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What's an indemnity?

An indemnity is a promise by one party to compensate another for the loss suffered as a consequence of a specific event, called 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 action

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 damage claim.

Why do I need an indemnity clause?

Indemnity clauses are used to manage the risks associated with a contract, because they enable one party to be protected against the liability arising from the actions of another party. They are particularly useful when the actions of one party are likely to create a risk which 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, it 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.  

When to give an indemnity?

Indemnities are used in a wide variety of contexts and there is no general rule about when to give an indemnity. It depends mostly on the circumstances of the contract (eg if the contract is a high risk contract), the parties' willingness to do so 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 able 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
  • the remedies available with a pure damage claim would not be sufficient to cover the loss suffered

 Examples of contracts where indemnities can be used include:

  • assignment of intellectual property rights: when assigning IP rights to someone, the assignor often gives the assignee an indemnity against loss they may suffer from defects in those rights
  • software licensing agreements: when a software developer grants a company the right to use its software, there is usually an indemnity clause to protect the company against any liability arising from the use of the software, for example in the event of claims from third parties (eg if the company gets sued because the software was copied from a third party)
  • share purchase agreements: when buying shares, the buyer often seeks an indemnity against tax liabilities of the target company

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

  • 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 paid by a consumer to a business are generally deemed unfair and are prohibited

Exclusion of indemnity

Some loss cannot be indemnified, including:

  • loss caused by the receiving party's deliberate acts: eg in an insurance contract, the insured should not be indemnified if the trigger event results from their own intentional act (for example if the insured burns their own house intentionally)
  • loss caused by the receiving party's own fraud or crimes: indemnities do not cover the consequences of the receiving party's own illegal acts

Limitation of liability under an indemnity

In certain cases, the risk of loss caused by a breach of contract may exceed the contract price, and the indemnifying party may not afford an uncapped indemnity. That is why 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.  

Drafting your indemnity clause

When drafting your indemnity clause, always think of:

  • which loss a party might suffer
  • how the loss would arise (ie which event/action should trigger the indemnity)
  • who should pay for them
  • 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 loss 'arising out or in connection' with the trigger event, no matter how remote or indirect it may be
  • a list of loss: for more certainty, the indemnity clause can include a sub-clause stating that the indemnity covers a specific list of loss, such as liabilities, costs, expenses, damages, taxes, penalties, etc
  • direct loss only: the parties can agree on a narrow indemnity clause that will restrict the indemnity to the loss 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 everything else

As a general rule, the amount of the 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 extend into very onerous obligations which the law would not normally impose.

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

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