Do indemnity clauses have superpowers?

The standard remedy for breach of contract is damages. Termination may or may not be available but damages can always be claimed. Why then do indemnity clauses seem to be creeping wider in scope? And why do some habitually strike them out on the basis that “we don’t give indemnity”. Are indemnity clauses really so effective? Or so scary?

Do indemnity clauses have superpowers?

1. What do we mean by an indemnity, anyway?

As used in contracts, an indemnity is just a way of saying that one party will compensate or reimburse the other party for a specific event or type of loss.

Indemnities often go hand in hand with the requirement to defend us and hold us harmless – which give a strong impression that this is giving us something very valuable. Note that while “defend” has a different and useful meaning, there are few clear reliable indicators that “hold harmless” means anything different from “indemnify”. Likewise “fully indemnify”. Note that “make good” may be different – and could mean that we can only recover for liabilities we have already incurred, while we could normally want the indemnity also to cover costs and expenses before this.

2. What if the indemnity clause wasn’t there?

It may be helpful to think about what would happen in relation to a particular breach of contract if we didn’t have any indemnity clause. The reality is that we’d be left with contractual damages (and/or possibly the ability to terminate the contract).

So does the indemnity gives us more? Yes, but probably relatively little. The generally accepted arguments are that – unlike under a regular damages claim – the claimant: (i) wouldn’t need to take steps to mitigate (avoid) losses or be prevented from claiming avoidable losses; and (ii) can claim the entire amount of the loss covered even if it might normally be too remote (i.e., does not flow naturally from the breach of contract or was not contemplated by the parties). Note, however, that there continue to be different lines of argument over whether this applies only where the claim is a quantified debt, and not an unknown sum, so even these benefits are not 100% certain.

And of course, the indemnity clause does not stand in isolation – and nor does it have any magical status that automatically overrides anything else in our contract. So it is perfectly possible to have an additional or separate provision that requires any party making an indemnity claim to mitigate their loss, which a prudent indemnifying party might be well advised to ask for. The same goes for exclusion and limitation clauses: our indemnity clause may be – and depending on whose perspective we are taking quite possibly should be – subject to any exclusions of indirect and consequential losses or a maximum cap on liability agreed elsewhere in the contract. It all depends on how the various clauses are drafted and how the contract is put together.

So asking someone to indemnity, defend and hold us harmless for their breaches of contract may not actually give us much more at all than we would have been entitled to anyway. And, under English law at least, indemnifying parties often oppose this – the standard rules on quantum of damages, remoteness, causation and mitigation for breaches of contract are well understood and developed. If we want to define a particular category of loss as direct loss or otherwise specify that it is recoverable, we can of course always do so.

3. Where is an indemnity clause useful?

There are some specific cases where there are well-developed practices around indemnities – such as “knock for knock” indemnities in construction and engineering contracts, which relate to voluntary assumption of particular liabilities. These call for specialised examination and we won’t refer further to them here.

One of the main reasons indemnity clauses become useful (and most likely were invented) is not to extract extra damages out of a breach of contract claim, but to enable the innocent party to be compensated for losses that wouldn’t normally be covered. Good examples are losses that may not be based on breach of contract at all (e.g., torts such as defamation, interference with goods or breach of statutory duty).

Where our loss arises from a third party claim or action by a regulator or tax office it may be less easy to say whether this is direct loss, indirect loss, or recoverable at all. One of the most common (and useful) applications may be where our provider breaches a third party right in something that they deliver to us and we then publish (and so are the primary target of an infringement claim – the third party will have no way of knowing, or any interest in, who the creator was). Also such losses risk only becoming known and claimable when we have gone through the process and had judgment. So we do want to be defended (and the other party needs to take charge of the claim right from the start – and bear even the costs of dealing with hopeless claims) and also indemnified for any loss and damages (and costs and expenses including legal costs) that we incur or are awarded against us.

An indemnity clause can also protect parties who are not parties to the contract: e.g., our group companies, directors, shareholders, sub-licensees, customers, employees, contractors and representatives or anyone else who might be the recipient of a claim based on the contract (in which case we should make sure that our “no third party beneficiaries” clause doesn’t contradict this).

4. Is an indemnity always unlimited?

We need to be conscious that any risk that the indemnity doesn’t cover effectively becomes a risk for the licensee or acquiror. Situations where indemnity clauses are regularly asked for include content licenses (to cover infringement of third party rights and possibly breach of aplicable laws), or mergers and acquisitions (e.g. to cover pre-existing tax, employment or environmental liabilities that emerge after the purchase).

On the other hand, as indicated, it is perfectly possible to agree a limited indemnity, that is expressly subject to an upper limit on liability, to a duty for indemnified parties to mitigate their losses, or to an exclusion of certain categories of loss (e.g., indirect losses, losses of profits). And in any event the indemnity clause should be very specific regarding the particular liabilities that are to be covered. An indemnifying party would also want to exclude losses that they did not actually cause, e.g., to the extent that they are due to misuse or modification of the deliverables, their combination with another unapproved item, or failure to use any fixes or workarounds provided.

Whether the indemnity is limited or unlimited, the indemnifying party (as the party who is liable to foot the bill) will generally also want to add some additional conditions, such as prompt notification of any claim, no admissions or prejudicial statements and reasonable collaboration from the indemnified party, control by the indemnifying party of the defence of the claim, and no settlement except with the consent of the indemnifying party.

Note that these could be drafted as ‘conditions precedent’ to the obligation to indemnify, so breach of any of them would lead to loss of the indemnity. This is potentially harsh (e.g., in the case of slight delays in notification) so requires very specific drafting. A compromise position might be that any failure to abide by the conditions reduces the obligation to indemnify to the extent that this actually prejudices the defence of the claim.

5. Final thoughts

In particular, where we are outsourcing anything or having a third party provide something that we have no control or visibility over, then a properly considered indemnity clause is something we may be well advised to ask for.

Considering all the above, an indemnity clause needs to be read in the light of the entire contract. And additional remedies may also be appropriate: the indemnified party’s immediate interest may be less in being compensated for third party claims than in: (i) obtaining the rights to continue to use what was delivered; or (ii) having that deliverable replaced or fixed so that it can be used without infringing third party rights or applicable laws.

Indemnity clauses are widely misunderstood and may not always have the super-powers that some believe. But they clearly can be significant in re-allocating liability between contractual parties. The keys to making them effective are to be critical regarding what we’re trying to achieve, clear as to what and who they cover and when, and coherent in relation to the contract as a whole.

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