Drafting Effective Indemnity Clause under English Law

“Indemnity” as defined by Black’s Law Dictionary is “[a] duty to make good any loss, damage or liability incurred by another,” or alternatively “[t]he right of an injured party to claim reimbursement for its loss, damage or liability from a person who has such duty.”

In other words, indemnity clause gives the right to a party who is legally responsible under the law for a loss, to contractually shift that loss to another party. Therefore, the purpose of indemnity clause is to distribute risks arising from the contract in a different (or more certain) way than the one offered by the law.  It has been held by the courts that commercial parties must be left free to decide how to allocate commercial risks. (See Homburg Houtimport BV and Others v. Agrosin Private Ltd and Another [2003] UKHL 12).

However, parties often attempt to draft broadly worded indemnities to protect their position. However, according to the case law, this approach has proved to be wrong. In fact, an indemnity provision provides the most benefit when they are tightly drafted.

It is, therefore, recommended to clearly identify the scope of the indemnity and to expressly list the parties to be indemnified and all the types of liability to be excluded. The wording of the contract shall be sufficiently clear and unambiguous allowing no room for multiple different interpretations. If the wording of a clause is ambiguous, it will be construed "contra proferentem". This means that the court will interpret the clause strictly and construe any ambiguity against the party seeking to rely on it as the basis for avoiding liability.

The below highlights the major aspects to be considered when drafting an indemnity clause under English law and proposes few guidelines to follow and present some pitfalls to avoid.

Who will be indemnified?

The indemnity clause shall list all the parties that will be indemnified, which usually extends beyond the contracting legal entity and include non-signatories such as affiliated companies, whether the parent company or subsidiaries and also explicitly cover the officers, directors, consultants, agents and employees of all the foregoing. A signatory to an indemnification provision can be indemnified and has the standing to enforce that right to be indemnified. However, non-signatories are not entitled to make claims under the indemnity unless there is an express intention for non-signatories third party to benefit from the indemnity, in absence of such express intention; it is presumed that only parties to the indemnity provision are the ones who can benefit themselves.

“Indemnify” vs. “defend and indemnify”

Obligation to indemnify requires that the claim be successful, while the obligation to defend will require the indemnifying party to handle the litigation even though the claim may end up being rejected as lacking merit. In this respect, while drafting indemnity clause it is important to make sure that your intended coverage is included, examples are as follows:

• Obligation to defend and indemnify (in this case indemnified party should have the obligation to cooperate with the defense)
• Obligation to indemnify while clearly excluding the obligation to defend (in this case the indemnifying party will lose the right to control the claim)
• Include the right (not an obligation) for the indemnifying party to choose to defend a claim.
• Whether the obligation to defend also includes the right to settlement and whether the other party should consent to such settlement?

“Hold harmless” vs. “make good”

There is a difference between the obligation to “hold harmless” the indemnified party and the obligation to “make good” any loss or damage incurred. “Hold harmless” means that the party giving the indemnity will be in breach once the indemnified party suffers any loss or damage and the indemnified loss or damage is established. On the other hand, “make good” gives the indemnified party the right to request the indemnity when they suffer loss or damage and therefore the party giving the indemnity is not obliged to do anything until it is requested by the party receiving the indemnity and accordingly the party giving the indemnity will not be in breach until it received said request and refused to provide the agreed indemnity. The foregoing distinction affects the time the limitation period will start running. In the “hold harmless” wording, the limitation period will start running immediately from the date the loss or damage occurred, while in the “make good” wording the limitation period will begin when the indemnifying party refuses to provide the agreed indemnity.

Indemnity against what?

As mentioned earlier, the best way is to expressly list all possible damages that are intended to be indemnified for. For example, if a clause aims to exclude liability for negligence, general words such as "any loss" or a reference to loss "howsoever caused" may not be sufficient. An express reference to "negligence" should appear in the wording. In the judgment of Walters v Whessoe Ltd and Shell Refining Co. Ltd. [1960], the Court stated that it is “well established that if a person obtains an indemnity against the consequences of certain acts, the indemnity is not to be construed so as to include the consequences of his own negligence unless those consequences are covered either expressly or by necessary implication”.

Examples of possible damages that can be expressly excluded are property loss, property damage, injuries, illness, death, pollution or contamination, IP infringements, fines, costs and expenses including litigation cost and attorneys’ fees. It should also be clear whether the indemnity will cover the foregoing damages when suffered by the other party only or will it extends to cover third parties, their other contractors, their subcontracts, their agents, etc.

The Extent of Indemnity

The indemnity provided could be unlimited or otherwise limited as follows:

• The indemnifying party’s liability is limited to a maximum dollar amount (i.e. monetary cap)
• The indemnifying party has no liability until a minimum dollar threshold is reached (i.e. floor)
• The indemnifying party’s liability is tied to the amounts that can be recovered from a third party often an insurer (i.e. conditional upon third party recovery).

The major trap with limited liability is that the provision must state explicitly that the indemnified party will indemnify the party giving the indemnity for any amounts above the limit; otherwise the indemnified party may bring a common law claim in respect of loss in excess of the agreed limit.

Also, it is very important when drafting limitation provision that will apply to the indemnity, such provision must clearly set out what is covered under such limitation.  In WesternGeco Ltd v. ATP Oil & Gas (UK) Ltd Aikens J, the contract provided for the following:

• Clause 19 where the Contractor is liable for damages caused to third parties by the negligence of the Contractor; and
• Clause 19.8 where the Company was required to indemnify the Contractor in case of "liability under this contract" that exceeded the aggregate amount of payments the Contractor would receive under the contract.

In this case WesternGeco (the Contractor) negligently damaged the property to a third party; Total E & P UK Plc. Total brought a claim against the Contractor. The amount sought by Total exceeded the amount that the Contractor received under the contract. Aikens J decided that contractor cannot claim the excess amount over its contract receipts from the Company under the indemnity in clause 19.8. The meaning of "liability under this contract" was construed to mean only liability between the parties to the contract (not the liability to Total, the third party). Therefore, the limitation intended would have been valid if the clause had explicitly stated “liability under this contract whether to Company or to third parties”.

When will the indemnity be due?

A party can enforce an indemnity even before it has paid out for the liability covered.  This default position can be changed contractually if the indemnity provision states clearly that payment by the indemnified party is a pre-condition to liability under the indemnity and that the indemnified party must pay first before it can claim reimbursement from the indemnifying party [See the recent case Durley House Ltd v Firmdale Hotels Plc [2014] EWHC 2608 (Ch)].

Duty to mitigate loss

Generally, a party to a contract has an obligation to mitigate any loss suffered as a result of a breach of contract. However, this obligation is does not apply to a party claiming under an indemnity (unless the indemnity expressly requires them to mitigate losses). Therefore, any party providing an indemnity should consider including a requirement that the party receiving the indemnity should take reasonable steps to mitigate its loss.

Limitation Periods

The limitation period will be determined depending on whether the indemnity is part of an agreement or whether the indemnity is executed separately as a deed. The limitation period is 6 years in the event that the indemnity is part of an agreement or otherwise it would be 12 years if executed as a deed. The limitation period for an indemnity claim will starts to run from the date the indemnified loss is established.

How will the indemnifying party meet its indemnity obligation?

A perfectly worded indemnity clause will be useless if the party giving the indemnity does not have the financial capability to meet its indemnity obligation. Requesting the party giving indemnification to provide guarantor to back up the indemnity obligation or to have its indemnity covered under insurance policy are possible ways to ensure that indemnity provided is actually enforceable. The trap with requesting insurance is to make sure that the indemnity is actually covered by the insurance policy, that the insurance will remain valid and not cancelled and finally to request to include the indemnified party as jointly insured or additional insured. Similarly, the party giving the indemnity should contemplate how it will fund its indemnity obligation whether through its own recourses, insurance, some other arrangement such as concluding back-to-back indemnity agreement, or combining some or all of the foregoing.