What is an indemnity clause?

An indemnity clause is a legally binding promise by one of the contracting parties that they will pay for the costs associated with damage or loss that the other party may suffer. In essence, indemnity clauses allocate risk from one of the contracting parties to the other. Under an indemnity clause one party (Party A) promises to pay an amount equal to the other party’s losses or costs (Party B) if Party B suffers losses or costs under the contract.

For example, Sally runs a solar hot water system installation business. She has an indemnity clause in her contract with the manufacturers of the solar panels, batteries and other associated equipment. This means that if the equipment fails or is faulty and causes loss, the manufacturer will be liable (i.e. will pay for) the cost of rectifying the loss. So let’s say Sally correctly installs a hot water system on a roof, but the hot water system catches fire (as the machine was faulty) and burns through the tiles or roof of the house. Given that there is an indemnity clause that protects Sally the manufacturer will be responsible for covering the cost to repair the tiles and roof (and not Sally). This creates peace of mind and business certainty for the Sally.

Perfect you say – I want one in my contract. Well, don’t we all! The reality is that they are fought over (sorry I should say they are ‘negotiated heavily’) given the financial impact that the clause can have on both parties (positive financial impact for one party, and a negative financial impact for the other.)

So far it seems simple and straightforward. However in reality, there are many different forms of indemnity clauses and they are a source of a lot of dispute and legal risk.

What can indemnity clauses be used for?

Indemnity clauses can be used to cover a wide range of scenarios. It depends entirely on the subject matter of the commercial agreement. Indemnity clauses commonly cover situations of breach of contract, property damage, personal injury and financial loss.

Why have an indemnity clause?

Indemnity clauses are useful, as seen in the example above, because they move risk from the contracting party that is least able to absorb it to the party who can.

The law covers a range of situations where one contracting party has the right to recover their losses from the other party. However that often requires lengthy and expensive legal proceedings and there are restrictive limitations, including time limitations on recovering losses and a party must take steps to mitigate (or lessen/reduce) their losses. However, indemnity clauses get around these restrictions, making it easier to recover losses and providing certainty for the contracting parties.

Limitations and exclusions

Indemnifying parties usually seek to cover direct loss and to exclude consequential (indirect loss). Indirect losses cover things like loss of profit, loss of business opportunity (and others). It can be very tricky sometimes to tell what is a direct or consequential loss.

For example, if Sally received a batch of solar panels that were all faulty and as a result she couldn’t install any solar panels for a month (lets say it took the manufacturer 1 month to resupply her with some working solar panels) and as a result Sally lost that business to a competitor, is the business she lost, and the lost profit by not being able to work for that month, a direct or consequential loss?

Well I can tell you that if the manufacturer has an indemnity clause, but the indemnity clause only covers direct losses, and the clause states that they will not cover consequential losses, then as sure as the sun rises in the east and sets in the west, the manufacturer would argue that the loss is consequential (and so they dont have to pay Sally for 1 month of lost profit/lost work). See… things can get complicated very quickly.

Limitation of Liability

Indemnifying parties also commonly seek to place a cap on what they will pay if the other party suffers a loss. This is called a limitation of liability clause. For example, if the manufacturer does agree to pay for Sally’s loss of profits when she receives the batch of faulty solar panels, they may limit their payment to a certain amount depending on what was agreed to in the limitation of liability clause, for instance they might agree that the most that the manufacturer would pay out under the limitation clause is say $10,000. So if Sally incurred losses greater than $10,000 then she would not be compensated for those amounts that exceed $10,000.

Things to be aware of

Anyone seeking to include an indemnity clause in their commercial contract needs to keep the following three things in mind:

  1. Make sure that the indemnifying party (i.e. the party giving the indemnity, in our example above this is the manufacturer) has insurance that lines up with what is covered by the indemnity clause (so that if they have to pay Sally out then they can recover the amount they had to pay to Sally from their insurance)
  2. Make sure the clause is specific. If the clause is ambiguous, courts will interpret the clause against (not in favour of) the person who is seeking to rely on it.

Clear as mud? Don’t worry, it took us a little while to get our heads around these clauses. If you would like some advice on an indemnity clause or assistance drafting an indemnity clause feel free to pick up the phone!

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