Indemnity clauses

Indemnity clauses: what you should consider when negotiating indemnities

Bartier Perry’s Michael Cossetto, Partner; Eric Kwan, Senior Associate and Natalie Zomaya, Lawyer explain the why’s and how’s of indemnities.

When negotiating equipment rental and other agreements, you have likely come across the term ‘indemnity’ – what does this really mean and how wise is it to give an indemnity? It is important to understand the implications of both requesting and providing an indemnity as there can be significant ramifications. While this overview can assist in understanding when it is (and is not) appropriate to include indemnity clauses in agreements, reliable legal advice is essential.

UNDERSTANDING INDEMNITY

Essentially, an indemnity in a contract is a promise or guarantee to compensate the other party to the contract for loss or damage suffered. However, an indemnity is not required to recover loss suffered under a contract. If a party has suffered loss under a contract and there is no indemnity to rely on, that party can rely on their rights under common law to make a claim for damages against the breaching party to recover the loss suffered. Recovering loss by way of a claim for damages under common law may be considered more beneficial to parties, especially given that there are inherent checks and balances to protect both sides.

WHY ARE INDEMNITIES USED?

While an indemnity is not required to recover loss, indemnities are commonly used because they are seen as an easier way to recover loss. This is because a party does not need to prove or demonstrate everything they would normally need to prove if they were to make a claim for damages under common law. Rather, they are only required to demonstrate the event giving rise to the indemnity occurred and that they have suffered loss or damage and they can provide parties with increased certainty regarding liability under a contract.

WHAT ARE THE CONSEQUENCES OF GIVING AN INDEMNITY?

While indemnities may be good for the party receiving it, they can have some unintended consequences for the party giving it. One example is the contracting out of defenses. One of the main consequences for the party giving the indemnity is that they are effectively contracting out of some of the defenses they may have under common law. This is because the party receiving the indemnity may not need to show any causal link between the event and the damage suffered. All they must do is show the event that they are being indemnified for has occurred and that they have suffered loss. They may not need to show that they have taken any steps to try and minimise or mitigate their loss. This means that the party giving the indemnity may find themselves liable for loss beyond what the common law would deem them liable for.

It is also common to find ‘exclusion provisions’ in insurance policies which limit or completely exclude coverage for assumed contractual liabilities (such as an indemnity). This means the party giving the indemnity may not be able to recover from their insurance policy all the amounts they have paid out, or are required to pay out, under the indemnity.

WHEN ARE INDEMNITIES APPROPRIATE?

An indemnity may be appropriate where there is no other practical way to manage or apportion risk fairly. Typical examples of this include situations where the potential impact to a party is huge but they have no direct control or ability to manage, for example, if the equipment is used by someone other than a customer. Another example is a party being promised something fundamental but there is no practical way for that party to verify that promise — for example, the other party has not infringed on someone else’s intellectual property. When considering whether to ask for an indemnity, it’s advisable to first conduct an internal risk assessment. This would include identifying potential risks and work out where you might suffer loss or damage, assessing the likelihood of those risks occurring; and evaluating what steps can be taken to manage those risks if no indemnity is given.

If the identified potential risk of loss or damage is significant and cannot be effectively managed, then it may be appropriate to request an indemnity from the other party. If this is the case, the party seeking the indemnity should also consider when the indemnity should come into play; and what the potential cost to the other party might be if the indemnity is triggered, and whether having an indemnity is fair on each of the parties.

A fairly drafted indemnity designed to address a legitimate concern and not disproportionate to the risk involved is more likely to be accepted by the other party, and ultimately save time and effort in negotiations.

WHEN ARE INDEMNITIES NOT APPROPRIATE?

If a party has been asked to give an indemnity, they should consider whether it is commercially appropriate or if there is a more appropriate remedy. For example, it may not be appropriate to give an indemnity for a breach of contract, because the other party already has a right to claim damages for breach of contract under common law. It may also be inappropriate for events or circumstances where the party giving the indemnity receives no benefit or has no control over.

NEGOTIATING INDEMNITIES 101

It is vital you review the clause carefully to understand when the indemnity kicks in and what the scope of the liability is. This will help determine if the indemnity is acceptable or if it needs to be finessed to make it fair for all parties involved. When finetuning an indemnity, certain limitations or restrictions can be imposed. These may include placing time restraints, restricting recourse to certain types of loss, setting a cap, limiting recourse to ‘reasonable’ costs and expenses, or imposing an obligation to mitigate.

In summary, parties should always seek legal advice before entering into an equipment rental agreement that includes an indemnity clause. As parties have common law rights to make a claim for damages to recover loss they may have suffered, indemnities should generally not be given unless it is appropriate in the context of the commercial arrangement.

If an indemnity is considered appropriate, parties should take into consideration the potential impact of the indemnity on their insurance coverage, their risk of exposure to liability under the contract, and whether any limitations should be imposed on the indemnity to limit their exposure.