Indemnity clauses in commercial contracts. How to step through the minefield without losing your head (or your business).

Few terms in a commercial contract are negotiated with such intensity as indemnity clauses. And rightly so. Providing an indemnity which increases your risk from ‘acceptable’ to roughly the size of the Northern Hemisphere is a mistake you are likely to make only once. Hopefully, your bank account (and your business) will survive.

An indemnity is a promise to pay for any loss or damage that is incurred by another person where an agreed event occurs.  

For example, it is very common for software contracts to state that the supplier will indemnify the customer if the software infringes the intellectual property rights of a third party. These are usually considered fair and reasonable as it would be unfair for the customer to be forced to pay damages if it turns out the software contained code that was copied unlawfully. It is for the supplier to do their homework! In most cases, the supplier will provide a warranty that the software is free from copied code and then an indemnity clause will state that if the warranty is breached, damages will be payable by the supplier to compensate the customer for all of their losses.

Where things get ugly

That’s all well and good. But often indemnities simply don’t work like that. For example, by agreeing to indemnify one party, you may find yourself responsible for the actions of a third party over which you have no control. To make things even worse, there is no obligation on the party you’re indemnifying to ‘mitigate their losses’ by taking steps to reduce the impact of whatever it is they’re claiming for. In other words, they can sit back while their losses accrue (passive income!) and, in their own good time, issue you with a hefty invoice payable on receipt. 

If you were not fearful enough already, the chances are that you will be unable to rely on any limitation of liability clause in the contract. Assuming that such a clause is present, it will normally be expressed to exclude the indemnity. As a last resort, you may look to your insurer. However, don’t bank on them coming to your rescue, as many insurers simply will not provide cover for unlimited indemnities and you can be certain that they will have made that crystal clear somewhere deep within the policy wording. Worst scenario? Your business folds.

Managing the risks associated with indemnity clauses

By now it should be clear that if you are asked to agree to an indemnity clause, you should treat such a move with the same caution you would if you discovered an unexploded WWII shell in your back garden. However, that doesn’t mean that the choices are simply to accept a risky indemnity or ditch the contract altogether. If you are asked to provide an indemnity, here’s what you need to do: 

• Ensure that you limit its scope to things that you have actual (or, at least, some) control over. 
• State the types of loss that can be recovered and those that can’t. Only agree to indemnify in respect of losses that are reasonably foreseeable or are directly caused by the breach. This will require careful negotiation with the other side and very precise drafting.
• Include a duty on the other side to use their best endeavours to mitigate their losses. If possible, set out the steps that they should take. 
• Ensure that you have the right to take over conduct of the claim which the other side has received from a third party. After all, you’ll be footing the costs! Make sure you list the steps that the other party must take when they receive a claim and ensure that, if they fail to do so, the indemnity will become invalid. 
• Most importantly of all, impose a cap on the level of damages recoverable under the level of indemnity and a timescale for claiming. Then, before signing, contact your insurance broker to arrange the necessary cover. That will enable you to sleep at night. 

The importance of accurate drafting of indemnity clauses

Accurate drafting is as vital as robust negotiation when it comes to indemnity clauses. So much can go wrong! 

For the indemnifying party, the dangers of signing up to paying out unlimited sums in respect of matters over which you have no control are very real. Equally, for organisations that legitimately wish to protect their interests by requesting fair and reasonable indemnities, the danger is that the indemnity may be watered down to such an extent that, when crunch-time comes, it’s no indemnity at all.

Technical Terms provides in-depth legal advice on drafting and negotiating indemnity clauses in commercial contracts. If you require further information, please book a no-cost, no-obligation Discovery Call.