An indemnity is a contract by one party to keep another harmless against loss.[1] It transfers risk from one party to another to compensate for loss. Some businesses assume that throwing in a broad, boilerplate indemnity clause into a contract will protect them from all potential losses. This approach is ineffective. If you intend for an indemnity clause to be enforceable it needs to be drafted clearly and effectively.
An indemnity clause can be altered in many ways. A clause may be drafted to ensure that specific types of losses are claimable (such as direct losses), to provide that the innocent party has a specific obligation to mitigate losses or to exclude or include consequential loss.
How specific do indemnity clauses need to be?
Indemnities are often drafted widely in an attempt to cover third parties and circumstances beyond the ordinary breach circumstances available under the common law.
If you want to exclude all losses and liabilities, you will need to use very clear and precise language. Courts have generally construed that ‘all losses’ or ‘all damages’ are too wide to be enforceable. If you are the indemnified party, you should avoid drafting clauses too widely or risk unenforceability.
If a party is seeking to exclude consequential loss from application in the contract, it is necessary to be specific and define exactly what losses are excluded. Failure to define ‘consequential loss’ will leave the contracting parties open to the risk of uncertainty because the court will determine its ‘plain and ordinary meaning.’[2] It is worth considering whether the exclusion of consequential loss applies in favour of one or all the parties in the contract.
What should you do?
There is no strict interpretation for popular expressions such as ‘consequential loss’ and ‘indirect loss’ at common law.
All businesses, when drafting an agreement, should:
- use clear headings to ensure the purpose of all clauses cannot be misinterpreted;
- avoid vague expressions, particularly in exclusion clauses. Instead, expressly state how you want the clause to apply; and
- remain aware of legal decisions that may impact potential liability claims.
The key to drafting an effective indemnity clause is to understand what the underlying risks are and to be as specific as possible. Indemnity clauses deserve to be treated as more than a ‘boilerplate’ provision if you want to successfully protect your business from unwanted risks.
What should you consider?
Besides making sure that indemnity clauses are clear and specific, you should consider some of the following questions about the nature and implication of indemnities in the specific contract to ensure the contract reflects your intentions:
- Is the indemnity in favour of one party to the contract or are the indemnities mutual?
- Is the obligation to indemnify extended beyond the parties to the contract? For example, the related parties of the indemnified party?
- Are there any exemptions from liability?
- Are there any limitations of liability and are those limitations appropriate?
- Does the indemnified party need to incur costs and liabilities before seeking recourse pursuant to the indemnity?
- Is there a time frame for exercising any of the indemnities (particularly in a share sale agreement)?
- Does your insurance cover protect you for the risks that have been shifted to you pursuant to the indemnity clause?
Drafting a clear and effective indemnity clause and considering related issues may appear burdensome. However, the consequences of a poorly drafted indemnity clause are dire, particularly if the balance of the agreement does not level the playing field. A well-drafted indemnity clause helps parties avoid contractual disputes and the costs associated with interpretation by the court of the indemnity’s scope and liability.
[1] Yeoman Credit Ltd v Latter (1961) WLR 828
[2] Environmental Systems Pty Ltd v Pearless Holdings Pty Ltd [2008] VSCA 26
The team at Bryks Lawyers are experts at negotiating, drafting and advising on contracts in a full spectrum of commercial arrangements. If you need assistance with or more information on risk and indemnity, start the conversation today!
