Indemnity

An indemnity is a promise by one party to compensate another for losses suffered due to a specific event (ie the 'trigger event').

The trigger event can be anything defined by the parties, including:  

• a breach of contract

• a party's fault or negligence

• a specific actio

An indemnity operates as a transfer of risks between the parties and changes what they would otherwise be liable for or entitled to under a normal damages (eg compensation) claim.

Indemnity clauses are used to manage the risks associated with a contract. They enable one party to be protected against  losses that may arise from the actions of another party. Indemnities are particularly useful when the actions of one party are likely to create a risk that the other party would otherwise have to bear.

For example, suppose a manufacturer sells products to a retailer. The retailer may fear that, if the products are defective, the retailer will be exposed to product liability claims by consumers. The retailer will usually seek an indemnity from the manufacturer against those claims, in order to be compensated if such claims arise.  

Indemnities are used in a wide variety of contexts and there is no general rule about when to give an indemnity. Wheter or not one is appropriate depends mostly on the circumstances of the contract (eg if the contract is a high-risk contract), the parties' willingness to indemnify, and their relative bargaining positions. A party who is in a stronger negotiating position is more likely to ask for an indemnity from the other party, whereas a party in a weaker position is less likely to ask for an indemnity.

 It may be useful to seek an indemnity when:

• one of the parties is likely to suffer a loss from a commercial transaction, and/or

• the remedies available following a successful pure damage claim would not be sufficient to cover the loss suffered

 Examples of contracts where indemnities can be used include:

• Assignments of intellectual property rights - when assigning (ie transferring) intellectual property rights (IPRs) to someone, the assignor (ie the party transferring their IPRs) often gives the assignee (ie the party taking ownership of the IPRs) an indemnity against losses they may suffer due to defects in those rights

• software licensing agreements - when a software developer grants a business the right to use its software, there is usually an indemnity clause to protect the business against any liability arising from the use of the software, for example, if claims are brought against the business because the software was copied from a third party

• Share purchase agreements - when buying shares, a buyer often seeks an indemnity against tax liabilities of the target company (ie the company in which they’re buying shares)

On the contrary, indemnities should generally be avoided in certain contracts, for example:

• Confidentiality agreements - an indemnity for breach of contract in a confidentiality agreement should be resisted as it will potentially increase the liability of the party who's receiving confidential information, allowing the disclosing party to recover for all liabilities, costs, claims and expenses incurred in connection with the breach, as opposed to the loss it actually suffers

• consumer contracts - indemnities made by a consumer to a business are generally deemed unfair and are prohibited

Some losses generally cannot be indemnified, including:

• loss caused by the receiving party's deliberate acts - eg in an insurance contract, the insured person should not be indemnified if the trigger event results from their own intentional act (for example, if the insured person intentionally burns down their own house)

• losses caused by the receiving party's fraud or crimes - indemnities do not cover the consequences of the receiving party's own illegal acts

In certain cases, the risk of loss that may be caused by breach of a contract may exceed the contract price (ie the amounts due under it), and an indemnifying party may not be able or willing to afford an uncapped indemnity.

To manage this, the parties will often negotiate to limit the liability of the indemnifying party by capping it to a certain amount or restricting it to certain circumstances. For more information, read Limitation of liability clauses.

When drafting your indemnity clause, always consider:

• which loss a party might suffer

• how the losses would arise (ie which events or actions should trigger the indemnity)

• who should pay for the losses

• to what extent the indemnifying party should pay for them

Depending on the way the clause is drafted, indemnity can cover:

• all loss caused by the trigger event - the clause can be drafted very broadly, so that the indemnifying party has to pay for all losses 'arising out of or in connection' with the trigger event, no matter how remote or indirect they may be

• a list of losses - for more certainty, the indemnity clause can include a sub-clause stating that the indemnity covers a specific list of losses, such as liabilities, costs, expenses, damages, taxes and penalties

• direct loss only - the parties can agree on a narrow indemnity clause that will restrict the indemnity to the losses directly caused by the trigger event

• the most likely loss - the indemnity can specify what a party has to pay if the trigger event occurs, excluding all other losses and amounts

As a general rule, the amount of an indemnity should remain reasonable and should not be more than what the law would allow as damages for breach of contract. Indeed, an indemnity that gives 100% recovery of all loss caused by the trigger event could constitute a very onerous obligation, which the law would not normally uphold. For more information, read Limitation of liability clauses. 

Ask a lawyer if you need help in the drafting of an indemnity clause.