Having an Effective Indemnity Clause

By Andrew Low, Lawyer, MST Lawyers

Indemnity clauses are a common feature of most commercial contracts and can be invaluable in protecting the business interests of the indemnifying and indemnified party. However, care needs to be taken to ensure that the indemnifying clause is properly drafted so that it operates in the manner sought by the contracting parties.

What are indemnity clauses?

Indemnity clauses operate as a form of risk allocation in commercial contracts. They are flexible tools and can be used in a variety of ways. Some common forms of indemnities[1] include:

1. ‘Bare’ or ‘General’ indemnities
Party A indemnifies Party B for all liabilities or losses in connection with certain events or circumstances without setting any specific limitations. These indemnities are often silent on whether the indemnity extends to losses arising from Party B’s own acts and/or omissions.

2. Reverse indemnities
Party A indemnifies Party B against losses incurred as a result of Party B’s own acts and /or omissions.

3. Proportionate indemnities
Party A indemnifies Party B against losses except those incurred as a result of Party B’s own acts and/or omissions.

4. Third Party indemnities
Party A indemnifies Party B against liabilities to or claims by Party C.

5. Financing indemnities
Party A indemnifies Party B against losses incurred if Party C fails to honour the financial obligation to Party B. These indemnities are often coupled with a guarantee in financing arrangements.

6. Party/Party indemnities
Each party to a contract indemnifies the other for losses occasioned by the indemnifier’s breach of the contract.  

Why have an indemnity clause?

Having a properly drafted indemnity clause can have several advantages over a claim for damages for breach of contract:

• a claim of damages for breach of contract is limited by the common law rules of causation, remoteness, foreseeability and mitigation. Having a properly drafted indemnity clause can exclude the operation of these common law rules which reduce the damages claim;
• an indemnity may be drafted so that an indemnified party need not have actually paid the loss out of its own money to be entitled to make a claim – all that is required is that the indemnified party demonstrate that the event triggering the obligation to pay has occurred;
• an indemnified party may bring further claims under the indemnity for ongoing losses stemming from the event. By contrast, damages for breach of contract are ‘once and for all’; and
• an indemnity may be drafted so as to protect the indemnified party from the actions of a third party to the contract.

Indemnity Clauses: some things to think about

Indemnified Party

Be specific

Any ambiguity in the indemnity clause is likely to be construed in favour of the indemnifying party. It is therefore important that beneficiaries of indemnity clauses ensure that the clause is clearly drafted so as to clearly delineate what is intended to be the scope of the indemnity clause. The danger is that parties with significant bargaining strength often draft wide indemnity clauses which are non-specific. This runs the risk of being read down by courts so as to exclude liabilities or circumstances that the indemnified party intended to be covered by the indemnity.

Preventing loss or making good?

Despite being a commonly used device, there are two views on what obligation an indemnity clause places on the indemnifying party:

• Prevent loss: Some courts have interpreted indemnity clauses as requiring the indemnifying party to ‘prevent loss’ or ‘hold harmless’ the indemnified party. In such clauses, it has been held that the primary obligation of the indemnifying party is not to compensate the indemnified party for the loss. Rather, the obligation is to prevent the loss and, if they fail to do that, the indemnifying party has a right to claim damages for breach of contract.
• Making good: Other courts have interpreted indemnity clauses as requiring the indemnifying party to ‘make good’ or compensate the indemnifying party once certain circumstances are triggered.

In our experience, the reason why an indemnified party has negotiated for an indemnity clause is because they wish to bind the indemnifying party to the second obligation (i.e. to make good) so that it is entitled to monetary compensation without the need to bring a claim for damages.

If this is the case, the indemnity clause needs to be clearly drafted to provide for this. In particular, language such as ‘pay’, ‘compensate’, ‘reimburse’ or ‘make good’ should be incorporated into the clause so as to avoid ambiguity. Simply stating that one party indemnifies another may lead room for a court to imply that the obligation is to ‘prevent loss’ only.

Indemnifying Party

Limiting extent of indemnity

Indemnifying parties may seek to limit the extent of compensation to be made pursuant to an indemnity clause by:

• placing a cap on the indemnity;
• limiting the indemnity only to certain types of losses;
• requiring the indemnified party to use its best endeavours to mitigate any loss or damage; or
• excluding consequential losses.

Checking insurance policy

Some indemnifying parties may agree to an indemnity on the basis that it will be covered by insurance. This is not necessarily the case. Some insurance policies may exclude any liability assumed by the indemnifying party pursuant to an indemnity clause. Indemnifying parties should therefore closely review their insurance policies or discuss with their broker prior to agreeing to grant an indemnity.

Conclusion

Indemnity clauses are widely used in commercial contracts as a form of risk allocation and should be properly drafted so as to ensure that this is effective. The above are just a few of the considerations that should be kept in mind while negotiating and drafting the indemnity clause to an agreement.

For more information or to discuss any concerns you may have with your existing agreements, please contact our Corporate Advisory team by email corporate@mst.com.au or by telephone +61 8540 0200.

 

[1] D’Angelo N, “The Indemnity: It’s all in the drafting” (2007) 36 ABLR 93 at 104.