Indemnities in commercial contracts – more than just boilerplate

Introduction

Indemnities are regularly used in commercial contracts in order to allocate risk between contracting parties. Whether you are the party giving or receiving an indemnity, when entering into a contract which is to contain an indemnity it is important to give careful consideration to the outcome sought to be achieved and to ensure the form of words used accurately records the parties’ agreement. Failing that, unintended and potentially costly results can flow.

This article outlines:

  • the main types of indemnities encountered in commercial practice;
  • some of the more common objections raised by parties seeking to avoid giving an indemnity; and
  • some suggestions for drafting indemnities and some of the techniques that can be used to seek to curtail their impact.

Back to basics

At its core, an indemnity is a legally enforceable promise by one party to a contract to accept the risk of loss that another party may suffer in a particular situation. As a general proposition, indemnities look to make the party best able to manage a particular risk responsible for the consequences of the risk materialising.

Indemnities are often seen in situations where a party, in the absence of an indemnity, may otherwise be liable to compensate another party. A supplier of goods might indemnify its customer against claims brought against the customer by third parties – for example, where the goods are found to be defective. Indemnities can also cover situations where a party, in the absence of an indemnity, would not otherwise be liable. For instance, a party which leases equipment might indemnify the owner against losses that may flow if a third party damages the equipment. This distinction helps to explain why some indemnities tend to be more hotly debated than others.

In practice, indemnities appear in many different guises. The word “indemnify” need not be present for a party to assume the risk of loss from another party; expressions like “hold harmless”, “indemnify, defend and hold harmless”, “reimburse”, “be liable for”, “pay” or “make good” are often seen in practice, and, depending on the construction of the particular clause, may yield similar outcomes.

Other examples of how markedly indemnities can vary include:

  • Some clauses (sometimes referred to as “bare” indemnities) seek to provide blanket protection against any and all amounts and liabilities incurred in particular circumstances; other clauses have much narrower application and may be limited, for instance, to personal injury, loss of life and damage to tangible property caused by the indemnifying party;
  • Some clauses (often characterised as “proportionate” indemnities) expressly exclude from their coverage losses arising from the indemnified party’s negligence, breach of contract, wilful misconduct, fraud and/or illegal conduct, etc.; other clauses – known as “reverse” indemnities – expressly extend to the indemnified party’s own acts and/or omissions;
  • Some clauses provide indemnity in relation to breach of contract and / or negligence. The ostensible purpose of these clauses is to augment the indemnified party’s ability to recover compensation for the indemnifying party’s breach of contract / negligence; other clauses provide indemnity in relation to claims brought by third parties against the indemnified party; and
  • Some clauses seek to extend protection to third parties associated with the indemnified party (such as officers, employees, agents, related entities, etc of the indemnified party); others are limited to the indemnified party personally.

Some common objections to indemnities

By their nature, indemnities give rise to a form of contingent liability, the magnitude of which is often not possible to quantify with any certainty at the time a contract is entered into.

As a consequence, it is relatively common in practice for a party from which indemnity is sought to object to it.

Some of the more common objections include that it is not commercially fair or reasonable for the party from which indemnity is sought to be required to:

  • accept responsibility for events over which it has no effective means of control or in respect of which it is unable to obtain insurance;
  • agree that its liability is to be determined other than by reference to the common law damages rules developed by the courts; or
  • effectively act as the other party’s insurer.

How spirited and sustained an opposition is mounted will turn on a range of factors including a party’s appetite for risk.  The outcome will often be a simple reflection of the relative bargaining power of the parties.

Tips for managing indemnities

As a starting point, companies should have a clearly articulated policy which provides guidance in relation to the organisation’s position on indemnities. The benefits of such a policy include that relevant staff will have a reference point to guide internal deliberations and negotiations with third parties, thereby facilitating a consistent approach across the organisation.

Some companies will start from the position that they do not provide indemnity at all. Others will agree to provide indemnity in relation to certain matters (such as personal injury, loss of life and tangible property damage caused by their own negligence where insurance is generally available) and will draw a line in the sand there. Others will look to blunt the force of any indemnity – for instance, by seeking to qualify it in one or more of the ways identified below.

Where it is proposed to give an indemnity, steps need to be taken to ensure the scope of the indemnity is understood. This includes identifying the risk/s proposed to be covered and making an assessment as to whether those risks are manageable or the benefits outweigh the risks. Other options include exploring the availability of insurance coverage for the risks likely to be covered by the clause. In exceptional situations, a party might need to be prepared to walk away from an arrangement where the level of risk sought to be transferred is not commercially palatable.

Where it is determined to entertain an indemnity, a number of devices can be employed to try to dilute its effect. These include:

  • limiting the indemnity to “direct” or “reasonably foreseeable” loss and damage;
  • avoiding the use of phrases such as “arising from or in connection with”, “arising directly or indirectly in relation to”;
  • excluding loss and damage to the extent caused by the indemnified party’s breach of contract or negligence, etc.;
  • limiting the coverage of the indemnity to the indemnified party only and refusing to indemnify directors, officers, employees and other third parties;
  • requiring the indemnified party to take reasonable steps to mitigate its loss;
  • limiting the indemnity to “reasonable” costs and expenses incurred by the indemnified party (as opposed to “indemnity” costs);
  • requiring the indemnified party to consult with, or preferably give control to, the indemnifying party in respect of the conduct of any third party claim in relation to which indemnity is or may be sought; and
  • bringing the indemnity within the scope of a broader limitation of liability regime.

Where indemnities are given, it is prudent for an organisation to maintain a register including details of the relevant contract and clause for audit and reference purposes.

Conclusion

Properly used, indemnities can help provide increased certainty to contracting parties. They can be a useful device to shift liability to the party best placed to manage a particular risk and can also help to simplify recovery.

On the other hand, if not used with care, indemnities can produce unintended and sometimes costly outcomes.

Wherever possible, contracting parties should carefully analyse and agree the risk allocation sought to be achieved in a particular scenario and ensure that agreement is clearly articulated in their contract. Despite best intentions, that kind of analysis is sometimes impracticable. In those cases, there is benefit in having a policy to guide the degree to which indemnities will be tolerated.

Either way, maintaining a clear and consistent approach to indemnities, and promoting awareness of their nature and effect, is an important component of any organisation’s risk management program.


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