Legal Briefing

Number 79

26 July 2006

Indemnities in Commonwealth contracting

Linda Richardson Special Counsel
T 02 6253 7207 F 02 6253 7301
linda.richardson@ags.gov.au

Andrew Miles Senior Executive Lawyer
T 02 6253 7100 F 02 6253 7316
andrew.miles@ags.gov.au

Shaun Tipson Lawyer
T 02 6253 7483 F 02 6253 7316
shaun.tipson@ags.gov.au

Risk is an essential consideration in all commercial transactions. Risk determines whether a transaction is viable, and risk is an indispensable – albeit often overlooked – component of the transaction’s total price. In the Commonwealth context, risk management is a key motivation behind the Commonwealth Financial Management and Accountability (FMA) framework.¹

This briefing discusses how risk can be allocated and managed through the use of transactional documents such as contracts and leases, and in particular by a particular type of contractual clause: the indemnity. This briefing also discusses how indemnities are regulated by the FMA framework, before considering the associated issues of limitations on liability and insurance.

Terminology

In this briefing, risk is used to mean the chance of something happening that will have an impact on objectives. Risk is often specified in terms of events and consequences, and the magnitude of risk is normally determined by the combination of the consequences of an event and the likelihood of that event occurring.²

Another term for the consequence of a risk occurring is damage,³ which goes hand in hand with the legal responsibility for the damage, or liability. Legal agreements such as contracts and deeds assign to one or more parties the liability for damage in the event that a specified risk occurs. An indemnity (without pre-empting the discussion which is set out below) is a particular type of contractual clause that allocates liability between parties, and is normally expressed in the form of one party ‘indemnifying’ another for a particular class or classes of liability.

In this briefing there is an assumption that the Commonwealth is dealing with a provider of goods or services, who will be referred to as the contractor. The contractor could be anyone – it could be a landlord under a lease, a builder under a works contract, an IT provider, a specialist consultant engaged by the agency to provide, for example, audit, accounting or legal services. It could be an outsourced payroll function provider, a provider of travel services, a director of a Commonwealth authority or company or a supplier of goods to the Commonwealth. The discussion is equally applicable to all of these scenarios, but the single term ‘contractor’ is used for convenience.

Sources of liability

Before examining indemnities in more detail, it is worth commenting on the general nature of contractual liability. One of the primary purposes of all legal agreements is to regulate liability (the other, related, purpose is to provide an agreed statement of the nature of the parties’ relationship). It is obvious that when a party enters into a contract it is entering into a legally binding arrangement under which it can incur legal liability to the other contracting party for breach of that contract. However, this does not mean that breach of contract is the only means by which a party may become liable, or that the potential scope of liability is limited to the clauses of the contract.

For example, the Commonwealth can lease land from another person, and then conduct an activity which is noisy and noxious and has an adverse affect on other tenants. This could be a breach of the lease for which the Commonwealth would be liable to the landlord. But it could also give rise to liability under other causes of action at the same time. It could also be the tort of nuisance or a breach of applicable environmental legislation.

Identifying all possible sources of potential liability is part of risk management generally. It is particularly relevant to indemnities, however, since being aware of the scope of potential liability assists greatly when it comes to actually considering the terms of proposed indemnities and determining whether they extend the Commonwealth’s liability beyond that for which it would be liable in any case (such as in negligence).

Indemnities

At law, an indemnity is a legally binding promise by which one party undertakes to accept the risk of loss or damage another party may suffer. Essentially, it is a promise to ‘hold harmless’, and these exact words are often used in indemnity provisions, particularly older ones.

The classical form of indemnity is an insurance contract. Under an insurance contract, an insurer agrees to indemnify the policyholder in respect of certain specified losses and liabilities on the occurrence of certain specified events. In this case, the whole contract is one of indemnity.

The context of this briefing is contractual indemnities, which are a specific class of indemnity. A contractual indemnity is typically one provision of a larger commercial arrangement which states that a party agrees to hold harmless another party against the risk of loss or damage that that other party may suffer (including that party’s liability to third parties for third party loss resulting from activities under the contract).

In the sphere of Commonwealth contracting, indemnities given by the Commonwealth (referred to in this briefing as Commonwealth indemnities) are particularly significant because the legal, policy and financial framework within which Australian Government agencies enter contracts gives specific recognition to, and has specific policies intended to deal with, Commonwealth indemnities.

Commonwealth indemnities in favour of a contractor

Three perspectives on indemnities

In assessing an indemnity in the Commonwealth context, there are three relevant perspectives – all of which are closely related to each other:

First, from a commercial perspective: that is, what are the commercial implications of the Commonwealth granting an indemnity to a contractor in relation to a particular contract? That is, what is the potential cost of this commitment requested by the contractor?
Second, what are the implications of a proposed indemnity from an FMA and Commonwealth policy perspective? This deals with the requirement to obtain authorisation under any applicable regulations, where necessary, and to consider Commonwealth and departmental policies in approving proposed spending proposals.
Third, what are the implications of granting a proposed indemnity on the insurance coverage enjoyed by a Commonwealth agency?

The second and third perspectives are discussed later in this briefing. However, before looking at the nature of indemnities in more detail, it should be emphasised that the consequence of the first perspective is that a decision to grant an indemnity by the Commonwealth is a commercial decision. It is not a legal decision, although an informed commercial decision will often be made with the assistance of legal advice.

Anatomy of an indemnity

Invariably, an indemnity can be broken down into four constituent components – ‘who’, ‘what’, ‘when’, and ‘how’.

Take the example of a lease where the Commonwealth is the proposed tenant. The landlord has requested the grant of an indemnity in the following terms:

The Commonwealth indemnifies the Landlord in respect of all actions, claims, proceedings, losses, costs, expenses and damages for which the Landlord suffers, incurs or becomes liable and which arise from the Commonwealth’s use and occupation of the premises.

Who gets the benefit of the indemnity?

Considering each of the four elements: the ‘who’ refers to the person that the Commonwealth is indemnifying, in this case the landlord. In the case of contractual indemnities, the ‘who’ will almost invariably be the contractor, although sometimes the language used in the contract will be broad enough to extend the ‘who’ to also include the contractor’s officers, employees, agents, subcontractors and in some cases related parties such as holding companies.

What types of liabilities does the indemnity cover?

The second element is the ‘what’. This refers to those things in respect of which the indemnity is granted: in this case ‘all actions, claims, proceedings, losses, costs, expenses and damages’. These are fairly standard terms in an indemnity.

Clearly there can be a range of different types of liabilities that might be picked up by this type of language, including liabilities for:

tangible losses (e.g. death and injury, damage to property)
intangible losses (e.g. infringement of intellectual property rights, damage to data, disclosure of personal or confidential information)
pure economic losses (e.g. statutory fines or penalties, lost productivity, loss of opportunity).

When is the indemnity applicable?

The third element is the ‘when’. In this case, it is: those things ‘for which the Landlord suffers, incurs or becomes liable’. Note that it could have just said those losses, costs etc. ‘for which the Landlord becomes liable’, which is much narrower than losses, costs etc. which the landlord suffers or incurs. This is because the use of the term ‘liable’ implies a legal obligation to pay (i.e. no choice), but in the case of losses ‘incurred’, this is broad enough to encompass voluntary expenditure incurred by the landlord in the absence of legal compulsion.

How is the indemnity triggered/what does it cover?

The fourth element, the ‘how’, is the most important element of all because it is the trigger that invokes the indemnity. In this case, the trigger is all those things ‘which arise from the Commonwealth’s use and occupation of the premises’. This is extremely broad. This indemnity can be activated whether or not there is any fault on the part of the Commonwealth.

A much narrower provision would be something like ‘arising out of the negligence of the Commonwealth’. This actually requires actionable negligence on the part of the Commonwealth before the indemnity is triggered. Importantly, this form of indemnity, subject to one qualification, does not extend the Commonwealth’s exposure beyond that for which it would be liable, since the common law of negligence would apply in any event (this is especially significant in the context of Comcover insurance – see page 12ff.).

Legal costs under indemnities

The one qualification is this: while the indemnity does not go any further in imposing additional causes of action, it can go further in relation to the award of costs following a court case. Generally, after one side wins a court case it will be awarded costs, but the winning party does not usually get 100% of those costs. However, under this indemnity the landlord would be entitled to 100% of its legal costs. So, commercially, the indemnity does go a little further than the common law in that respect. But it does not expose the Commonwealth to liabilities by way of additional causes of action.

Meaning of ‘suffers or incurs’

In the case of the broader ‘suffers or incurs’ wording, though, the indemnity could result in the Commonwealth incurring liability for which it would not otherwise have been liable. The expression ‘arising out of the Commonwealth’s use and occupation’ is broad enough to capture those things which are not actionable but which nevertheless cause the landlord loss. For example, if the Commonwealth builds a structure on the land with the landlord’s consent which blocks out the light and air flow to a neighbouring tenant, and that tenant successfully sued the landlord for derogating from the grant of its lease, the landlord may be able to recover the lost rent from the Commonwealth, despite the landlord’s earlier consent.

Even standard form indemnities need careful consideration

In summary, indemnities come in all shapes and sizes, although the wording (especially in similar classes of legal agreement) can be similar. Nonetheless, it is important to examine the terms of an indemnity before allowing its insertion into a contract, since seemingly innocuous indemnities have the potential to markedly increase the Commonwealth’s risk exposure. An example is a clause which indemnifies a specialist contractor for all liability ‘arising out of the provision of the specialist services’.

At face value, this indemnity seems reasonable. The services are being provided for the agency and it has agreed to indemnify the specialist in respect of liability arising out of the provision of the services. However, its terms are arguably wide enough to cover acts of the consultant which are fraudulent, reckless or negligent. So, if the consultant was fraudulent and incurred liability because of that fraud he or she could arguably seek recourse for the loss from the Commonwealth.

As a general rule, for indemnities that go beyond a mere restatement of the common law position, the only way to determine the Commonwealth’s additional risk exposure is to carry out a risk assessment (the broader implications of giving such an indemnity in the Commonwealth FMA framework are discussed in the next section).

The Commonwealth FMA framework

A complete description of the Commonwealth FMA framework is beyond the scope of this legal briefing. For this reason, the following discussion focuses on the key aspects of the FMA framework relevant to risk, liability and indemnities.

The FMA framework is underpinned by the Financial Management and Accountability Act 1997 (Cth) (FMA Act) and the Financial Management and Accountability Regulations 1997 (Cth) (FMA Regulations).

FMA Regulations

The FMA Regulations provide the following:

The Chief Executive of an agency may give instructions (to be called Chief Executive’s Instructions) (CEIs) on various matters, including ‘making commitments to spend public money’ and ‘acquiring property that is to be public property’. (FMA Regulation 6)
The Finance Minister may issue guidelines (to be called Commonwealth Procurement Guidelines) (CPGs) about matters relating to the procurement of property and services, including ‘matters affecting Commonwealth contracts’. (FMA Regulation 7)
An official performing duties in relation to the procurement of property or services must have regard to the CPGs (FMA Regulation 8(1)), and an official who takes action that is not consistent with the CPGs must make a written record of his or her reasons for doing so. (FMA Regulation 8(2))
An approver must not approve a proposal to spend public money unless satisfied after reasonable inquiry that the proposed expenditure ‘is in accordance with the policies of the Commonwealth’ and ‘will make efficient and effective use of public money’. (FMA Regulation 9)⁴
An approver must not approve a spending proposal for which an appropriation of money is not authorised by the provisions of an existing law or a proposed law before the Parliament unless the Finance Minister has given written authorisation. (FMA Regulation 10)
A person may not enter into a contract, agreement or arrangement under which public money is, or may become, payable unless the proposal to spend the money ‘has been approved under regulation 9 and, if necessary, in accordance with regulation 10’. (FMA Regulation 13)

When a contract is silent as to how liability is allocated between the parties for risks arising because of the contract, each party’s liability will be determined at general law on the facts of each event. To provide greater certainty to the parties, a liability regime may be agreed and set out in the contract. Often the liability regime will shift liability that would have fallen on one party at general law to another party. To achieve this outcome, the regime will impose a contractual obligation to pay money if a specified event occurs (such as an indemnity). This is called a contingent liability (i.e. the liability to pay is contingent upon the event occurring).

A contingent liability relates to money that ‘may become payable’ under a contract and therefore if it is a Commonwealth liability, it must be considered as part of the total value of the spending proposal for the purposes of FMA Regulations 13 and 10. Unless the contract places a value or upper limit on the contingent liability, a risk assessment will be required to assess the dollar value of the contingent liability. If there is insufficient uncommitted appropriation to meet the total value of the spending proposal (which will generally be the case, for example, where the risk assessment cannot quantify the contingent liability), the operation of FMA Regulation 10 will be triggered.

FMA Regulation 10

Under the structure of the FMA framework, FMA Regulation 10 authorisation, where it is necessary, is the first step in the process of entering into a contract. In order, the steps are as follows:

FMA Regulation 10 authorisation, where required
FMA Regulation 9 approval of proposal to spend public money
execution of the contract by authorised person/delegate – usually a delegate under section 44 of the FMA Act.

However, it is recommended that agencies do not seek FMA Regulation 10 authorisation unless they are confident they would otherwise meet the requirements for FMA Regulation 9 approval, including compliance with the policies that relate to the operation of FMA Regulation 10.

The Indemnity Guidelines (discussed in the next section) make it clear that in most cases uncapped Commonwealth indemnities will require FMA Regulation 10 approval.

The requirement for authorisation under FMA Regulation 10 will automatically be triggered where the potential cost of the instrument is unquantifiable, except where there is an unlimited standing appropriation supporting the relevant arrangement.

So, in the lease example used above, the usual indemnity in respect of the tenant’s negligence, as standard and innocuous as it seems, does trigger the need for FMA Regulation 10 authorisation, simply because it is by definition unquantifiable. Moreover, this would be the case even where the risk assessment discloses that the risks are remote and not material risks.

However, it is possible to have a Commonwealth indemnity where there is sufficient uncommitted appropriation available to support the grant of the indemnity. This may be the case where the indemnity contains a financial limit (or where a financial limit can be calculated). It would then be possible to ascribe a quantifiable financial exposure to the grant of the indemnity and reach a conclusion that there is sufficient uncommitted appropriation for the total value of the spending proposal. Note, however, that if the available appropriation is insufficient, then FMA Regulation 10 authorisation would nonetheless be required, despite the inclusion of a limit.

The Indemnity Guidelines

The Department of Finance and Administration has issued Guidelines for Issuing and Managing Indemnities, Guarantees, Warranties and Letters of Comfort (Indemnity Guidelines). The Indemnity Guidelines were published in September 2003 as Financial Management Guidance No. 6, and publication occurred in conjunction with Finance Circular 2003/02.

The Indemnity Guidelines are a policy of the Commonwealth, and approvers are required by FMA Regulation 9 to ensure that expenditure is in accordance with the Indemnity Guidelines when considering whether to approve proposals to spend public money.⁵

The Indemnity Guidelines essentially divide indemnities into two classes:

losses or damages for which the Commonwealth may otherwise be liable even in the absence of an indemnity
losses or damages for which the Commonwealth would not otherwise have been liable without having issued an indemnity.

The Indemnity Guidelines then go on to state that:

The Australian Government’s policy on issuing indemnities, guarantees, warranties and letters of comfort is to accept such risks only when the expected benefits, financial or otherwise, are sufficient to outweigh the level and cost of the risk which the Commonwealth would be assuming. As a matter of principle, risks should be borne by those best placed to manage them – that is the Australian Government should generally not accept risks which another party is better placed to manage.

Significantly, the Indemnity Guidelines emphasise that there needs to be an explicitly identified risk before an indemnity may be granted.

Relevant factors under the Indemnity Guidelines

The Indemnity Guidelines set out an extensive list of factors that should⁶ be taken into account before an indemnity is provided, including mitigation measures and alternatives such as:

time limits on the indemnity (e.g. to claims made the during term of contract)
use by the contractor of commercial insurance
reserving a termination right for the Commonwealth
the imposition of maximum financial limits on claims
the insertion of subrogation and notification clauses that give the Commonwealth the right to take over any litigation related to the indemnity.

There is also a recommendation that the indemnity does not cover damage from acts by the indemnified person which are ‘malicious, fraudulent, wilful, illegal, reckless etc.’ This policy mirrors the Corporations Act 2001 (Cth) ss 199A–199C and the Commonwealth Authorities and Companies Act 1997 (Cth) ss 27M–27P which limit the circumstances in which Commonwealth companies and authorities may indemnify officers against their own conduct and insure them in respect of liabilities arising out of that conduct.

Requirement to seek legal advice

The Indemnity Guidelines contain a further recommendation that legal advice should be sought to ensure that the Commonwealth is exposed to the minimum risk necessary to achieve the particular objective. The questions on which legal advice is suggested to be sought are very comprehensive. They are:

whether any applicable legislation restricts the scope of executive power of the Commonwealth to enter into the arrangement (more likely to be applicable to loan guarantees than indemnities – see FMA Regulation 14(2))
whether the party to be provided with the indemnity is actually exposed to the purported risks and what the potential liabilities could be
the extent to which the proposed indemnity protects another party against liabilities imposed on them by common law or legislation and, if this is the case, the indemnity should be excluded unless there is a clear justification for the agency doing so
whether the proposed indemnity only seeks to replicate liabilities imposed on the Commonwealth by common law or Commonwealth legislation and, if so, as noted above the Indemnity Guidelines state that the provision is redundant and should be excluded unless there is a clear justification for the agency granting the indemnity (an agency may, for example, take the view that normal industry practice or likely additional costs constitute ‘clear justifications’)
the extent to which FMA Regulation 10 applies.

Risk management in the Indemnity Guidelines

A persistent theme in the Indemnity Guidelines is one of effective risk management. A number of requirements either directly or implicitly contemplate that the risk identification and assessment process has been carried out. There are references to indemnities only being granted in respect of ‘explicitly identified risks’, to ‘the expected benefits objectively outweighing the level and costs of the risks’, to agencies having ‘assessed the specific risks to be covered’, to potential losses having been ‘rigorously investigated and identified’ and to appropriate risk management arrangements being in place.

All of these references assume appropriate risk assessment and management. The Indemnity Guidelines provide a brief outline of appropriate risk management processes (see page 12), but for more detail agencies should consult A/NZS 4360:2004 Risk Management.⁷

Commonwealth Procurement Guidelines

The most recent edition of the CPGs was issued by the Department of Finance and Administration in January 2005. The current CPGs make clear that agencies should consider risk:

at the commencement of a procurement process (see [2.2])
when determining the relative value for money of proposals (see [4.4])
when deciding upon the appropriate procurement method to use (see [5.7]).

The CPGs also contain a separate section on risk (see [6.7]–[6.19]), which reiterates the principles set out in the Indemnity Guidelines. The CPGs specifically state (at [6.17]):

Arrangements to limit liability carry direct and indirect costs which must be considered within the determination of value for money. Better practice request documentation [such as RFTs] will include a draft contract with clear liability provisions, with potential suppliers required to indicate compliance against each clause of the draft contract, including liability provisions, and to clearly state and cost any alternative clauses. Request documentation may allow for any additional direct or indirect costs borne by the Commonwealth to be reflected in a commensurate adjustment to the terms of the contract where negotiations to limit a supplier’s liability occur after the nomination of a preferred supplier.

Chief Executive’s Instructions

Specific guidance to an agency’s officers on financial management is provided by the CEIs issued by the agency’s Chief Executive under FMA Regulation 6. CEIs are legally binding upon the officers of that agency under the FMA legislation.

To assist agencies in developing their own CEIs, the Department of Finance and Administration has issued Finance Circular 2004/15 Chief Executive’s Instructions. The Circular attaches Guidance on the Development of Chief Executive’s Instructions, which assume that agency CEIs will contain a section on contingent liabilities (including indemnities).

Although agency specific, in terms of providing guidance and instruction to officers on Commonwealth procurement policies and practice (including managing risk), CEIs largely encapsulate and expand upon the FMA legislation, CPGs and relevant Finance Circulars.

Associated issues

This section discusses a number of issues that are relevant to risk and indemnities but not directly within the hierarchy created by the FMA Regulations, Indemnity Guidelines, CPGs and CEIs.

Delegated authorisation

If the operation of FMA Regulation 10 has been triggered, the authorisation of the Finance Minister is required before a spending proposal can be approved. The Finance Minister has, however, delegated the exercise of his power in certain circumstances to agency chief executives.⁸

In relation to the delegation there are two initial observations:

If Regulation 10 authorisation is required, an approver under Regulation 9 cannot approve a spending proposal under Regulation 9 until the Reg 10 authorisation has been obtained.
Indemnities that do not have a quantifiable maximum financial exposure require Regulation 10 authorisation by the Finance Minister as, by definition, such an indemnity cannot be met by sufficient uncommitted appropriation (unless it is supported by a standing and uncapped appropriation).

The delegation contains a number of directions to delegates considering whether to grant an authorisation under Regulation 10. Two of the things that must be considered are:

the total amount of public money that would or could become payable under the spending proposal and when it would or could become payable
any direct or indirect risks arising from the spending proposal.

In effect, the delegation requires a risk assessment to have been carried out. Agencies contemplating seeking approval under the delegation should also consult their CEIs for agency specific guidance to delegates, and the scope of the delegation. If necessary, legal advice should be sought as to whether the spending proposal can be approved under a delegation.

Agencies should also note that it is possible to seek a determination from the Finance Minister that the delegation applies to certain spending proposals. Such a determination may be sought, for example, in cases of high-volume spending proposals such as administered discretionary grants programs.

A more detailed discussion of FMA Regulation 10 (and the delegation) is beyond the scope of this briefing.⁹ In the context of indemnities, however, it is sufficient to note that the effect of the Regulation 10 delegation is that administrative policy (as well as good commercial practice) requires agencies faced with an indemnity provision to:

first, carry out a risk assessment to determine whether an indemnity should be granted at all
secondly, if an indemnity is to be granted, endeavour to include provisions such as financial caps and time limits.

If the delegation does not apply, the matter will need to be referred to the Department of Finance and Administration. Agencies should take this possibility into account in developing their procurement timetable and strategy.

Contractor liability to the Commonwealth

This briefing has so far looked at the Commonwealth’s liability to the contractor, particularly where the Commonwealth grants an indemnity to the contractor. In this section we look at the contractor’s liability to the Commonwealth.

Typically, Commonwealth contracts will contain an indemnity from the contractor to the Commonwealth. The principles discussed above about the ‘who, what, when and how’ of indemnities are equally relevant to indemnities provided by contractors.

The two most common issues that arise in relation to contractor indemnities are liability caps and insurance.

Liability caps

What is a liability cap?

A liability cap is a contractual provision which caps the liability of the contractor to the Commonwealth under the contract to a certain amount. Often this can be a fixed dollar figure, although sometimes contracts tie the cap to the contract sum or a multiple of the contract sum. The mechanical fixing of a cap amount at a contract multiple is a practice that should be avoided where possible, since the price payable by the Commonwealth under a contract has nothing whatsoever to do with the potential liability that might arise when the contract is carried out.

Another type of cap that should be avoided is capping liability to what the contractor can recover from insurance. This type of cap is fraught with difficulty because it is likely to be reliant on:

the detailed terms and conditions of the contractor’s insurance policy (and in particular is subject to any exclusions set out in the policy)
the contractor actually complying with the requirements of the policies, so as not to void the insurance.

As a result of its activities under the contract, the contractor may be liable to the Commonwealth for loss, damage or expense that the Commonwealth has suffered directly (e.g. for damage to Commonwealth property) or indirectly (e.g. for claims by third parties against the Commonwealth for third party loss as a result of the contractor’s actions). The only way to properly determine an appropriate amount for a liability cap is through a risk assessment.

Some agencies have recently encountered some additional approval requirements where they have sought to cap a contractor’s liability for damage to Commonwealth property that is not the responsibility of the agency. AGS recently sought clarification on this issue from the Department of Finance and Administration which indicated that:

In general, an FMA Act agency Chief Executive may only cap a contractor’s liability for damage to Commonwealth property for which that Chief Executive is responsible. This follows from section 44 of the FMA Act in that a Chief Executive must manage the affairs of the agency in a way that promotes the efficient, effective and ethical use of Commonwealth resources for which the Chief Executive is responsible.

When determining whether there is sufficient justification to issue a liability cap that limits a contractor’s liability for damage to Commonwealth property which that Chief Executive is not responsible for, a risk assessment must be conducted. This risk assessment should assess the most probable expenditure that could arise if the liability cap were called upon and the likelihood of the contingency occurring. If the amount would be considered to be immaterial and if the contingency had a remote chance of occurring, the Chief Executive may consider entering into the arrangement as the risk to property for which another Chief Executive is responsible is low. If, however, the amount would be considered to be material or if the contingency had more than a remote chance of occurring, the Chief Executive would need to obtain the prior agreement of the Prime Minister, Cabinet or the Chief Executive that is responsible for the resources to which the liability cap relates. This is in addition to any requirements under both Regulation 9 of the Financial Management and Accountability Regulations 1997 (FMA Regulations) that a spending proposal must not be approved unless, among other things, it is in accordance with the policies of the Commonwealth, and Regulation 10.

Do liability caps trigger the need for FMA Regulation 10 authorisation?

Paragraph 6.18 of the Commonwealth Procurement Guidelines provides:

Agreements to limit a supplier’s liability to the Commonwealth or a third party that take the form of an indemnity, guarantee, warranty or letter of comfort provided by the Commonwealth, come within the scope of a ‘contract, agreement or arrangement under which public money … may become payable’ under FMA Regulation 13. The full potential cost to the Commonwealth as a result of these instruments must be considered, and if necessary, authorised under FMA regulation 10 before the spending proposal can be approved under FMA Regulation 9.

If the Commonwealth agrees to cap the contractor’s liability and indemnify the contractor for liabilities that the contractor may incur above the cap, FMA regulation 10 authorisation will be required unless there is an uncommitted appropriation to cover the indemnity.

Where the Commonwealth agrees to cap the contractor’s liability and does not agree to indemnify the contractor for liabilities above the cap, there are two distinct situations.

In the first situation, where the liability cap relates only to the Commonwealth’s own direct loss (e.g. damage to Commonwealth property), the effect of a liability cap is that the Commonwealth may need to find funds to meet a potential cost (e.g. to replace that property), in circumstances where it would otherwise have been able to recover those amounts from the contractor but for the existence of a liability cap. If it chooses to expend those funds at that time, then that will be the subject of a separate spending proposal subject to the FMA framework. Accordingly, the Department of Finance and Administration has advised that in its view FMA regulation 10 approval is not required in these circumstances (although, as discussed above, approval from Comcover and possibly other agencies may be required in some cases).

The second situation is where the limitation extends to Commonwealth liability to a third party and the Commonwealth may have a legal obligation to pay money to a third party (e.g. as a result of a court judgment against the Commonwealth), where it cannot recover part or all of that amount from the contractor because of the liability cap. This area is more complex and may raise FMA regulation 10 authorisation issues that require specific legal advice. The Department of Finance and Administration also advises agencies to consult with it on a case by case basis.

AGS understands that the Department of Finance and Administration is considering whether additional guidance in this area would assist.

Liability caps should comply with the Indemnity Guidelines

While indemnities and liability caps are different legal structures, they can end up having much the same result. For this reason, both the FC2003/02 Finance Circular and the Guidance to the FMA Regulation 10 delegation state that the provision of a liability cap must comply with the Indemnity Guidelines.

Agencies should also be aware that the CPGs state that legal advice for each proposal to limit a contractor’s liability should be obtained as appropriate to the complexity of the purchase and the level of risk (see [6.15]).

Insurance

It is beyond the scope of this briefing to comprehensively discuss the relationship between risk management and insurance.¹⁰ However, that relationship is obviously an aspect of risk management. This was given fresh impetus with the establishment of Comcover, the insurable risk managed fund, in 1998. The then Minister for Finance and Administration, in announcing Comcover stated that:

The policy of non-insurance, which has been in place since 1909, offers little incentive for public sector organisations to manage their risks effectively. The introduction of the new fund will, for the first time, require the systematic identification, quantification, reporting and management of risk across Commonwealth departments and agencies.

Many quantifiable contingent liabilities are uninsurable by nature but agencies need to have regard to those risks that are insurable risks in accordance with Comcover’s policy terms and conditions. It should be noted that Comcover, as part of its risk management services, provides advice to Commonwealth agencies on how to effectively manage risks and assists in seeking to instil a proper risk management culture via education programs and regular risk assessments.

From a practical perspective, agencies that intend to provide indemnities should be aware of Comcover policy condition 2.9.12 (effective from 1 July 2004) which excludes from coverage:

liability arising out of any indemnity unless the liability would have arisen in the absence of such indemnity.

In other words, Comcover does not cover any liability under an indemnity beyond that for which an agency would have otherwise been liable unless specific approval is obtained from Comcover beforehand. As noted above, an adequate assessment of whether an indemnity does go beyond (rather than merely restates) the common law position requires an understanding that liability of the Commonwealth can arise from different sources (and not just breach of contract).

Agencies should also be aware that the Comcover policy provides for Comcover to be subrogated to the rights of the agency when a claim payment is made. It may be a breach of the policy to agree to a proposed liability cap without disclosing that fact to Comcover under condition 2.10.3 of the policy or under 2.9.13 on the basis that the agency has ‘otherwise compromised [the agency’s] legal position’. This may entitle Comcover to refuse to indemnify the agency. AGS recently sought clarification from Comcover on this issue, and Comcover’s reply was as follows:

It must be stressed that the decision to include a liability cap within a contract is entirely the responsibility of the agency involved. There is no requirement to obtain Comcover approval for liability caps. However, if the liability cap relates to an insurable risk and the agency wishes Comcover to fund potential losses arising out[side] of the cap, then approval must be sought for Comcover’s agreement to waive its right of subrogation. This approval must be sought in advance and provided in writing.

In addition, an agency’s Comcover policy relates to the insurable risks for which that agency is responsible. If a proposed liability cap relates to insurable risks for which another agency is responsible then Comcover may need to consult that agency. This can arise where a liability cap is expressed to encompass damage to Commonwealth property, and in the circumstances of the particular contract, there is a potential for the contractor to cause damage to Commonwealth property administered by more than one Commonwealth agency.

Finally, it is important to note that insurance cover from Comcover in relation to an indemnity does not of itself mean there is sufficient appropriation to meet the contingent liability created by the indemnity and thereby avoid the need for FMA Regulation 10 authorisation.

This briefing does not look in any detail at commercial insurance which is a substantial area in its own right. However, agencies should be aware that in the context of Commonwealth contracts, the primary purpose of requiring the contractor to hold commercial insurance in relation to particular liabilities is to ensure that the contractor will have the necessary resources to meet any liabilities that arises as a result of the contract. Agencies should bear in mind that:

the fact that a person is required to hold insurance in relation to a particular type of liability does not of itself make them liable for that type of liability – the common law, legislation or the terms of the contract will determine if that liability exists
agreement to a certain level of insurance does not generally equate to agreement to limit liability to that level – agencies need to take care to avoid any misunderstandings about this issue
commercial insurance policies often contain a range of terms and conditions which can impact on whether or not a claim may be made in particular circumstances – this can have a significant bearing on the effectiveness of the policy
in some cases it is necessary to obtain specialist insurance advice in relation to proposed insurance arrangements for contractors.

Summary

In summary, the main points in this briefing are:

The decision to grant a Commonwealth indemnity is a commercial decision, not a legal one, although it should obviously be informed by sound legal advice.
It is not enough to say that a contractor has sought ‘an indemnity’; agencies need to go that further step and analyse the risks accepted under the indemnity.
In carrying out indemnity risk assessments, agencies should consider the anatomy of the indemnity by reference to the 4 step analysis described above.
Know the contents of the Indemnity Guidelines, particularly in relation to when a Commonwealth indemnity may be granted, the conditions which should be included and when to seek legal advice.
Know that most uncapped Commonwealth indemnities trigger the need for FMA Regulation 10 authorisation and that, if it is required, the authorisation must be given before FMA Regulation 9 approval can be given.
In some cases the FMA Regulation 10 approval may be given within the agency under the FMA Regulation 10 delegation but in other cases it may need to be given by the Finance Minister.
Liability caps require compliance with the Indemnity Guidelines and may or may not trigger FMA Regulation 10.
Finally, and most importantly, whether one is dealing with the legal, commercial, insurance or financial aspects of liabilities and indemnities, a risk assessment is required.

This briefing was prepared by Linda Richardson, Andrew Miles and Shaun Tipson with the assistance of Cathy Reid, National Practice Manager of AGS’s Commercial Practice Group. It supersedes AGS Legal Briefing No. 66 ‘Managing Procurement Risk and Liability’ (12 May 2003).

Linda Richardson is Practice Leader of our Commercial group in Canberra and has extensive expertise in commercial work, specifically government tendering and contracting and Commonwealth accountability. She has significant experience as a negotiator of commercial and government to government agreements and has drafted best practice guidance for various agencies.

Andrew Miles acts for government in a wide variety of commercial matters including building and construction, property acquisitions, disposals, funding agreements, finance and insurance arrangements, corporate governance and Corporations Act matters. He has particular experience in negotiating, documenting and contract managing major projects and advises on all aspects of commercial risk, including risk management and the role of warranties, indemnities and limitations on liability.

Shaun Tipson regularly advises on all aspects of Commonwealth procurement, and particularly in relation to information and communications technology contracting, where indemnities are often a fiercely contested negotiation topic. Shaun also provides general compliance advice to clients on the Commonwealth financial management and accountability regime.

Notes

This briefing uses ‘agencies’ to refer to agencies that are subject to the FMA regime. However, much of the discussion is also applicable to Commonwealth Authorities and Companies Act 1997 (Cth) bodies, in that it represents a prudent approach to the question of risk management.
Standards Australia, Australian/New Zealand Standard AS/NZS 4360: 2004 Risk Management at [1.3.13].
This briefing uses the word ‘damage’ – which implies a negative consequence – because this is the type of risk which is most often managed contractually. For completeness, note that AS/NZS 4360:2004 defines risk to include events that have both positive and negative outcomes. These positive, less often analysed, risks are often referred to as ‘opportunities’.
Reg 9 of the FMA Regulations should properly be read in conjunction with Section 44 of the FMA Act, ‘Promoting efficient, effective and ethical use of Commonwealth resources’. In that section ‘proper use’ means ‘efficient, effective and ethical use’. Managing risk is implicit in both Section 44 of the FMA Act and Reg 9 of the FMA Regulations.
A further policy of the Commonwealth relevant to this briefing is the policy in relation to indemnification of officials which is currently Finance Circular 1997/19 Indemnification of Persons Acting in an Official Capacity on Behalf of the Commonwealth or Commonwealth Bodies, available from <http://www.finance.gov.au/finframework/fc_1997_19.html>. This Circular deals with assistance in legal proceedings and potential legal proceedings, and should be considered before any indemnity in relation to legal costs is given. Note that it is understood that this policy will shortly be updated.
The Indemnity Guidelines do not impose an absolute prohibition on agencies entering into indemnities without complying with the listed preconditions (see pages 8–9). The Guidelines do, however, require any agency that does not impose one or more of the preconditions to record the reasons for doing so in writing.
Standards Australia, Australian/New Zealand Standard AS/NZS 4360:2004 Risk Management. See also Management Advisory Board, MAB/MIAC Report No. 22 Guidelines for Managing Risk in the Australian Public Service, October 1996.
The relevant delegation is the Financial Management and Accountability (Amendments relating to Regulation 10) Delegation 2003, available from <http://www.finance.gov.au/finframework/fc_2004_10.html>.
See Finance Circular 2004/10 Using the Financial Management and Accountability Regulation 10 Delegation, available from <http://www.finance.gov.au/finframework/fc_2004_10.html>.
There is a comprehensive discussion of this topic in a speech given by Ian McPhee, Deputy Auditor-General on ‘Risk Management and Governance’ to the National Institute for Governance on 16 October 2002. The speech can be accessed on the ANAO website.

AGS contacts

AGS has a national team of lawyers who provide advice on indemnities, liabilites and risk management. For further information please contact our practice leader in this area, John Scala, the authors, or any of the lawyers listed below:

John Scala Chief Counsel Commercial
T 03 9242 1321 F 03 9242 1481
john.scala@ags.gov.au

Canberra	John Snell	02 6253 7025
Sydney	Simon Konecny	02 9581 7585
Melbourne	Paul Lang Josephine Ziino	03 9242 1322 03 9242 1312
Brisbane	Robert Claybourn	07 3360 5767
Perth	Lee-Sai Choo	08 9268 1137
Adelaide	Mary Hannigan	08 8205 4287
Darwin	Jude Lee	08 8943 1405
Hobart	Peter Bowen	03 6220 5474

For enquiries regarding supply of issues, change of address details etc.
T 02 6253 7052 F 02 6253 7313 E ags@ags.gov.au

The material in this briefing is provided to AGS clients for general information only and should not be relied upon for the purpose of a particular matter. Please contact AGS before any action or decision is taken on the basis of any of the material in this briefing. © AGS All rights reserved