Using warranties, representations, covenants, indemnities and guarantees in contracts
Contract law is more concerned with ensuring that the parties perform their obligations than it is with ensuring that they receive the expected benefits under the contract. We have all entered into contracts where we did not get exactly what we were expecting e.g. the meal was not as good as we anticipated, or we did not enjoy the holiday as much as we hoped. This does not usually give us a right to demand the cancellation of the contract and the repayment of our money.
Our clients look to us to ensure that they get what they wanted under the contract as well as to protect their interests in the event and things go wrong. In general you will cover these points in a variety of clauses, used in combination with each other, including: covenants, warranties, representations, indemnities, and guarantees. You will use one type of clause where another type of clauses inappropriate or ineffective.
In this 2-part article I will look at the types of clauses which are most suited to ensuring that we impose precise obligations on the other side in contract. This week I will deal with covenants representations and warranties. In the second part of this article, next week, I will look at indemnities and guarantees.
Most of the obligations which are imposed in contracts occur in clauses which are covenants. Depending on the nature of the contract, however, you will also want to ensure that you include the necessary warranties, representations and indemnities as well as third party guarantees. Frequently it is best to use these different clauses in combination to ensure that you impose the obligation and to get what you want from the other side.
You cannot draft a contract without understanding the legal differences and effects between these different types of clauses and so we will start with an explanation of what each one is, and its legal effect.
Let’s begin with Covenants.
A Covenant is a promise by one party pledging that something is either done, will be done, or shall not be done. e.g. 1 “Licensee shall pay Licensor a flat royalty based on 2.5% of Gross Revenues received from the sale of Licensed Products.” The party receiving the licence is making a promise that they will pay the party giving the licence royalty from each sale of the products covered by the licence. This is very straightforward.
e.g. 2: “Company A hereby covenants not to sue Company B under any patent listed in Exhibit A for infringement based upon any act by Company B of manufacture, use, sale, offer for sale or import that occurs after the Effective Date.” The party giving the licence is making a promise that they will not do something - that is, they will not sue the party receiving the licence. So you can see that a covenant is a promise imposed on one or both of the parties in a contract.
A Representation is a statement of fact that induces a party to enter into the contract. The statement, which must be made before, or at the time of making the contract, regarding a past fact or existing circumstance related to the contract which influences the other party to enter the contract.
e.g. 1: “Licensor represents to Licensee that it has the full and unencumbered right, power and authority to enter into this Agreement and to grant the license rights granted by Licensor to Licensee hereunder.” There would be no point for the licensee to enter into this contract unless the licence or owned the rights to those licences. The Licensor’s statement that it owns the rights to the licences is what causes the licensee to enter into the contract.
e.g. 2: “Seller hereby represents that it owns full legal and equitable title to the land shown on the map marked hereon.” The seller is promising that it owns the land and upon this promise the purchaser is happy to hand over payment for the land.
A warranty is a contractual assurance from a seller to a buyer that a particular fact is true. It is a subsidiary or collateral provision to the main purpose of the agreement: the sale itself.
A warranty is an undertaking or stipulation that a certain fact in relation to the subject of the contract is or shall be as it is stated or promised; and refers to an agreement to protect the recipient against loss if the fact is or becomes untrue.
e.g.1: “Licensor warrants to Licensee that it has not received any written notice or claim, and is not otherwise aware that the Licensed Technology infringes or misappropriates the proprietary rights of any other Person.” If there were any subsequent challenges to the ownership of the copyright, or patent, the on the licensed technology then, clearly ,the licence would not be as valuable as the purchaser believed. The purchaser would be entitled to claim the difference in value between what they paid and what the licence was now worth if ownership of the intellectual property rights were challenged.
Example 2: “Company A warrants to Company B that the Technical Information provided hereunder will be the same as that used in the design, production, installation and maintenance of Licensed Products produced in its own factories.” If the information provided is not as good as that used by Company A then company B will probably not be able to sell any of the items it produces – Why should customers pay for an inferior product when they could buy Company A’s product instead?
It is important to note that there are a number of huge differences between warranties and representations.
First, a warranty is only ever given in a sales contract and it is only ever given by a seller. It relates to a collateral or side issue – not the main objective or purpose of the contract e.g. warranty for the free repair of a car in a sales contract for the car. You are not paying US$30,000 to get the promise of a free repair, you are paying in to buy the car. The warranty is a side-issue which gives you sufficient extra confidence/incentive to enter into the contract.
Second, where there is a breach of warranty the standard legal position is that this will give the injured party the right to claim compensation, under contract law, for all the different financial remedies available BUT it will not give the right to terminate the contract. Contrast this with a breach of a representation which will not only give the injured party the right to claim compensation but will also give them the right to terminate the contract.
When a party gives a representation there is a heavy inference that they have personally checked the facts relating to the representation – So any breach carries the suggestion that they may have been lying, although many representations are given innocently but mistakenly. With a warranty there is no inference that the seller has checked the facts, merely that they believe the warranty to be correct and are willing to pay compensation if it turns out not to be so.
Purpose of Warranties
One of the main purposes and effects of warranties is to apportion risk and liability between a buyer and a seller. Warranties protect a buyer by providing a possible price adjustment mechanism if a warranty is false and, in a sale of a business, enables a buyer to gather information through a disclosure process. In a Breach of Warranty - The damages for which a seller is liable is the amount necessary to compensate the purchaser for any loss resulting from the breach.
A breach of warranty claim is an action for breach of contract and is subject to the normal legal requirements of proving loss. A party that breaches a warranty is only responsible for the loss and damage that is foreseeable as a result of the breach.
Warranties can be written into the contract, or stated verbally OR they can be implied by the law or by the usual practices of a particular industry or field of business. As we will consider next week, a warranty can run alongside a guarantee.
Next week we will look at the meaning and use of indemnities and guarantees and then consider how we can use combinations of these five different types of clauses to not only ensure that the client gets what they want from the contract but the other important job – ensuring that the client’s interests are protected if things go wrong.
USING WARRANTIES, REPRESENTATIONS, COVENANTS, INDEMNITIES AND GUARANTEES IN CONTRACTS
Part 2 – Using Indemnities and Guarantees
Indemnities and Guarantees are 2 more essential tools to use contracts, especially when you are looking to protect the client after the contract has started. Too many lawyers draft contracts on the basis of what they want to happen, without adding provisions to protect the client’s interests in the event that things don’t turn out as expected. You should try to draft contracts on the basis of what might go wrong and then write the solution to the problem which this would cause into the contract’s clauses. Indemnities and guarantees are excellent tools for this purpose.
Let’s begin with indemnities.
Indemnity = Recompense for loss, damage, or injuries; restitution or reimbursement.
In Contract Law the onus is on the buyer to show breach of contract and quantifiable loss. An indemnity contract/obligation arises when one individual takes on the obligation to pay for any loss or damage that has been or might be incurred by another individual. The right to indemnity and the duty to indemnify ordinarily stem from a contractual agreement, which generally protects against liability, loss, or damage.
Simply put, an indemnity is a promise by one party to another that they will not suffer a financial loss. This is a very different matter from guaranteeing a profit. An indemnity merely assures one party that they will not be out of pocket in respect of a particular issue. Put more formally, an indemnity clause is a contractual transfer of risk between two contractual parties generally to prevent loss, or compensate for a loss, which may occur as a result of a specified event.
Purpose of Indemnities
Indemnity clauses help manage the risks in commercial transactions by protecting against the effects of an act, a contractual default or another party’s negligence. The normal tendency is to seek an indemnity which will protect a party to the greatest possible extent against liabilities arising from the actions of another. The purpose of an indemnity is to provide guaranteed compensation to a buyer/owner on a euro-for-euro basis in circumstances in which a breach of warranty would not necessarily give rise to a claim for damages or to provide a specific remedy that might not otherwise be legally available. e.g. remoteness of damage of the breach of warranty from the harm caused means compensation cannot be claimed.
You should use indemnities to cover potential losses where there are difficulties in using Warranties, Covenants, or Representations, although you will frequently find that a cocktail of all these clauses is needed to protect the client and make sure that they get what they are expecting.
Contract Law differences between Indemnities and other Contract Terms
Under Common Law, the non-breaching party is clearly obliged to mitigate any loss for a breach of the contract but There is no such clear obligation for a buyer to mitigate its loss under an indemnity.
Disclosures might be made against warranties in certain transactions, such as share or asset sales, thereby limiting liability. In which case one party might initially seek an indemnity because of information disclosed either during due diligence or in a disclosure letter.
It is necessary for the injured party to prove that financial losses arose as a result of a breach of contract – With an indemnity, however, a buyer can recover any losses sustained without having to prove that there has been reduction in value – merely that a loss was suffered e.g. court and legal expenses in defending a claim.
Depending on the terms, a buyer that is aware of a breach of warranty might not be able to claim because they were aware of the problem and decided to enter into the contract regardless. However, knowledge of a potential breach of contract or warranty will not prevent a buyer from making a claim under an indemnity. Buyers often negotiate an indemnity as contractual protection from a specific problem that they have discovered.
Scope of Indemnity
Indemnities are often drafted too widely seeking to cover third parties and circumstances beyond the ordinary breach circumstances actionable under the common law. In some circumstances indemnity clauses also seek to apply even when there is no breach of contract by the party. A well known instance of this is a guarantee where one party indemnifies another party for the act, default or breach of a third party. Indemnities in these circumstances can therefore extend into unintended onerous obligations which the common law would not otherwise impose.
It is not uncommon for a party with the most commercial influence and bargaining strength in respect of a project, particularly where the project is large or risky, to insist on indemnities from other participants. Such indemnity clauses are often drafted in the broadest possible terms. The adoption of broad-ranging indemnities is not always, however, the best tool for achieving risk apportionment.
Ambiguity in the drafting of an indemnity clause presents a risk that the indemnity will not be held to cover losses, which they expected it to cover. Ambiguity is also a risk to the indemnifier that it will be held to cover losses that were not within their contemplation. We will look at how to draft these clauses in a separate Contract Drafting article next week.
It is important to take care in commercial negotiations to confine and document the intended scope of the indemnity being negotiated and to identify precisely what is sought to be achieved economically.
Duration of Liability.
If you are receiving the Indemnity ask for it to run for a little longer than the risk/liability will last last - If you are giving the Indemnity thenb eware of giving open-ended Indemnities which last forever - Put a cut-off date is and possibly a cap on the amount of liability which the Indemnity will cover.
Enforcement of Indemnity Clauses
Another point about indemnity clauses is the extended time for which they may remain available for enforcement compared to a claim for breach of contract. Statutes of Limitation exist in all states that limit the time by which a claim must be brought for breach of contract. Normally, the period is 6 years for an ordinary agreement, commencing from the date of the breach.
It is critical to understand that the limitation period in relation to an indemnity clause starts from the date on which the indemnifier refuses to honour the indemnity. The indemnified party would then have a further 6 years from that date within which to bring legal proceedings to enforce the indemnity. Consequently, an action on the indemnity to seek recovery of its loss may be brought many years after the right to bring damages for breach of contract has expired. In most instances, parties granting indemnities are not adequately advised of this potential impact and the extended period of risk they are assuming as part of their indemnity obligations.
6 different types of indemnity clauses
There are loosely six types of indemnity clauses, which provide a guide to their scope and operation, including:
Bare Indemnities – e.g. Party A indemnifies Party B for all liabilities or losses incurred in connection with specified events or circumstances, but without setting out any specific limitations. These indemnities will be silent as to whether they indemnify losses arising out of Party B’s own acts and/ or omissions, and maybe even be interpreted to be a reverse indemnity, below.
Reverse or Reflexive Indemnities – e.g. Party A indemnifies Party B against losses incurred as a result of Party B’s own acts and/ or omissions (mostly Party B’s own negligence)
Proportionate or Limited Indemnities –These are the opposite of Reverse Indemnities. e.g. Party A indemnifies Party B against losses except those incurred as a result of Party B’s own acts and/ or omissions
Third Party Indemnities – e.g. Party A indemnifies Party B against liabilities or claims by Party C , someone outside the contract.
Financing Indemnities – Party A indemnifies Party B against losses incurred if Party C fails to honour the financial obligation (ie the primary obligation) to Party B (most often these are coupled with a guarantee), and
Party/ Party Indemnities – Each party to a contract indemnifies the other(s) for losses occasioned by the indemnifier’s breach of the contract.
We will look at common indemnity clause drafting mistakes in the contract drafting tips article to be published next week.
Guarantee: This word is both a Noun and a Verb: Noun = A commitment by a third party to make good in the event of a default by a party to a contract, by paying the money, or providing the performance, due from the defaulting party.
Verb = To promise to make good in the event of a default by a party to a contract, by paying the money, or providing the performance, due from the defaulting party.
A guarantee is a contractual promise to:
- Ensure that a third party fulfils its obligations (pure guarantee); and/or
- Pay an amount owed by a third party if it fails to do so itself (conditional payment guarantee).
A guarantee is a secondary obligation because it is contingent on the obligation of the third party (principal) to the beneficiary of the guarantee (beneficiary). Lenders will often seek a guarantee and indemnity if they have doubts about a borrower's ability to fulfil its obligations under a loan agreement. Guarantors and indemnifiers take on a serious financial risk in entering into such transactions, and it is important that they are aware of all the implications. A guarantee is distinct from a demand guarantee (also called an on demand bond). The latter is a guarantee that imposes a primary obligation on the guarantor to pay the beneficiary on its first demand for payment, where the principal fails to perform the contract.
Advantages of a guarantee over Indemnities
Guarantees tend to be more advantageous to the guarantor because they confer certain rights including:
- Right to indemnity. Once the guarantor pays the beneficiary under the terms of the guarantee, it has a right to claim indemnity from the principal, provided that the guarantee was given at the principal's request.
- Right of set-off. Where the principal, satisfies its obligations by way of set-off against the beneficiary's liabilities to the principal, the guarantor is also entitled to that right of set-off, and will be discharged from its obligations under the guarantee.
- Subrogation. A guarantor who fulfils the principal's obligations under the guarantee is entitled to all the rights of the beneficiary against the principal under the primary agreement, including any rights of set-off and any security that the beneficiary had taken from the principal.
- Marshalling. The equitable doctrine of mashalling applies to guarantees so that a guarantor may be able to obtain the benefit of another creditor's security over the principal's assets that it would otherwise not have security over.
Too many lawyers draft contracts purely on the basis of what they want to happen. You should take the time to consider what could go wrong and then draft the solution to the problem this will cause an add it to the clause.
We will look at contract drafting points regarding these types of clauses in a series of contract drafting posts starting next week.
The material in this article is taken from the current British Legal Centre course: Contract and legal document drafting. You can find more about the regular on-line broadcast lesson’s from the course on our website.