04 November, 2015
Indemnities are common place in commercial contracts, including construction contracts. Where an indemnity is linked with a fitness for purpose warranty is it clear in your contract where a claim under the indemnity becomes statue barred?
Introduction
The use of indemnities as liability devices is common in the construction industry. Typical examples include:
- an indemnity by a contractor in favour of the principal in respect of third party claims arising in connection with the work;
- an indemnity in favour of the principal from the parent company of a contractor, as one element of a contract of guarantee and indemnity; and
- an indemnity by a contractor in favour of the principal for loss caused by breach of a warranty of quality or fitness.
Clearly, since these are all different indemnities, applicable in a variety of situations, there is no reason to think that they will all work in the same way. Principles governing indemnities will therefore have different applications in different contexts. See generally Wayne Courtney, Contractual Indemnities, Hart Publishing, Oxford, 2014.
The particular issue with which we are concerned is the commencement of the limitation period where a claim is made on an indemnity which has been provided in connection with a fitness for purpose warranty. This is an issue on which diverse views have been expressed. We have seen suggestions by some commentators to the effect that commencement of the limitation period is always postponed until a demand is made on an indemnity without any supporting case law being cited. While it is certainly possible to draft an indemnity which expressly provides for its ongoing operation over an extended period of time, these suggestions related to indemnities not drafted in this manner. We think it is worthwhile exploring this view.
Limitation Periods
Simple contracts
A claim on an indemnity generally arises out of a simple contract. The limitation period is six years from accrual of the cause of action. See eg Limitation Act 1969 (NSW), s 14(1)(a).
Deeds
If the indemnity is contained in a building contract executed to take effect as a deed, the limitation period is the longer period applicable to causes of action founded on deeds. See Henry Boot Construction Ltd v Alstom Combined Cycles Ltd [2005] 1 WLR 3850 at 3873-4; [2005] EWCA Civ 814 at [66] per Dyson LJ (with whom Sir Andrew Morritt VC and Thomas
LJ agreed).
In most jurisdictions the period is 12 years. See eg Limitation Act 1969 (NSW), s 16. A period of 15 years applies in South Australia and Victoria (Limitation of Actions Act 1936 (SA), s 34; Limitation of Actions Act 1958 (Vic), s 5(3)). Under s 18 of the Limitation Act 2005 (WA) the period is 12 years (but if s 38(1)(e) of the Limitation Act 1935 (WA) applies the period is 20 years).
Building Actions
The limitation periods stated above may be affected by s 109zk of the Environmental Planning and Assessment Act 1979 (NSW), and equivalent provisions in other jurisdictions: s 134 of the Building Act 1993 (Vic), s 142 of the Building Act 2004 (ACT), ss 159 and 160 of the Building Act 1993 (NT), s 73 of the Development Act 1993 (SA) and ss 255 and 266 of the Building Act 2000 (Tas).
The most recent case on one of these provisions − the Victorian Court of Appeal in Brirek Industries Pty Ltd v McKenzie Group Consulting Pty Ltd [2014] VSCA 165 − found that s 134 of the Building Act 1993 (Vic) replaced the six-year period under the Limitation of Actions Act 1958 (Vic) for an action on a simple contract with the 10-year period provided for by the Act.
Commencement of Limitation Period
There is no doubt about the general principle where a cause of action is founded on simple contract or deed. A cause of action in damages for breach of contract accrues at the time of breach. Therefore, the general rule is that time begins to run from that date.
That is qualified, at least for an action in tort (where the six-year period also applies) in relation to loss or damage sustained by the owner of a building which is attributable to a latent defect. In that situation, the cause of action arises when the defect becomes manifest or is otherwise capable of being discovered with reasonable diligence. See eg Christopoulos v Angelos (1996) 41 NSWLR 700.
Since the common law conceives that loss or damage is a prerequisite to being able to claim on an indemnity, the general principle is that time commences to run from the moment loss or damage is first suffered. Wardley Australia Ltd v State of Western Australia (1992) 175 CLR 514 is High Court authority illustrating application of that principle. But the actual position must ultimately depend on the contract. When the cause of action accrues is a question of construction. So also is the question of what amounts to ‘loss’. See Wardley (1992) 175 CLR 514 at 524. Construction contracts frequently include very broad definitions of the concept of ‘loss’. Typically, loss will be defined to include ‘liability’.
The position under s 109zk of the Environmental Planning and Assessment Act 1979 (NSW) (and equivalent legislation in other jurisdictions) is somewhat different. For a ‘building action’, that legislation identifies specific events for the commencement of the limitation period – eg the issue of an occupancy permit. Once the fixed 10-year period has expired, a ‘building action’ cannot be brought.
Fitness for Purpose
One context in which the commencement of the limitation period may be of particular importance is when an indemnity is given in respect of a fitness for purpose warranty.
At common law, there is an implied warranty of fitness for the intended purpose in respect of materials supplied under the contract. See, eg Reg Glass Pty Ltd v Rivers Locking Systems Pty Ltd (1968) 120 CLR 516. However, there is no implied term if the matter is dealt with expressly.
There is no implied warranty of fitness in relation to services under the common law, or in respect of the finished product. Contrast Lawrence v Cassel [1930] 2 KB 83 (sale of land with a house to be built). But, of course, express warranties may be given in relation to either matter.
Consumer guarantees of fitness may arise under the Australian Consumer Law (Competition and Consumer Act 2010 (Cth), Sch 2), for goods or services, including the ‘end product’ of services. However, they are not a concern of this paper.
Breach of warranty
Subject to the possible application of the latent defect qualification, and assuming there is no indemnity if there is a breach of a fitness for purpose warranty, the cause of action in contract accrues at the time of supply.
At least so far as the principal-contractor agreement is concerned, the cause of action will usually accrue at the date of practical completion. From that moment, the breach of warranty entitles the principal to claim damages. (The position may be different for breach of an agreement between the contractor and a sub-contractor.)
If the work has been done on the principal’s land, the measure of loss under the claim for damages is presumed to be the cost of making the work done conform to the requirements of the contract. See Bellgrove v Eldridge (1954) 90 CLR 613. (That measure is, of course, subject to mitigation considerations.)
Indemnity Claims
The question is whether having an indemnity makes a difference to commencement of the statutory limitation period. The issue is, as noted above, always one of construction. There are two important variables: the trigger event and the loss. Assume that the trigger event specified in the indemnity is the contractor’s breach of contract. For example, the indemnity might provide:
‘The contractor must indemnify the principal in respect of any loss caused by breach of the fitness for purpose warranty …’
Variations in the formulations of the warranty are unlikely to have an impact on the occurrence of trigger event. For example, the warranty may be in form to the effect that:
‘… the work will be and will remain fit for its intended purpose for [X] years.’
Unless the builder is also required to maintain the work in a particular state, any breach of this warranty occurs, once and for all, at the time of practical completion. See Larking v Great Western (Nepean) Gravel Ltd (1940) 64 CLR 221 at 236 per Dixon J. Cf KG Bominflot Bunkergesellschaft für Mineralöle mbH & Co v Petroplus Marketing AG (The Mercini Lady) [2011] 1 Lloyd’s Rep 442 at 446; [2010] EWCA Civ 1145 at [21] per Rix LJ (with whom Maurice Kay and Patten LJJ agreed). Therefore, there is no reason to think that the trigger event has been postponed by the ‘will remain fit’ wording.
But is the principal’s right of action on the indemnity enlivened by the occurrence of the trigger event (breach of warranty) or the occurrence of loss from that event? As a matter of general principle an indemnity is concerned with loss from an event, not the event itself. The event (breach of warranty) may coincide with the occurrence of loss. The cause of action on the indemnity will then accrue at the same time as the breach of the warranty. Alternatively, the loss may occur after the breach of warranty and the right of action on the indemnity will, accordingly, accrue at that later time. However, it is difficult to envisage situations in which, although the fitness warranty has been breached, the principal has suffered no loss. In respect of building work, if the work is not fit for purposes the asset will surely be worth less than it would otherwise be.
The central question is: what is the principal’s loss? Unless ‘loss’ under the indemnity is expressly defined, there is no simple answer. It must depend upon construction of the contract and characterisation of the adverse circumstances. One possibility, which might also be adopted expressly by appropriate drafting, is that the loss is the cost incurred in the carrying out of remedial work. If so, the cause of action on the indemnity may not accrue until the principal commences remedial work, that is, actually incurs costs in remedying defects in the work.
As also noted above, generally sophisticated construction contracts rely on broad definitions for concepts of ‘loss’ and ‘liability’.
Accordingly, instead of relying on the usual broad generic definition of loss, the contract may expressly provide that for the purpose of the indemnity ‘loss’ is the ‘cost and expense incurred by the principal in remedying defects in the work’.
Further issues arise if the indemnity requires the principal to make a demand.
Demand
General position
At the time of practical completion the principal may not know that the work is unfit, or what amount can be claimed under the indemnity (generally, the costs of remedial work). The principal may therefore wish to postpone making its demand on the indemnity.
The mere fact that the precise amount that can be claimed under the indemnity is still to be determined is not in itself a basis for saying that the limitation period commences to run at a later date than it otherwise would. Commencement is not deferred until the principal actually makes its demand on the indemnity. See Scott Lithgow Ltd v Secretary of State for Defence 1989 SC (HL) 9 at 20-2 per Lord Keith, with whom the other members of the House of Lords agreed. Therefore, the fact that the principal may prefer to delay postponing its demand under the indemnity until the full amount to be claimed has been determined is irrelevant.
Obligation to meet demand
The position is not changed by making express reference to a demand by the principal. Three situations can be contrasted.
First, as a matter of construction, an express provision for the making of a ‘demand’ may simply emphasise that the principal is not required to allow the contractor any opportunity to remedy defects in the work done (or materials supplied). To put it another way, the parties have limited the mode of performance of the indemnity to the payment of compensation. This is probably the usual situation. Defects liability periods, during which the contractor may be required to remedy defects in the work are typically for much shorter periods than statutory limitation periods.
Second, the indemnity may be drafted so as to require the contractor-indemnifier to pay any amount demanded by the principal when the demand is made. Third-party performance bonds and the like are often drafted in this way. However, it may be an element of a party-party indemnity between the principal and the contractor. Provided the demand is a bona fide demand, the contractor must meet it. Of course, the amount demanded might not correspond to the principal’s actual loss. To accommodate that possibility, the contract may also require a later process of accounting between the parties to ensure that the principal receives no less and retains no more than the amount of its actual loss. Although a failure to meet the demand may perhaps give rise to a distinct cause of action, it is not open to the principal to postpone the making of the demand beyond the limitation period.
Expressed more simply, the principal must make any demand on the indemnity within the applicable limitation period, determined in the ordinary way.
Prior demand may be made a precondition
Third, prior demand may be made a precondition to any action on the indemnity. Expressly making a demand by the principal a precondition to any action on the indemnity does not appear to be common.
Logically the precondition would be associated with some procedure under which an alleged defect in a contractor’s work is investigated to ascertain responsibility for the defect, and the amount of liability of the person responsible. If liability on the part of the contractor is established under that procedure, the principal is entitled to make a demand. See Wayne Courtney, Contractual Indemnities, Hart Publishing, Oxford, 2014, §5-13.
In such a situation, although the breach of warranty occurs at the time of practical completion, since demand by the principal is an ingredient of the cause of action on the indemnity, time only runs from the making of the demand. Cf Wardley (1992) 175 CLR 514 at 525 per Mason CJ, Dawson, Gaudron and McHugh JJ.
Whether the procedure would be of much assistance to the principal from a statute of limitations perspective may be doubted. Two points can be made. One is that drafting an indemnity so as to make demand a precondition does not entitle the principal to ‘sit on its hands’. Even if it is assumed that there is an agreed procedure which does not include specific time limits, it would almost certainly be implied that the principal must act with reasonable diligence, and within a reasonable time.
The other point is that if there is no agreed procedure, and therefore no obligation on the principal to institute any steps to investigate responsibility for the defect and to quantify the amount of the claim, once the principal becomes aware of the breach of warranty, it will usually be required to act with reasonable diligence. If it does not, issues of estoppel and mitigation of loss may well arise.
Conclusions
In this brief paper we have considered the interaction between limitation periods, contractual indemnities and the liability of contractors under building contracts. We have not, however, sought to address the question whether the parties to a building contract may agree to a longer limitation period than would otherwise apply under the applicable statute of limitation (including provisions such as s 109zk of the Environmental Planning and Assessment Act 1979 (NSW)).
The background to the analysis is the existence of fixed statutory limitation periods for breach of contract (including building actions) under statutes of limitation. The focus of the analysis is the time for commencement of the limitation period where the liability regime includes an indemnity by the contractor in favour of the principal. An important context is the impact of an indemnity on the contractor’s responsibility under a fitness for purpose warranty. In relation to the question whether an indemnity improves the principal’s position from a statute of limitation perspective, the general answer is that an indemnity does not necessarily have that effect. There are five points.
First, an indemnity may take various forms, and have different legal effects.
Second, the interaction between the indemnity and the commencement of the statutory limitation period is in all cases a question of construction. It follows that whether the indemnity at issue impacts on the commencement of the limitation period depends on terms of the particular contract.
Third, most indemnities conform to the common law presumption that no action may be brought on an indemnity until loss or damage within the scope of the indemnity is suffered by the principal. However, since a fitness for purpose warranty is breached at the time of practical completion, and because in most (if not all) cases loss or damage will be sustained at that time, the limitation period will commence to run from practical completion.
Fourth, where relevant provisions such as s 109zk of the Environmental Planning and Assessment Act 1979 (NSW) will provide a fixed end date to a right to call on an indemnity regardless of when loss is suffered.
Fifth, the fact that the indemnity refers to a ‘demand’ by the principal will generally have no consequences because the principal must make its demand within the limitation period. In other words, if loss or damage (within the scope of the indemnity) has been suffered, the limitation statutes do not postpone commencement of the limitation period until a demand is made in respect of that loss or damage. However, it is in principle possible by appropriate drafting to postpone the suffering of loss or damage in respect of which a demand may be made.
For further information, please contact:
Hamish Macpherson, Partner, Herbert Smith Freehills
hamish.macpherson@hsf.com
