I often get questions from start-ups about contracts. I should say upfront that I am not a lawyer of any description and the comments in the blog below should not be taken as verbatim - however - I've spent a large part of my work life reading contracts and trying to understand the implications of what it is I'm signing.
What I've learned over the years of working with start-ups is that they commonly misuse particular words that when used in a contract have a specific legal meaning. The biggest misuse/misunderstanding is with the terms Indemnity, Guarantee and Warranty.
In this post I'll attempt to describe the difference.
In an indemnity agreement, you are exactly agreeing to assume all responsibility and liability for any injuries or damages to someone else.
It is accepted that all the parties to the indemnity agreement agree that in the event that one is held liable, the other shall indemnify them for the consequences. There is an underlying principle for this scenario which is that the party that is in the better position to avoid liability is given an incentive to do so by being made responsible for the consequences.
Having used this principle both in the UK and the USA, the terminology for common phrases contained in indemnity agreements include that the person or entity agrees "to indemnify and hold harmless" or "to defend, indemnify and hold harmless.". This might vary dependent on the legal jurisdiction you're working under.
If the indemnity agreement includes a requirement for you to defend a claim, you will often find the agreement requiring the person who is being indemnified to "tender the defence" to you. Or you should include language maintaining your "right to control" the defence, including requiring that you have final approval of any settlement.
Without such provisions, the party you are indemnifying can rack up huge legal fees and costs which will you will need to pay. If you are controlling the defence, you can choose the lawyer and have a say in litigation costs and expenses, which could be vital to your business.
Usually any indemnity agreement covers things like loss, damages, costs, expenses and legal fees. However, if the indemnity agreement is silent on the subject of legal costs, then the court will not impose this or require the person promising to indemnify to pay legal fees. Even if the indemnity agreement included legal costs, this means "reasonable" fees, which the lawyer has the burden of proving.
It is another important concept to account for, that there be some ‘consideration’ for the issue of the indemnity and, where there is a concern about the adequacy of the consideration, the agreement should be signed as a deed. Appropriate gross-up provisions should also be applied to ensure that, if any money paid is treated as taxable income, the seller should be obliged to gross up the damages to cover any such liability.
There is a further aspect to keep in mind. Contribution involves the distribution of liability for damages among culpable parties according to each party's relative percentage of fault. Indemnification, in contrast, shifts the entire loss from one party to the other. In other words, contribution asks another to share, while indemnity requires another to pay it all. It is often confusing with the difference between indemnification and contribution but the important point is that liabilities can be shared if the situation dictates it.
A guarantee is an agreement to answer for a debt, default or other financial liability of another person. This is in contrast to an indemnity agreement which is a promise to answer for the legal liability of another. You are in essence promising to perform a contract or piece of work or pay a debt in the event the principal person or company cannot or refuses to do so. Once the principal obligation has been paid or otherwise satisfied, then the guarantor's obligation is completed. You could be asked to sign a personal guarantee as part of a loan agreement or as part of a structured debt agreement like an overdraft with your bank.
A guarantee agreement is regarded as "collateral" to another contract, debt or obligation. It is this contract for which you would be secondary liable. Because of this you should always review the underlying contract before signing any guarantee agreement.
There are different types of guaranties. A guarantee might be an absolute and unconditional undertaking, or it may be subject to some conditions established by both parties. Under an absolute guarantee, the guarantor agrees to pay or perform a contract/work upon default of the principal without limitation or advanced notice. Consequently, the guarantor is obligated to pay the entire debt at maturity if the principal doesn't.
With a conditional guarantee, the guarantor's liability doesn't start until the creditor has taken certain agreed steps against the principal. The guarantor can choose the condition that triggers the obligations in the underlying contract. A solid clause to have is that the third party must have tried all remedies against the principal party before pursuing any remedial clauses with the guarantor.
A guarantee can also be to a single transaction, or a continuing guarantee, which extends to future dealings. A continuing guarantee is for an indefinite period and is effective until revoked.
A warranty agreement is an assurance by one party to a contract of the existence of a fact, often times relating to the quality or quantity of the subject matter of a contract upon which the other party might be relying. A breach of warranty will only give rise to a successful claim in damages if the buyer can show that the warranty was breached and that the effect of the breach was to reduce the value of the asset acquired.
A warranty agreement is intended to relieve a party of the task to research the fact(s) for themselves, and amounts to a promise to indemnify for any loss if the fact proves untrue.
No specific words are required to construct a warranty if it is clear that the parties intended one. An express warranty will be seen in accordance with natural import of the language used, as applied to the subject matter of the contract. Liability under a warranty will be enforceable only in view with its terms. You can disclaim any warranties by including a disclaimer provision in your contract. Under common law, a buyer is clearly obliged to mitigate any loss for a breach of warranty. There is no such clear obligation for a buyer to mitigate its loss under an indemnity.
It is very important to understand that even if a contract is labelled as a warranty, indemnity or guarantee, a court may decide the contract is a different type depending on the actual attributes it contains. Just writing the word Warranty at the top doesn't explicitly make it so. Disclosures might be made against warranties in certain transactions, such as share or asset sales, thereby limiting liability, but should not be made against indemnities.
The extent of your liability relative to the warranty, indemnity or guaranty agreement will be determined by the terms and conditions of the contact. The lesson I've learned here is to choose the language carefully, as you will be accountable for the words you choose to use.
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