Indemnity clauses and commercial contracts

An indemnity is a promise to protect a party against loss or damage in the event of a specified event. The contract itself will identify the nature of the trigger and amount of payment.

Indemnity clauses are an important part of contracts. Indemnity clauses outline a form of insurance compensation for damages and losses. In an indemnity agreement or clause, one party agrees to offer financial compensation for any anticipated losses or damages caused by another party and to take on liability for any damages incurred. In simple words it is a promise by one party (the indemnifying party) to be responsible for and cover the loss of the other party (the indemnified party) in the event where it would be unfair for the indemnified party to suffer a loss.

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What is included in an Indemnity Clause?

An indemnity clause will include two key elements:

1. A description of the specific event or events that will trigger the indemnity; and
2. A description of the types of loss the indemnifying party will be liable for.

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Defining the events that trigger an indemnity cause less negotiation in comparison to defining the losses the indemnifying party is liable for. The indemnified party will want to recover all losses including legal costs, professional costs and other expenses, whilst the indemnifying party will want to limit the losses to ‘reasonable’ costs and expenses. Although some clauses do not include financial losses and may simply be used to remove liability from a party.

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An indemnity clause is made between two parties and may only extend to a person or company that is listed as a beneficiary of the written agreement or a person specified in the agreement who benefits from a third-party right.

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As an indemnity clause transfers liability, it may be treated as a term which excludes or limits liability and as such may fall under the Unfair Contract Terms Act 1977 (UCTA 1977) where there is a business to business contract dealing on one party’s standard terms and conditions.

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Examples of Indemnity Clauses

• Intellectual property rights such as copyright may form the underlying basis for an agreement in software, data or photography licensing agreements. The party receiving the intellectual property rights may want to protect themselves as the licensor (party giving the intellectual property rights) may not own the rights which are being paid for. In the event a licensee suffers a loss, the licensee may want to have a financial remedy against the licensor if the licensee is sued by the owner of the intellectual property rights.
• Some contracts may have a mutual indemnification clause where each party agrees to indemnify the other from all claims arising out of a breach of the agreement by the indemnifying party.
• Indemnity clauses may be used in construction projects to allocate risk between a client and a contractor or a contractor and sub-contractor. A clause may be included which requires the contractor to indemnify the client from the losses arising from the works.

Claiming under an indemnity clause does not require a breach of contract and provides a higher compensation than what is offered under the common law of damages, which has complicated issues such as remoteness, causation and mitigation of loss.

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Guarantees and Indemnities

People often confuse indemnity with guarantee. So let's start by defining the two:

Guarantee: A guarantee is an undertaking (promise) by a third party to fulfil a promise if the primary individual fails to meet his/her obligations. For example a parent acting as a guarantor for his/her child’s mortgage.

Indemnity: An indemnity is a contractual promise to indemnify another person against a specified loss. For example if you send an employee to carry out work at a company, and the employee suffers an injury, the contract signed may have state you will be required to indemnify the company in the event of unintentional harm or claims arising from a specific event. This highlights the importance of and indemnity/liability clause.

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An indemnity is a promise from one person to the other, whereas a guarantee is a secondary obligation. This offers a certain degree of protection and security to the indemnified party. It is also worth noting that a guarantee can only be limited to the extent the individual being guaranteed is liable. Whereas an indemnity can cover additional losses and exceed the original liability.

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Warranties and Indemnities

Warranties: a warranty is a contractual statement of fact made by one party to the other. It is a form of assurance that can be used by the seller when warranting the condition of a product/ Where an award of damages for a breach of warranty is awarded it aims to put the claimant in the position he/she would be in had the warranty been accurate.

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The purpose of an indemnity is a promise to reimburse the other party if a loss is suffered and can be used where a breach of warranty may not give rise to damages.

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Indemnity Clauses and Limiting Liability

It is common for risk to be apportioned in a contract and for parties to limit or restrict their liability on the occurrence of specific events. When doing so it is important to consider:

• The exclusion or limitation clause is only enforceable if it has been incorporated into the contract and the terms incorporated have been reasonably and fairly brought to the other party’s attention. Where a party is trading on its standard terms, an unusual, onerous or unclear exclusion clause is likely to fail.
• The words most cover what they intend to cover, general words covering “negligence”, "consequential losses" or “any loss” may not be sufficient. The rules of contract interpretation apply to limitations apply to all clauses and in the event of a dispute courts will look to serve justice as well as give effect to the parties’ intentions.  
• Whether the clause will fall foul of UCTA as it attempts to exclude a liability which may not be excluded or which is unreasonable.

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Are indemnities subject to limitations of liability?

There is no rule which states whether clauses limiting liability apply to indemnities in the agreement. One may assume the wording “liability under the agreement” would cover indemnity, however an indemnity claim may be argued as a debt claim which is a promise to pay rather than a liability. This highlights the importance of clear drafting to make it clear whether any limits of liability include/cap indemnity or not. It would also be useful to consider whether any amount paid under an indemnity clause is counted towards the liability cap. Having clear contractual provisions prevents disputes.

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What is Indemnity Insurance?

Indemnity clauses can have the added benefit of assurance where the indemnifying party has an insurance policy and has the means to pay. It may be a contractual term where the indemnified party requires the indemnifying party to maintain an insurance contract in order to mitigate any risk of the indemnifying party being unable to pay.

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Drafting Indemnity Clauses

A poorly worded indemnity clause can do more harm than good as you may find you are unable to rely on the clause as it has not been drafted accurately. What should you consider?

• What loss a party might suffer
• How the loss might arise (direct loss/indirect loss/consequential loss)
• Who is responsible for the indemnification
• Whether any limitations on liability apply to the indemnity clause
• Are there any exclusions of indemnity
• The bargaining position of each party and the effects UCTA may have on the clause

There are many factors to consider and indemnity clauses vary across industries. It is important your indemnity clause is carefully drafted to cover your particular circumstances.

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The opinions on this page are for general information purposes only and do not constitute legal advice on which you should rely.