Indemnity clauses are commonplace in a wide variety of agreements: from share purchase agreements to software licences and contracts for the supply of goods and services. Indemnities are often the one clause that a customer really wants to have and a supplier really doesn’t want to give; so much time (and money) is spent negotiating them, often in circumstances where it’s inappropriate for them to be used in the first place.
In this (admittedly longer than usual) post, we take a look at what indemnity clauses are, what they’re meant to achieve, how they can be misused and how they should be approached.
What is an indemnity clause?
The word indemnity originates from the Latin word indemnis, which means “unhurt or uninjured, suffering no damage or loss”. An indemnity clause is a promise by one party (the indemnifying party) to be responsible for and cover the loss of the other party (the indemnified party) in circumstances where it would be unfair for the indemnified party to bear the loss. In this way, an indemnity clause is a risk management tool.
Indemnity clauses fall into two categories: those that protect the indemnified party from loss or damage resulting from third party claims (third party indemnities) and those that protect the indemnified party from loss or damage resulting from the indemnifying party’s breach of contract or warranty (inter-party indemnities).
What does an indemnity clause contain?
Indemnity clauses consist of two key elements: a description of the specific event or set of circumstances triggering the indemnity (trigger) and a description of the types of loss which the indemnifying party should be liable for (payment).
For example, an indemnity clause:
- In a share purchase agreement, may require the seller to cover the buyer for the legal costs and damages (payment) resulting from a successful unfair dismissal claim brought by a former employee (trigger), which has been identified by the buyer during the due diligence process.
- In a software development agreement, may require the developer to cover the customer for the legal and expert evidence costs and any damages (payment) resulting from a claim by a third party that the software provided to the customer infringes that third party’s intellectual property rights (trigger).
In most cases, defining the trigger should be straightforward. The payment element, however, is often a matter for negotiation. For example, the indemnified party will often want the right to recover all of the legal and professional costs and expenses incurred in defending a claim (look for the phrase “full indemnity basis”), while the indemnifying party will only want to pay “reasonable” costs and expenses.
How are indemnity clauses misused?
Depending on the context, third party indemnities are generally acceptable (for example, indemnities for third party intellectual property infringement claims in the context of software development agreements, and indemnities for third party claims for personal injury or damage to property, in the context of manufacturing and construction agreements).
Inter-party indemnities, on the other hand, are commonly misused in the following ways:
- The trigger is too broad: often, inter-party indemnities attempt to capture every breach of contract, even those that would be unlikely to give rise to any material loss or damage. Depending on how the contract has been written, any limitation of liability clause may therefore be redundant.
- The trigger is linked to a breach of warranty: a warranty is a contractual promise which, if proved to be untrue, would entitle the party benefiting from it to bring a claim for damage, much in the same way as any other breach of contract. A breach of warranty does not generally give a party the right to terminate the contract. Sometimes warranties and indemnities are combined, which increases the risk attached to the warranty.
- The trigger does not allocate risk correctly: there is often a presumption that an indemnified party should be completely blameless if an indemnified risk materialises, even though that party may have contributed to the risk materialising. For example, where a supplier manufactures a complex component to a customer’s specifications, there may be some doubt as to whether the trigger occurred due to poor workmanship, or materials, or an error in the customer’s specifications.
Why are indemnity clauses misused?
Indemnity clauses are most commonly misused for two reasons:
- That if a risk is not covered by an indemnity, a party will not have adequate means of recovering its loss if the risk materialises.
- That an indemnity clause has advantages over a claim for damages such that if they can be used, they should be used.
The first perception is often a false one. Without an indemnity clause, a party may bring a claim for damages resulting from the other party’s breach of contract, subject to any liability cap agreed between them on a commercial basis. Over centuries, the courts have developed rules for assessing such claims to achieve a fair result based on the facts, taking into account whether any loss or damage was reasonably foreseeable (i.e. not too remote) and whether the claimant took steps to reduce the impact (mitigate) of any loss or damage resulting from the breach.
The second perception requires some further unpacking. The perceived advantages of indemnities include:
- All losses are recoverable regardless of remoteness: This is often called the ‘blank cheque' argument, where the word indemnity is taken to mean that a party benefiting from an indemnity clause is guaranteed to recover 100% of its loss. While it’s true that an indemnity is intended to enable recovery on a pound-for-pound basis, this may not be the case depending on how the indemnity is drafted (e.g. including wording to refer to losses that are reasonably foreseeable only). In any case, an indemnifying party may still challenge a demand for payment under an indemnity, with the courts often showing a willingness to apply the same principles for assessing fairness as they would in a claim for damages.
- Liability under an indemnity is unlimited: This is slightly different from recoverability as explained above. Liability under an indemnity may be capped, though the 'blank cheque' argument often leads to the conclusion that limiting liability under an indemnity would not make sense.
- Recovery is easier because it creates a debt: If a claim under an indemnity is a debt claim, then it’s not necessary to bring a claim for damages for breach of contract. Instead, a simple demand for payment can be made which, if not satisfied, can be recovered in the same way as any other debt (with statutory interest running on the unpaid sum). Whether a claim under an indemnity would be treated as a debt claim depends on how it has been drafted: if the indemnity provides for recovery of a specific or calculable amount or a specific type of loss (i.e. the potential liability can be worked out beforehand), then it’s likely to be treated as a debt claim; however, if the indemnity is ‘open-ended', the courts are generally more reluctant to exclude the principles of remoteness and mitigation.
- There’s no obligation to mitigate loss: If a claim under an indemnity is a debt claim, it’s clear that there’s no obligation on the party benefitting from the indemnity to mitigate its loss (though there would probably be good commercial reasons for doing so).
If an indemnity clause can be drafted in such a way that the above advantages can be achieved, then you might wonder why parties don’t insist on inter-party indemnities all the time. Just because indemnities can be used, however, does not mean they should be. Returning to the definition of indemnity, the question to ask is whether there is a specifically identifiable risk in respect of which it would be unfair to expect a party to bear the resulting loss or damage if that risk materialises. This requires an assessment of:
- The allocation of risk between the parties through defining roles and responsibilities that are linked to contractual obligations
- The overall commercial risk of agreeing to an indemnity clause (sometimes, but not always, relative to the value of the contract)
- Whether there’s a strong enough reason to displace a claim for damages for a breach of contract with an indemnity clause (note: if an indemnity clause does not provide that it’s to be the sole remedy, a party may be able to claim under the indemnity and/or claim damages)
- The extent to which the party giving the indemnity is insured against the risk materialising
- the relative bargaining power of the parties
How should indemnity clauses be approached?
With caution! When it comes to indemnity clauses the devil really is in the detail.
As noted, third party indemnities are generally less objectionable than inter-party indemnities. When it comes to inter-party indemnities, the indemnifying party is often in a weaker bargaining position.
As such, indemnifying parties need to watch out for the following pitfalls:
- Avoiding “on demand” wording which means that payment under the indemnity has to be made as soon as a demand is made.
- The scope of the indemnity is too broad and does not contain any qualifications regarding the indemnified party’s own acts or omissions.
- Ensuring that any indemnity claim is the sole remedy and not in addition to any damages claim for breach of contract (in particular where a warranty is combined with an indemnity).
- Negotiating whether liability under the indemnity can be capped (either at the same level of the liability cap or a negotiated ‘super-cap’).
- Making sure that the indemnified party is obliged to mitigate its losses.
- Requiring the indemnified party to give prompt notice of any claims and, where possible, to give the indemnifying party conduct of any claim.
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