This bulletin forms part of our Contract Basics 101 Series, which is aimed at helping business owners and managers understand and tackle various contract law issues that they will encounter during commercial negotiations.
In this bulletin, we provide an introduction to indemnities and practical tips for business owners and managers to keep in mind during commercial negotiations.
What is an indemnity?
An indemnity is a promise or guarantee to compensate someone for loss or damage suffered.
Are indemnities required to recover loss?
Put simply, no, an indemnity is not required to recover loss suffered under a contract.
If a party has suffered loss under a contract and there is no indemnity to rely on, a party can rely on their rights under common law to make a claim for damages against the breaching party to recover the loss suffered.
Recovering loss by way of a claim for damages under common law may be considered more beneficial to parties, especially given that there are inherent checks and balances to protect both sides.
Why are they used?
While an indemnity is not required to recover loss, indemnities are commonly used because:
- they are seen as an easier way to recover loss as a party does not need to prove or demonstrate everything they would normally need to prove if they were to make a claim for damages under common law – they only need to demonstrate that the event giving rise to the indemnity occurred and that they have suffered loss or damage; and
- they can provide parties with increased certainty regarding liability under a contract.
What are the consequences of giving an indemnity?
While indemnities may be good for the party who is being indemnified, they can have some unintended consequences for the party giving the indemnity.
Contracting out of defences
One of the main consequences for the party giving the indemnity is that they are effectively contracting out of some of the defences they may have under common law. This is because a person who is being indemnified:
- may not be obliged to show any causal link between the alleged action and the damage suffered – all they have to do is show that the event that they are being indemnified for has occurred and that they have suffered loss; and
- may not need to show that they have taken any steps to try and minimise or mitigate their loss.
It is also common to find 'exclusion provisions' in insurance policies which limit or completely exclude coverage for assumed contractual liabilities (i.e. an indemnity). This means that the party giving the indemnity may not be able to recover from their insurance policy all the amounts they have paid out, or are required to pay out, under the indemnity.
When are indemnities appropriate?
An indemnity may be appropriate where there is no other practical way to manage or apportion risk fairly. Typical examples of this include situations where:
- a party is being promised something fundamental, and there is no practical way for that party to verify that promise (e.g. the other party has not infringed on someone else's intellectual property); and
- the potential impact is huge but a party has no direct control or ability to manage or mitigate (e.g. the other party is entitled to sell products with your trade marks on it).
When considering whether to ask for an indemnity, a party should first conduct an internal risk assessment and look to:
- identify potential risks and work out where they might suffer loss or damage;
- assess the likelihood of those risks occurring; and
- evaluate what steps can be taken to manage those risks if no indemnity is given.
If the identified potential risk of loss or damage is significant and cannot be effectively managed, then it may be appropriate to request an indemnity from the other party. If this is the case, the party seeking the indemnity should also consider:
- when the indemnity should come into play; and
- what the potential cost to the other party might be if the indemnity is triggered, and whether having an indemnity is fair on each of the parties.
A fairly drafted indemnity that is designed to address a legitimate concern and is not disproportionate to the risk involved is more likely to be accepted by the other party, and ultimately save time and effort in negotiations.
When are indemnities not appropriate?
If a party has been asked to give an indemnity, they should consider whether it is commercially appropriate or if there is a more appropriate remedy. For example, a party may refuse to give an indemnity for:
- a breach of contract, because the other party already has a right to claim damages for breach of contract under common law; and
- events or circumstances where the party giving the indemnity receives no benefit or has no control over those events or circumstances.
How should you approach negotiations on indemnities?
In negotiating indemnities, it is important to review the clause carefully to understand when the indemnity kicks in and what the scope of the liability is. This will help a party decide if the indemnity is acceptable, or if it needs to be finessed to make it fair for all parties involved.
In finetuning an indemnity, certain limitations or restrictions can be imposed. These may include:
- placing time restraints: the indemnity may provide a limit on when a claim can be made under the indemnity. For example, a party may only be able to make a claim under an indemnity within twelve months after the event causing the loss occurred;
- restricting recourse to certain types of loss: the indemnity may be limited to specific types of loss suffered, such as personal injury, death or damage to property;
- setting a cap: the indemnity may provide a cap on the maximum amount of money that can be claimed under the indemnity;
- limiting recourse to 'reasonable' costs and expenses: the indemnity may limit the amount recoverable under the indemnity to the 'reasonable' costs and expenses the party has incurred. 'Reasonable' costs are costs that are deemed appropriate and fair in a particular circumstance; and
- imposing an obligation to mitigate: the indemnity may include a condition that a party can only make a claim under the indemnity if they have taken all reasonable steps to mitigate their loss.
Due to the nature of indemnities, business owners and managers should always seek legal advice before entering into a contract that includes an indemnity clause.
As parties have common law rights to make a claim for damages for any loss they suffer under a contract, indemnities should generally not be given unless it is appropriate in the context of the commercial arrangement.
If an indemnity is considered appropriate, when negotiating the indemnity, parties should take into consideration the potential impact of the indemnity on their insurance coverage, their risk of exposure to liability under the contract, and whether any limitations or restrictions should be imposed on the indemnity to limit their exposure or restrict their effect.
If your contract includes an indemnity clause, reach out to our Corporate & Commercial team who can advise you on the effect of the indemnity clause in the context of your commercial arrangement, and can assist in negotiating the indemnity clause so that it protects your interests more appropriately.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.