How to build an indemnity clause

In this article, we have a look at some of the important aspects that must be kept in mind when drafting indemnity clauses.

Most disputed terms WCC ranking: 

18

Most important terms WCC ranking: 

23

Most negotiated terms WCC ranking: 

3

What is the purpose of an indemnity clause?

An indemnity clause aims to protect the Indemnified Party against certain liability or losses that the Indemnified Party is not willing to take when entering into the transaction.

For example, suppose you are the Customer using the Provider’s Software. In that case, you do not want to be exposed to claims from third parties for the infringement of intellectual property rights related to the use of the Software. Therefore, the indemnity creates an obligation on the Provider to cover you for the indemnified losses arising from the intellectual property infringement claim.

What are the different types of indemnities?

There is no closed list of types of indemnities. Generally, indemnities can cover claims that third parties may institute (so-called third-party indemnities) and cover any losses that the Indemnified Party may suffer from a breach of the Agreement by the other Party (so-called inter-party indemnities).

The indemnities you would typically want to include in your contract will depend on the transaction you are concluding, the associated risks, and, in some way, your industry.

Common indemnities include:

Indemnities against third-party infringement claims
If you buy Software from someone or resell Software for someone, you don’t want to be exposed to any intellectual property infringement claims relating to the product. The Provider usually carries this risk, and the way you transfer this risk to the Provider is by inserting an indemnity against third party intellectual property claims in the Agreement.

Indemnities against third-party claims
You can consider including an indemnity in respect of any possible third party claim (it all depends on the risks the Indemnified Party faces). Typically, third party indemnities are provided to protect the Indemnified Party against claims relating to personal injury, damage to property, breach of laws and employee and contractor compensation.

Indemnities relating to breach of contract
There are arguments that including an indemnity for the breach of contract provides some substantive and procedural advantages for recovering losses.

There may be jurisdictions where this is the case (provided that the indemnity is correctly drafted).

At the end of the day, if the Parties intend losses can be recovered under the indemnity that is otherwise considered remote, clearly stipulate this in your indemnity!

Indemnities relating to breach of warranties
There may be advantages to “upgrading” the warranties to indemnities. If this will hold any benefit will again depend on the wording of the indemnity, what it says about the remoteness of losses and interpretation.

Do you have a stronger claim under an indemnity?

The general belief is that an indemnity provides an easier way to recover losses and isn’t easily resisted in legal proceedings (this belief is because an indemnity creates a primary obligation and functions as a debt and is not a claim for breach of contract).

If the Indemnified Party suffers the indemnified loss, a claim can be instituted under the indemnity. The usual hurdles relating to causation and mitigation are side-stepped (in a way), and an Indemnified Party may be able to recover more losses (compared to losses recoverable under a breach of contract).

The above, however, only holds if the indemnity is worded properly and used correctly.

TIP – If the intention is that an Indemnified Party can claim losses that were not foreseeable when the Agreement was concluded, expressly stipulate this!

Building blocks of an indemnity clause

building an indemnity clause

The Indemnified Party

The Indemnified Party is the Party that will be protected under the indemnity.

Will the indemnity also protect any third parties, for example, employees of the Indemnified Party?

Suppose you are acting for the Indemnified Party. In that case, you want to try and broaden the scope of the indemnity by adding, for example, Affiliates, agents, contractors, directors, employees and shareholders of the Indemnified Party.

The Indemnified Losses

Indemnified Losses refer to the losses that the Indemnified Party can claim under the indemnity.

For example, suppose it is a third-party IP infringement claim. In that case, the Indemnified Losses may be the amount of any judgment against the Indemnified Party and legal fees and costs reasonably incurred.

It is important to be as specific as possible here and make sure you are clear on the Indemnified Losses.

Also, under the Indemnified Losses, you want to be clear on specific indemnity obligations. For example, in certain jurisdictions, the obligation to indemnify, defend, and hold harmless may provide a more comprehensive indemnity obligation than only the obligation to indemnify.

The Indemnified Event

The Indemnified Event is the trigger required to claim under an indemnity.

For example, an Indemnified Event may be a situation where a third-party institutes (or even only threatens), for example, an IP infringement claim against the Indemnified Party due to the use of Software that the Indemnified Party supplied.

If you are the Indemnified Party, you want the Indemnified Event to be comprehensive and to occur as soon as the possibility of a claim arises.

Claims procedure

Claims procedure refers to the process the Indemnified Party needs to follow to claim under a third party indemnity.

If you are indemnifying someone else, you want then to jump through a couple of hoops before they can claim under the third party indemnity.

Typical claims procedures relate to when notification must be provided to the Indemnifying Party, the right to control the legal proceedings and the obligation to provide reasonable assistance.

Some indemnities provide that if the claims procedures are not adhered to, the Indemnifying Party will be absolved from their obligations under the indemnity. This type of provision benefits the Indemnifying Party and may be necessary for certain circumstances.

The Exclusions

The exclusions refer to the claims that will not be covered under the indemnity and are often the most negotiated part of indemnity provisions.

The effect of an exclusion is that if an Indemnified Event occurs, the Indemnified Party cannot claim under the indemnity.

Examples of typical exclusions are if the Customer modifies the supplied product somehow or the Client uses the product beyond specification/documentation.

These Exclusions must be worded carefully and must usually provide that the exclusion only applies to the extent that the exclusion relates to the claim.

Limitation of liability

A limitation of liability clause may limit the extent to which you can recover losses under an indemnity (i.e. there is a liability cap). If you are acting for the Indemnified Party, you would want to avoid a situation where there is a cap placed on an indemnity claim.

Some commentators argue an indemnity is a debt and not a liability and therefore does not fall under the limitation of liability. But rather be safe than sorry. If you do not want the indemnity to be limited by the limitation of liability, make sure to expressly stipulate this (i.e. carve it out from the scope of the limitation of liability provisions).

Minimum claim amount

Sometimes you want to include a minimum claim amount. In other words, the Indemnifying Party will not be liable for any claim where the claim is below a certain amount.

Defending claims under indemnities can cost a lot of money. You do not want to get involved in legal proceedings where the legal costs will exceed the actual claim amount.

Mitigation

It is possible to argue that there is no obligation to mitigate any losses related to an indemnity claim. However, do you want to leave this open for possible disputes?

It’s recommended that you expressly stipulate whether or not there is an obligation on the Indemnifying Party to take reasonable steps to mitigate their losses.

If you are acting for the Party providing the indemnity, you want the Indemnified Party to do everything possible to keep the Indemnified Loss to a minimum.

Reserved rights

If you are acting for the Indemnifying Party, it is usually a good idea to reserve some rights for the Indemnifying Party if the paw-paw hits the fan.

For example, the Indemnifying Party would typically want to have the right to replace any product subject to an IP infringement claim the moment such a claim is threatened.

Exclusive remedy

Must the indemnity be regarded as the exclusive remedy on the happening of an Indemnified Event? In other words, must the Indemnified Party only be able to claim under the indemnity and will not be allowed to claim damages under breach of contract?

Stipulating that the indemnity is the exclusive remedy can benefit the Indemnifying Party. Suppose the Indemnified Losses part of the indemnity provisions is drafted in your favour. In that case, the losses that can be claimed will be limited and very specific, enabling you to take out appropriate insurance.

However, if you are the Indemnified Party, you what to have all options open and pursue the remedy that will be most beneficial to you. Generally, you don’t want to agree that the indemnity will be the exclusive remedy.

Guarantees and undertakings

If you are acting for the Indemnified Party, it is important to know that entity behind the indemnity will be able to make good on the promise to indemnify. Contracting with an SPV that turns out to be a shell entity may leave you without much recourse if the indemnified event occurs.

A guarantee from the holding company may be an option. With the guarantee, the holding company guarantees the indemnifying party’s performance.

Example clauses

Customer friendly indemnity (third-party IP infringement claims)

1.           INDEMNITY: THIRD PARTY INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS

1.1         Indemnity:  The Provider (the “Indemnifying Party”) must indemnify, defend and hold harmless the Customer, their Affiliates, agents, contractors, directors, employees and shareholders (the “Indemnified Party”) against the Indemnified Losses and Liabilities in Section 1.2 on the happening of an Indemnified Event in 1.3.

1.2         Indemnified Losses:  The losses and liability covered under Section 1.1 are expenses, fines, legal fees and cost, legal fees and cost (reasonably incurred), paying for judgment finally awarded, paying for settlements and penalties (the “Indemnified Losses”).

1.3         Indemnified Event:  The event or circumstances covered under Section 1.1 is where a third party institutes a claim, or threatens a claim, against the Indemnified Party relating to, or arising out of the infringement of intellectual property rights relating to any product or service provided under this Agreement (the “Indemnified Event”).

1.4         Mitigation:  There is no duty on the Indemnified Party to mitigate their losses or liability if there is a claim instituted under Section 1.1.

1.5         No limitation of liability:  Despite anything stipulated in this Agreement, the indemnity under Section 1.1 will not be limited by any limitation of liability provisions in this Agreement.

1.6         Liability cap:  No amounts awarded or agreed to be paid under this indemnity will not count toward any liability cap stipulated in this Agreement.

Provider friendly indemnity (third-party IP infringement claims)

1.           INDEMNITY: THIRD PARTY INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS

1.1         Indemnity:  The Provider (the “Indemnifying Party”) must indemnify the Customer (the “Indemnified Party”) against the Indemnified Losses and Liabilities in Section 1.2 on the happening of an Indemnified Event in 1.3.

1.2         Indemnified Losses:  The losses and liability covered under Section 1.1 are paying for judgment finally awarded, whether or not foreseeable (the “Indemnified Losses”).

1.3         Indemnified Event:  The event or circumstances covered under Section 1.1 is where a third party institutes a claim against the Indemnified Party directly relating to the infringement of intellectual property rights relating to any product or service provided under this Agreement (the “Indemnified Event”).

1.4         Claims procedure:  The Indemnified Party must:

(a)         give the Indemnifying Party the sole right to control the legal proceedings;

(b)         promptly notify the Indemnifying Party of the claim; and

(c)         provide reasonable assistance and cooperation to the Indemnifying Party during the defence of the claim.

1.5         If the Indemnified Party does not notify the Indemnifying Party as per the obligation under Section 1.2, it will not affect the obligation to indemnify as per Section 1.1 unless it materially prejudices the ability to defend the third party infringement claim contemplated in Section 1.1.

1.6         Exclusions:  The Indemnifying Party is not liable to the Indemnified Party for any claim under Section 1.1 to the extent that the product or service provided under this Agreement is:

(a)         combined with any other product, service, or technology;

(b)         distributed outside the Territory;

(c)         modified in any way;

(d)         used beyond specification;

(e)         used in breach of this Agreement or applicable law; or

(f)           used without adherence to requirements.

1.7         Acts or omission by the Indemnified Party:  The Indemnifying Party is not liable to the Indemnified Party for any claim under Section 1.1 to the extent that the claim is a result of an act or omission of the Indemnified Party, their employees, contractors or agents.

1.8         Contributory acts:  Losses caused by a contributory act or omission of the Indemnified Party, their employees, contractors or agents must be apportioned to the Indemnified Party, and the Indemnifying Party is only liable for losses to the extent that it is their fault.

1.9         Miscellaneous:  If a claim under Section 1.1 is made against the Indemnified Party, or is likely to be made in the Indemnifying Party’s opinion, then the Indemnifying Party may modify or replace the product or service under this Agreement that is the subject of the claim, in defence or settlement of the claim.

1.10      Mitigation:  The Indemnified Party must use reasonable efforts to mitigate their liability if there is a claim instituted against them as contemplated under Section 1.1.

1.11      Sole remedy:  Despite anything else stipulated in this Agreement, the indemnity under Section 1.1 is the sole remedy available to the Indemnified Party if a claim, as contemplated under Section 1.1, is instituted against the Indemnified Party.

1.12      Liability cap:  Amounts awarded or agreed to be paid under this indemnity will count towards any liability cap stipulated in this Agreement.

 

Clauses you need to consider with your indemnity clause

Have a look at your limitation of liability clause. As the Indemnified Party, you also want the limitation of liability to cover claims under the indemnity. As the Indemnified Party, you would want unlimited claims when it comes to scenarios that fall under the indemnity.

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The Author

Martin Kotze is a commercial lawyer with over 10 years of experience. He specialises in transactional work within the Tech, Financial Services and Property industries. 

He is also one of the co-founders at DocNinja and regularly advises listed companies to small and medium enterprises on how to contract better with their customers. 

Martin Kotze

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