“Indemnities” – the hidden traps in building contracts

By Geoff Hardy, Auckland commercial lawyer

People often underestimate the significance of a legal contract. Too many times the completion of a contract is seen as a ritual that you go through at the commencement of a deal, following which the contract is filed in the bottom drawer, hopefully never to be seen again.

If you treat it as a ritual or a tedious exercise that has to be undertaken against your better judgment, then you are unlikely to bother familiarising yourself with the wording.

So when it comes time for that contract to be pulled out of the bottom drawer, chances are, the actual wording will come as a complete surprise to you.

I understand why that happens. Reading pages and pages of legalese is drudgery compared to the fun part of eagerly anticipating the benefits that the deal is going to bring you. And if you have to spend time negotiating the terms of the contract with the other party at the outset, it tends to raise sensitive issues and cause aggravation, right at the time when both parties are in that honeymoon period, when everything looks exciting and they just want to get on with it.

Why focus on the things that can go wrong when your natural inclination is to be positive?

There are two answers to that question. The first is that the honeymoon will end, sooner or later, and it will often be followed by separation or divorce.

The second is that when that happens, you need a set of rules to say what happens next. If you don’t have those rules, it will take you three times as long and cost you three times as much to restore order out of the chaos.

It is your contract that contains those rules. So you better make sure it says what you want it to say when everything turns to custard. That applies just as much to a building contract as it does to any other kind of contract.

There is one particular word in a building contract that you need to be particularly wary of. And that is the word “indemnity”.

An indemnity is a promise that you will ensure the other party suffers no harm whatsoever if something adverse happens to them. You will put them back in the position they would have been in if it had never happened. Usually that involves paying them a lot of money, and the worst thing is you might not have realised it.

Indemnities are reasonably common. For example, your insurance company promises to indemnify you if your car gets stolen or your house burns down. Assuming it is a full replacement policy, they will pay you the full amount of your loss (other than the excess).

It is similar when someone guarantees a bank loan. If the borrower doesn’t repay it, usually the guarantor has to reimburse the bank not only for the unpaid debt, but also all accrued interest, and any legal costs the bank incurs in trying to recover the debt. To the last cent.

When indemnities were first dreamed up centuries ago, they were usually given by Party A to protect Party B from something that Party C did to them. For example, the Sherriff of Nottingham allows Blackadder to mill the timber in Sherwood Forest in return for a shilling per tree, but Blackadder is nervous that Robin Hood will sabotage the sawmill.

So the Sherriff agrees to indemnify Blackadder in case that should happen. Similarly, the insurance company agrees to pay you the replacement cost of your car if someone else totals it. Or you agree to reimburse the bank for its unpaid loan, interest and recovery costs if the borrower defaults in payment.

In recent times people have lost sight of the original purpose of an indemnity. Now they are just as often given by Party A to protect Party B from something that Party A might do to them.

Take the standard form building contracts for example. NZS 3910 (the contract used in most big commercial projects), requires the contractor to indemnify the principal against any losses, liability or costs the principal incurs as a result of the contractor’s building work or any defects in that work. NZS 3902 (the small works and residential projects contract) says something similar, as do the four NZ Institute of Architects contracts and the UK-based FIDIC contracts.

The concern that I have, is that many contractors won’t know these contracts contain an indemnity, and may not appreciate their full significance if they do.

There is nothing wrong with indemnities in principle. The principal and the contractor are free to negotiate any terms they wish. An indemnity is just one way to allocate risk in a construction project, but what the indemnity does is allocate all the risk to the contractor (although he might be able to insure against it).

The idea is that if the contractor (or the suppliers and subcontractors for which he is responsible) does anything wrong, then the principal won’t be out of pocket at all, and won’t have to share the burden to any extent. If these building contracts did not contain such an indemnity, then the outcome would be different. If the contractor did anything wrong then he would almost certainly be in breach of contract and possibly be negligent as well, so he could be sued by the principal for damages. Damages can be either less generous or more generous than an indemnity.

Damages for breach of contract or negligence can be less generous than an indemnity because they typically don’t compensate the principal for every conceivable loss the principal might suffer.

That could be because some of those losses weren’t reasonably foreseeable, or the contract excludes indirect or consequential losses, or the principal allowed the loss to become greater than it needed to be, or some other event occurred which made the loss inevitable regardless of the contractor’s default.

More importantly, even if the principal wins in court and is awarded costs, the contractor won’t have to pay anything like the full legal costs the principal had to pay.

Damages for breach of contract or negligence can be more generous than an indemnity if the contract provides for liquidated damages, and they turn out to be greater than the principal’s actual loss. Even though liquidated damages are supposed to be a genuine pre-estimate of the principal’s loss, it’s not an exact science and the courts won’t require the principal to refund the excess if it turned out the parties guessed wrong.

There is no question that an indemnity will cost the contractor more than if he is simply liable for damages, and they are either not liquidated, or they are liquidated but the parties have underestimated the losses the principal would incur.

An indemnity is intended to reimburse the principal for every last cent, including 100 percent of his legal costs. If you are the contractor and you have spent a fortune unsuccessfully defending a court case against you, it’s bad enough that you have to pay your own lawyer.

Imagine if you had to pay the principal’s lawyer as well. An indemnity will make you do that. A large contractor might be able to take that in his stride, but it could wipe out a smaller contractor. When negotiating the building contract, you don’t have to agree to an indemnity. But even if you do, the important thing is to know that it’s in there, so you can manage your risk.

Geoff Hardy has 43 years’ experience as a commercial lawyer and is a partner in the Auckland firm Martelli McKegg. He guarantees personal attention to new clients at competitive rates. His phone number is (09) 379 0700 and e-mail geoff@martellimckegg.co.nz. This article is not intended to be relied upon as legal advice.