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demystifying the indemnity

12 June 2020

We know that one of the most difficult and troublesome areas of contracts to navigate are indemnities and how they interplay with warranties and liabilities. They are often misunderstood and most often present themselves in varying form, style and substance.

This note is not intended to be chapter and verse. It is intended as a guide to help those working in-house to identify ‘red flags’ in contracts presented to them for review.

Whilst, what is agreed in any contract is always a commercial decision, this note should assist in providing useful hints and tips to effectively use a contractual indemnity. A practical tool for in-house legal teams would be a set of precedent indemnity clauses, accompanied by a set of guidelines (approved by senior management) as to when and how to use them. This would benefit in-house teams by being able to quickly cross-reference an indemnity with those in the precedents, enabling a view to be taken on whether it can be accepted or not as well as being able to use such precedent clauses for adding in to their contracts when an indemnity is required.

Many contracts make reference to a party (or both parties) giving an indemnity to the other. An indemnity may be drafted broadly (for example an indemnity against all losses, claims, demands, costs, charges etc. arising from a breach of contract) or it may be much narrower in scope (for example an indemnity against 3rd party claims for a breach, including negligence, of a statutory obligation such as data protection).

Drafted correctly, indemnities provide valuable financial protection to a business for potential losses arising from a specific risk or set of circumstances.

For example, in a research and collaboration agreement between academic institutions, each party will often make their background Intellectual Property and know-how (IP) available to the other party. Use of such IP may be limited to the purposes of the project or it may extend to being able to use that IP in commercialising both existing and new IP which is created by the project. In this example, if you are licensing in IP you will want the benefit of an indemnity from the licensing party against potential financial losses if a future claim is made by a 3rd party for infringement of the IP (which may be background or new IP depending on how the parties agree to collaborate). Universities are often in good financial health which means it may be more attractive to the third party to pursue a claim against the University1 over the other party who may have a much lower ability to provide compensation. If the University benefitted from a contractual indemnity against this event, the University would be entitled to recover its losses from the other party without having to prove that it was in some way at fault.

Drafted incorrectly, an indemnity has the potential to unduly expose one or both contracting parties to financial risk which disproportionately exceeds the actual or perceived value of the contract. Contract terms which are not clearly drafted also run the risk of being in dispute between the parties. If disputed, the parties may incur costs for (a) seeking initial professional legal advice; (b) litigation costs; and (c) resourcing of time and management and perhaps reputational damage. Before we launch into the detail of the indemnity clause, it’s important to set out some basic principles of contract law as they relate to the use of indemnity clauses. These are principles of English law in a commercial transaction2. For the purposes of this article, we are not delving into the detail of these complementary contract terms.

  1. You cannot limit or exclude liability for death, personal injury caused by negligence or for fraud.
  2. You cannot exclude liability for direct loss arising from a breach of contract or consequential losses which are deemed foreseeable as a direct loss ordinarily flowing from the breach.
  3. You can limit (but not exclude) liability for direct loss arising from a breach of contract. Any limit provided that such limit is fair and reasonable (Unfair Contract Terms Act 1977).3
  4. You can exclude liability for indirect4 loss arising from a breach of contract.
  5. If liability is not expressly limited, it is unlimited.
  6. If indirect loss is not expressly excluded, it is potentially included (subject to tests of remoteness and causation).
  7. There is no automatic right for a party to provide or receive the benefit of an indemnity. If it is not expressly stated, it does not apply.5

In its most basic terms, what is an indemnity?

  1. In general terms, it is a promise to reimburse the other party (or an identified 3rd party) on a £:£ basis6. The obligation to pay arises when the specified event occurs.
  2. Its remedy is to allow the party who benefits from the indemnity the right to pursue a debt claim. Compensatory or damages based remedies are not relevant to an indemnity. A party may give or receive a contractual indemnity against all losses arising pursuant to a breach of contract. The indemnity in this case would be subject to assessment on normal damages principles requiring one party to be at fault (i.e. there is a breach) and the financial remedy being subject to principles of remoteness and mitigation. This is in conflict with the purpose that an indemnity applies: (i) whether or not there is any fault by the party which benefits from the indemnity; (ii) for which it is not necessarily required to mitigate its losses; or (iii) that those losses be subject to tests of reasonableness and remoteness of damage.
  3. It is business contingency planning; if X happens (which we hope it doesn’t), then this is how we will allocate financial risk. If drafted properly, there is no requirement to establish fault so an indemnity can apply in the absence of any breach.
  4. The financial risk if the specified event occurs will usually exceed any contractually agreed liability limit.

What’s the risk in giving a contractual indemnity?

  1. They are often drafted broadly and do not attach to specific identified risks or events which may have the effect of cutting across specified liability caps. The consequences may be either that (a) liability is not limited as intended as the liability clause is made ‘Subject to’ the indemnity clause; or (b) the risk to which the indemnity clause relates and which should extend the amounts recoverable under contract are made ‘subject to’ the liability clause which has the effect of limiting the amount recoverable under the indemnity which was not the intended consequence.
  2. They are often not limited to 3rd party claims and are drafted so that they apply to any claim (including a claim by the other party for breach of contract). This has the effect of the party giving the indemnity being financially liable for amounts which exceed the sums specified as limiting liability. The effect of this is that the claim is subject to assessment based on damages (and subject to legal proceedings) and not on a £:£ basis (reimbursed as a debt claim and a direct contractual obligation).
  3. As indemnities are usually used for specific risks which exceed the general liability cap, they should carry their own financial cap (or be unlimited). Risks identified as being suitable for an indemnity may be capped to the level of insurance carried by the indemnifying party. For indemnified risks which are also insured against, the indemnifying party should be careful not to contractually agree terms which conflict with the terms of its insurance cover as this will risk voiding the cover available.
  4. If a business does not carry insurance against a particular risk and the value of the indemnity is unlimited, the potential losses incurred by the indemnifying party may be significant as it would need to support any losses from its cash reserves or , if insufficient, its assets.

Indemnities are most effective when:

  1. They attach to a specific set of circumstances which are outside of the reasonable control of a party or which is specifically identified as a risk. In the example above, this would be the risk that (unknown to the licensor at contract signing) the licensed rights do infringe a 3rd party’s IP rights and such 3rd party pursues a claim for infringement against you (the licensee).
  2. If you are the party giving the indemnity then it only applies to a clearly defined, or set of clearly defined, risks and only in connection with 3rd party claims, being those not within the control of the other party. You would want other losses, such as those arising for breach of contract to be captured under the relevant liability clauses. This can be achieved by clearly setting out in its terms what losses are and are not recoverable (direct, indirect and specific included or excluded heads of loss) and when (act, omission, negligence, breach). If you are the party receiving the benefit of the indemnity then you would want it to be broad and apply to as many circumstances as possible without it being limited to potential claims made by 3rd parties or subject to any financial cap, whether under the general cap or a specified indemnity cap. It may be attractive to seek to negotiate an indemnity which is unlimited and which also applies to losses which would otherwise be recoverable by a claim for breach of contract. The remedy for a breach of contract claim is damages therefore an indemnity in connection with a breach of contract claim would also be subject to the tests of causation requiring you to take steps to mitigate potential loss.
  3. They are properly cross-referenced with any relevant warranty, liability and insurance clauses. For example, if you are benefitting from an indemnity, you will want to ensure the indemnity is not subject to the liability limit.
  4. They are subject to the indemnified party following certain steps, for example not making any admission of liability, not entering into any settlement proceedings or negotiation, providing notice of any claim promptly and providing reasonable co-operation in any actual or potential claim. The terms under which the indemnity applies should also mirror any conditions of insurance cover.
  5. It is supported by warranties. Warranties are used to flush out potential issues which are known by the contracting parties. Using the same example above; a licensor will usually warrant that as far as it is aware the licensed material does not infringe a 3rd party’s IP rights. The extent to which a warranty like this is given allows the licensee to assess the extent that such risk exists and the likelihood of a claim being made. This in turn may dictate the financial level at which the licensee requests an indemnity if the licensor fails to satisfy any questions which the licensee requests during negotiations. Failing to give a warranty at all in respect of a specific issue would be a red flag. Whilst it is always advisable to remedy any deficiency prior to entering into a contract, indemnities can be a useful tool to minimise financial exposure to a known or suspected business risk. Whilst an indemnity primarily favours one over the other, properly drafted indemnity clauses can be advantageous to the indemnifying party by ensuring the indemnity does not extend wider than the specifically identified risk and the value is properly capped.

The key point to note is that parties will often sign off on transactions on the basis that the contract includes an indemnity and may accept a commercial risk on that basis. An indemnity should not be accepted or given without fully considering its purpose and having considered whether its use is appropriate to the commercial risk and if properly drafted liability clauses (and limitations) should be the sole remedy.

 

1This example is illustrative only as a third party may claim against either or both parties.

2In this context commercial transaction means a business to business agreement which is performed in England and is subject to English law.

3This assumes the contract in question is one which is subject to the Unfair Contract Terms Act 1977 and therefore any limit on liability must be reasonable.

4NB: Consequential loss may be direct or indirect and may be excluded if it is both indirect and consequential.

5It is possible for the words used in a contract to amount to an indemnity even if the word is not expressly used. For the purposes of this article, it is assumed the drafting is clear.

6This may be subject to the party incurring loss being under a duty to mitigate those losses however the legal position is unclear and to avoid any confusion, the contract terms should be clearly drafted. Mitigation of loss is related to principles of causation which requires a calculation of damages. This is relevant if an indemnity is being provided in connection with losses arising from a breach of contract as the potential losses are unknown.

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The content on this page is provided for the purposes of general interest and information. It contains only brief summaries of aspects of the subject matter and does not provide comprehensive statements of the law. It does not constitute legal advice and does not provide a substitute for it.

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