Indemnity Agreement: Does the Indemnitee Have to Pay Out First Before Claiming from The Indemnifier?

Your friend Irfan asks you to come on board as a partner in a shipping business he intends to set up. He assures you that you will only be named a partner and he will handle the dealings and operations. Irfan even signs an indemnity agreement that states that he shall indemnify you against any and all liability of the business.

A year later you find out that the business is on the verge of shutting down and there are multiple legal suits amounting to RM100,000.00 against you in the capacity of a partner.

The debtors approach you and demand that you pay them first.

You are advised that you can use the indemnity agreement to recover the monies from Irfan later on.

Is there a way out?

What is an Indemnity Agreement?

An indemnity is a security or assurance to be compensated for damages, loss, and liability. An indemnity clause or agreement is a contractual agreement between two parties whereby one party (the Indemnifier) agrees to pay for potential losses or damages incurred by another party (the Indemnitee).

In contractual dealings, a simple indemnity clause is as follows:

[Person A] including his officers, employees and agents will be indemnified and held harmless by [Person B] against any claim, liability, losses, damages that arise from the affairs of the [Company].

The Law

The concept of Contract of Indemnity is codified in Section 77 of the Contracts Act 1950 which not only provides the definition but also illustrates a typical situation of indemnity.

Definition

A contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person, is called a “contract of indemnity”.

Illustration

A contracts to indemnify B against the consequences of any proceedings which C may take against B in respect of a certain sum of RM200. This is a contract of indemnity.

A contract for indemnity is not the same as a contract for guarantee. The distinction between the two was succinctly explained in Halsbury’s Laws of Malaysia (Volume 2(2)) (2013 Reissue):

“A guarantee is a contract which creates a secondary or accessory liability under which a third party agrees to be liable to repay the debt of another, or to be answerable for the performance of that debtor’s obligations to the creditors, conditional upon the debtor failing to do so. An indemnity is a primary liability under which a third party agrees to be answer for the liability of a debtor to repay a debt or perform obligation as if he (the third party) was the principal debtor”.

As in the Court of Appeal in R Marine Engineering (M) Sdn Bhd v. Bank Islam Malaysia Berhad [2013] 1 LNS 318 (COA), Courts often determine the nature of the agreement by looking into the words on the document and intention of parties, i.e. whether Indemnitor had undertaken a primary obligation to the Indemnitee or merely a secondary duty. If the former, the document is an indemnity and if the latter, the document is merely a guarantee.

Hence upon establishing a valid Indemnity Contract, you are entitled to being indemnified for the losses by the Irfan. But the question becomes, must you pay the Debtors first? Or can you claim the portion from Irfan before you make any payments?

Does the Indemnitee have to pay out first?

The answer to this legal question can be found in the following English cases:

1. British Union And National Insurance Co v Rawson [1916] 2 CH 476:

“the indemnified may call upon the indemnifier to pay the debt either to him or to the principal creditor before having paid himself and if paid to him the indemnifier has no concern what he does with the money”

2. Durley House Ltd v Firmdale Hotels Plc [2014] EWHC 2608 (CH):

“In summary, the following points emerge from Law Guarantee Trust. First, a general contract of indemnity is distinct from a contract of insurance, but the result was no different whether contract was one of insurance or indemnity. Secondly, under a contract of indemnity in general, in equity there is no requirement for the indemnified to have paid the creditor first; the indemnifier is required to pay the indemnified, regardless of whether indemnified has paid, or will pay, the creditor: Buckley LJ at 633-634, Kennedy LJ at 638-639 and Scrutton J at 652.

The rationale for adopting this equitable approach is succinctly put by Lindley LJ in Johnston v The Salvage Association And Mckiver (1887) 19 QBD 458:

“In equity a contract to indemnify can be specifically enforced before there has been any such breach of the contract as would sustain an action at law. In equity the plaintiff need not pay and perhaps ruin himself before seeking relief. He is entitled to be relieved from liability.”

The above precedents were followed by the Court of Appeal of Singapore in Management Corporation Strata Title Plan No 1933 v Liang Huat Aluminium Ltd [2001] 2 SLR (R) that held the following:

“To claim under an indemnity, the loss must have been incurred. But it is not essential that payment must have already been made to a third party who has undertaken the remedial works: see Halsbury’s Laws of England vol 20 (4th Ed) (1993 Reissue) para 356.”

In Artic Building and Civil Engineering Sdn Bhd v. Ahmad Zaki Sdn Bhd & Ors [2009] 9 MLJ 328 (HC), Abdul Malik Ishak J (as he was then) held that the right to be indemnified extends not only to the principal sum but also to any solicitor-client legal fee that the Indemnitee has to bear.

“And by virtue of the notice of indemnity, the first defendant was claiming full indemnity from the second defendant in respect of any order and/or judgment that may be pronounced by this court in respect of this suit, including costs on a solicitor-client basis as per the provisions of paragraphs 3(a), 3(b) and 3(c) of the said notice of indemnity. … At any rate the indemnity clause imposed a contractual duty on the second defendant to fully indemnify the first defendant including costs on a solicitor-client basis.”

In short, the law on indemnity does not require the indemnified to pay out first to a third party to claim the same from the indemnifier.

Conclusion

The law protects an Indemnitee from being forced to potentially ruin themselves and pay a debt that they are contractually indemnified from. As such, you can proceed to claim any demands or judgments from the Debtor against Irfan without having to first fork out the same.