How to build an indemnity clause

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!

Main components of an indemnity

The Indemnified Party

Who is being indemnified? Will the indemnity also protect the employees of the Indemnified Party?

The Indemnified Losses and Liabilities

What can be claimed 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 specific here as these couple of words often cause disputes.

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 just threatens) an IP infringement claim against the Indemnified Party due to the use of a product that the Indemnified Party supplied.

Other components of an indemnity

Claims procedure

If you are indemnifying someone else, you want to control any proceedings relating to third party claims instituted against the Indemnified Party.

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

Often the most negotiated part of indemnity provisions. If an Indemnified Event occurs and one of the Exclusions apply, the Indemnified Party cannot claim under the indemnity (usually, the claim is excluded to the extent that the Exclusion relates to the claim).

Examples of typical exclusions are if the Customer modifies the supplied product in some way or the Client uses the product beyond specification.

These Exclusions must be worded carefully!

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 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).

I know some commentators argue an indemnity is a debt and not a liability and therefore does not fall under the limitation of liability. But do you want to leave this in the hands of a court or arbitrator?

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 losses are below a certain amount.

Mitigation

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

I prefer to expressly stipulate whether or not there is an obligation on the Indemnifying Party to take reasonable steps to mitigate their losses.

Rights of the Indemnifying Party

If you are acting for the Indemnifying Party, it is usually a good idea to reserve a couple of rights for the Indemnifying Party.

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

Exclusive remedy

Don’t shoot yourself in the foot.

We have seen indemnities (which are structured as exclusive remedies) that make you jump through hoops before you can claim, and when you claim, the indemnified losses are framed so that you can only claim very limited indemnified losses. These indemnities place you in a worse position than claims under breach of contract (which are excluded under the exclusive remedy provision).

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 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 clause

Conclusion

Indemnities must be drafted with care. Each legal jurisdiction is unique, and the meaning of a word in one jurisdiction can differ from the meaning of the word in another jurisdiction. 

 

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