What is an indemnity clause?
An indemnity clause is a promise by one party (the indemnifying party) to be responsible for and cover certain types of loss or damage of the other party (the indemnified party). Indemnities should usually be used in circumstances where it would be unfair for the indemnified party to bear the relevant losses or damages. Indemnities might apply, for example, to loss or damage resulting from third party claims that relate to activities under the relevant contract; or to loss or damage resulting from the indemnifying party’s breach of the relevant contract.
Why are indemnity clauses often problematic?
Indemnity clauses operate as a risk management tool for the indemnified party, by shifting risk and responsibility onto the indemnifying party. This can result in differing views on the scope and application of a proposed indemnity. In particular, an indemnified party may seek to place an unreasonable amount of risk on the indemnifying party by making the scope of events for which it is responsible, or the scope of losses and damages for which it is liable, too broad. The indemnifying party will usually prefer for responsibility and liability for losses to depend on the circumstances of the relevant events and, if necessary, to be determined by a court or tribunal, rather than being specified in an indemnity clause.
Indemnity tips
The following are some suggested questions that contractual parties and their legal advisors can consider to help assess a proposed use of an indemnity, and try to avoid having their negotiations get bogged down in discussions around the indemnity clause.
1. Is an indemnity necessary?
Just because a precedent contains an indemnity clause doesn’t mean an indemnity is actually a necessary or appropriate means of risk allocation for the transaction at hand. Consider these questions:
(a) Has a proper risk analysis been carried out?
(b) What risks or heads of loss do the parties potentially face?
(c) Which party should bear each of the risks identified?
(d) For each of the risks identified, are remedies for breach of contract sufficient?
The answer to these questions will help you to understand precisely where an indemnity may be necessary or appropriate (if at all).
2. What sort of indemnity?
Some indemnities are drafted to apply between the contracting parties (e.g., breach of warranty). Others are drafted to protect a contracting party against third party claims (e.g., infringement of third party intellectual property). Sometimes these concepts are rolled together in one clause. You should make sure the indemnity clause in your agreement fits with the facts. Don’t assume that a precedent clause will cover your needs.
3. What should be excluded from the indemnity?
It is common for an indemnity clause to exclude indirect and consequential losses as well as punitive and exemplary damages. Given the uncertainty surrounding the meaning of “indirect and consequential”, it is usually wise to exclude particular types (or “heads”) of loss which, if included, would make the indemnity too broad in scope. Commonly, excluded heads of loss are: loss of revenue and profits; loss of business opportunity; loss of goodwill; and loss of data.
4. Should the indemnity be limited?
An unlimited indemnity may expose a party to risk or loss beyond what is commercially reasonable in the circumstances. Common ways of limiting an indemnity include:
(a) Restricting its application to a particular type of loss or damage – e.g., breach of the warranty in clause x.
(b) Capping the indemnity at a maximum monetary amount. This could be an agreed sum (e.g., $1 million) or expressed as a multiple of the value of the contract (e.g., 3 times the fees paid).
In this way, the extent and quantum of a party’s liability can be known – which may help with board sign-off or insurance cover.
5. Tips for avoiding problems down the track
If an indemnity clause is ambiguous or uncertain, it runs the risk of litigation to enforce it and/or it being read down in favour of the indemnifier. To reduce this risk:
(a) Be explicit! Don’t be afraid to draft the indemnity so it says exactly what you need it to say in plain language. For example, if you intend the indemnity to extend to third party claims, say so expressly and use the words “third party claims”. If in doubt, spell it out!
(b) Ensure a “meeting of the minds”. Because indemnities can be emotive, the temptation can exist to just use the familiar standard clause which perhaps won’t be focused on by the other side. This should be avoided. A purposely drafted and negotiated indemnity clause stands a greater chance of being effective.
Don’t seek unnecessary or unreasonable indemnities. The temptation sometimes exists for a party with a stronger bargaining position to seek a broad and unlimited indemnity in its favour. However, a deliberately targeted and commercially reasonable indemnity is a lot less likely to be contested down the track. It is better to get an indemnity that adequately covers your risk and that is accepted by the counter-party, rather than to try to get an unnecessarily broad indemnity that the counter-party will contest if you try to enforce it in any case.
