Indemnity’ clause in the contract:
indemnity is a contractual obligation, by one party (indemnifier) to pay or compensate for any potential losses, damages or liabilities incurred by another party to the contract (indemnitee) or by a third party. Indemnities are frequently created by contract, whether expressly defined or implied, and operate as a way to allocate risk between the parties to a contract.
Thus, the elements of an indemnity are that: 1) party A shall indemnify. 2) To party B. 3) Against claims, losses, damages and expenses.. 4) Arising out of actions, breaches of contract, non-performance/ defective goods/etc..
Furthermore, some contracts may also include a Letters of indemnity (LOI) This letter guarantees that both parties will meet the terms and conditions of the contract. If these terms and conditions aren’t met, the repayment will need to be made to the indemnified party. the party or parties are indemnified against a possible loss by some third party as well.
However, indemnity is primarily used in a legal sense, as an exemption for liability of any damages. They can simply be used to remove liability from a party in the contract.
Indemnities usually cover liabilities in two ways:
Third-party claims against the indemnified party, such as intellectual property infringement.
Claims made between the indemnifier and the beneficiary or indemnitee. For example, for breach of contractual provisions like a failure to pay an invoice.
Does the right to an indemnity cover losses caused by the indemnitee’s own negligence?
The right to be indemnified pursuant to an indemnity clause does not usually cover losses caused by the indemnitee’s own negligence. This right may be created by an express provision to that effect, but in general a party acting negligently must bear the consequences of that negligence. However, the nature and extent of the negligence may affect the outcome.
The same is true with regard to the civil law countries, where the court may decrease the amount of indemnity or reject any request for indemnity where the negligence of the indemnitee contributed to or aggravated the damage.
The notice requirement:
The wording of the indemnity clause will often contain a provision that the Indemnitee is required to give notice to the indemnifier of third-party proceedings against it which would be covered by the indemnity, in such case, Indemnity shall not be payable until the indemnifier is notified.
But if this is done and the indemnifier does not act, they will usually be estopped from claiming that the judgment or settlement was invalid or unreasonable. It will also be harder for the indemnifier to challenge the indemnitee’s legal costs. Notifying the indemnifier and joining them as a party to any proceedings thus avoids these problems from the outset.
Drafting the indemnity clause:
1- in drafting indemnity clause, there are Three Types of Indemnifications, broad, intermediate or limited, the broad form of indemnity, is often tempting to try to cover all eventualities by including wording such as “shall indemnify, defend and hold harmless the [other party]…”
- In this context, ‘defend’ means to protect the beneficiary from harm caused by a third party’s claim or other action, and requires the indemnifier to conduct any litigation. If the word ‘defend’ is included, an obligation on the beneficiary to cooperate with the indemnifier should also be included. Whatever the situation, it may be useful to require the beneficiary to give notice of all actual and potential claims to the indemnifier.
- ‘Hold harmless’ is usually understood to mean that the beneficiary will not be liable for any losses suffered by the indemnifier in relation to the subject of the indemnity. It means that the indemnifier may not sue or counter-claim against the other party, and may even include an obligation to keep others from suing where possible. As always, careful wording is key. In some circumstances, ‘hold harmless’ wording could have the effect of leaving the indemnifying party unable to bring an action against the beneficiary even where the beneficiary had committed a significant breach or been grossly or influential negligent. It is arguably unnecessary and potentially unreasonable, so it is worth reviewing what purpose is being served before including such wording. For this and other reasons, indemnity clauses should always be drafted with extreme care and as unambiguously as possible.
2- Include an obligation to mitigate loss where you act for the indemnifier: The party giving an indemnity may argue against the principle that there is no obligation to mitigate loss under indemnity. However, the indemnifier should consider including a requirement that the indemnifier should take reasonable steps to mitigate its loss following a breach of contract.
3- Indemnity will only extend to the person or company that is listed as a beneficiary in the written agreement (including any person mentioned in the third-party rights clause). Therefore, It is important to list all persons who should be covered by the indemnity; not only the company, for example, but if appropriate, its affiliate companies, directors, consultants, agents, employees and so on. This allows those who are non-signatories to the contract to make claims under the indemnity. If the agreement contains a clause covering third-party rights, this should be read in conjunction with the indemnity clause to assess their mutual effect.
4- Where the aim is to protect the indemnifier, the scope of losses losses should be limited as much as possible to direct losses. And overly broad wording such as ‘all losses arising out of …’ should be avoided. therefore deciding what losses to cover must be very accurate
5- Where the aim is to protect the Indemnitee, indirect losses should be expressly included. Consider the source of any potential loss or damage which may arise in connection with the contract. For example, loss or damage may arise from: breach of the contract through non-performance or defective performance; damage to real or personal property of contracting parties or third parties; injuries suffered by employees, subcontractors or the general public, and so on.
In conclusion:
While Liquidated damages are pre-estimates of damages caused by a possible breach of contract, which has to be reasonable and equitable with actual damages in light of the specified breaches. Indemnity is a promise by one party, indemnifier, to protect the other party, indemnitee, from any loss caused due to an act of the indemnifier or any third party. An indemnity clause thus provides for protection against all kinds of unforeseen and indirect losses, claims, and liabilities, howsoever arising, in relation to a specified transaction.
This forms the major difference between liquidated damages clauses and indemnities, the latter ones provide protection for the creditor against all kinds of unforeseen and indirect losses claims and liabilities in addition to direct and foreseen damage that liquidated damages clauses provide protection for. And it should be noted that Common law countries distinguish liquidated damages from penalty clauses, where the latter ones are considered unreasonable and thus unenforceable.
An important point to bear in mind is that while many contractual clauses dealing with liability are drafted as widely as possible, in an attempt to cover all eventualities, such clauses are more likely to be full-enforceable if they are tightly, clearly, and specified drafted, any ambiguity must be avoided for effective clauses. Consequently, each element of the clause should be clearly defined. Each element requires careful consideration in order to achieve the desired outcome. Better indemnity and liquidated damages clauses keep your contract safer from losses, which ultimately helps to protect you profits.
About the Author
Fatima AL-Sebai is a qualified lawyer with more than 9 years of legal experience in top-tier law firms in Egypt and Qatar, currently based in Doha and working as an in-House legal counsel for one of the leading trading and contracting companies in Qatar.
She holds an LL.B degree and an LLM in International Commercial and Investment Law from the University of Cairo, recently she is preparing for a Ph.D. in International Commercial law. Furthermore, she is studying common law and preparing for the QSE to become a Qualifying Solicitor in England & Wales.
She has a great interest in comparative legal research of the different foreign and international laws.
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