I previously looked at the status of warranties in contracts, how they’re used and their benefits and limitations.  Here I turn my attention to the much debated role and importance of contractual indemnities.

What is an indemnity?

An indemnity is simply a contractual undertaking to meet a specific potential liability. Importantly, indemnities are usually claimable as a debt,which means the claimant doesn’t have to worry about otherwise tricky legal questions such as causation and quantifiable loss. If the event triggering the indemnity occurs, the beneficiary simply claims the sums covered by the indemnity in question. The indemnifying party is effectively positioned as insurer for those sums (Royscot Commercial Leasing Ltd v Ismail (1993)).

Indemnities are often used to transfer risk where the other party is best placed to manage it (e.g. intellectual property claims relating to the supplier’s services) or it may be that such an arrangement simply reflects the parties’ bargaining power.

Why are indemnities so prevalent and so carefully negotiated?

In contrast to a claim for breach of warranty, an indemnified party has no need to mitigate its loss (or even to demonstrate that it has suffered any) unless the contract provides otherwise. Indemnities are therefore seen as the most effective means for a party to protect itself financially.

The courts have also declined to apply the principles in Hadley v Baxendale to losses claimable under an indemnity, although they will construe the scope of the indemnity strictly in accordance with the principle of contra proferentem (i.e. against the party seeking to rely on it). Accordingly, indemnities are usually drafted very widely, to include all costs associated with the investigation, defence and settlement of any claim, damages actually awarded and any related interest. They also frequently extend to indemnifying a company’s officers, directors and agents as well as the company itself. In business-to-business contracts indemnities are not usually subject to the restrictions in the Unfair Contract Terms Act 1977.

Suppliers will in turn seek to limit and narrow the scope of indemnities they have to give, to insist that indemnities fall under a contract’s general liability caps, and that where an indemnity is triggered the customer must mitigate its loss.

What are indemities used for?

Along with general contractual limits on liability, indemnities provide the most important financial protection under most agreements. They will typically apply to risks associated with claims by third parties where potential damages could far exceed the value of the contract (such as infringement of intellectual property rights).

Customers sometimes propose indemnities for straightforward contractual liabilities (such as failure to perform) but suppliers will resist this on the ground that the right to claim for breach of contract should quite reasonably require the customer to quantify, prove and mitigate its loss. Moreover, where indemnity protection is unlimited, indemnities which apply to performance may have the effect of overriding the general contractual limits in the agreement which will radically change the supplier’s risk profile and therefore be price sensitive.

While there are obvious commercial benefits in transferring risk to a supplier, customers should be realistic. Suppliers price only for risks within the usual sphere of their operational responsibilities (which they can manage) and for what they can insure (in which case the premium may be factored into their cost model). Forcing a supplier to underwrite additional risk may simply jeopardise the contract in the event of a claim. A company is only good for as much as it can draw from reserves, insurance or perhaps a parent guarantee. No company has limitless resources and most senior executives will not willingly bet the company’s future on a single contract.