Contract Law
Indemnity: The Basics
Author
Barbora Korcova
Author
Barbora Korcova
July 31, 2024
Contract Law
An indemnity can be an important part of mitigating risk in your contractual relationships but it can also represent a significant liability. Understanding indemnities is essential for effectively managing these potential risks and liabilities.
In this blog, we explore the meaning of indemnities, their benefits, key factors to consider when drafting indemnities and so on. By the end, you’ll have a comprehensive understanding of how indemnities work and how to utilise them to protect your interests.
What does an indemnity mean in simple terms?
It is a contractual obligation of one party to compensate for the loss or damages incurred by another party. Essentially, it is a promise of one party to pay money to the other party for its loss that results from a particular event (trigger event). For example, if you hire a contractor to do some work and they accidentally damage your property, an indemnity clause in your contract would ensure that the contractor is responsible for covering the repair costs. Without it, you would only be able to claim damages (see below).
When the indemnity should be given?
Indemnities are particularly useful in situations where a party is not in control of the loss that might be caused by another party that is better placed to manage it. For example, a distributor would seek an indemnity from a manufacturer of a product, because it did manufacture the product and so should be responsible for the manufacturing.
By incorporating an indemnity into a contract, the indemnified party can recover any losses it incurs from the indemnifying party if a particular trigger event occurs. This way the indemnity shifts the risk from the indemnified party to the indemnifying party.
Implied Indemnity
Whilst the parties usually set out the indemnity terms in writing or orally, the indemnity can also be implied. Read more about implied terms here.
This type of indemnity occurs by operation of law. It arises from circumstances surrounding the agreement, often in situations where one party should logically bear the responsibility for losses or damages due to their actions or omissions, even if there is no explicit clause outlining this obligation. Courts may recognise an implied indemnity to uphold fairness and justice, ensuring that the party best positioned to control and mitigate risks bears the associated costs.
Key factors in drafting effective indemnity clauses
1. PARTIES
Indemnifying party – party responsible for providing indemnity
Indemnified party – party that will receive the indemnity protection
Identify any third parties that could bring a claim
2. SCOPE OF INDEMNITY
Trigger event(s): circumstances that trigger the indemnity (e.g. breach of contract, third-party claims etc.)
Types of losses covered (e.g. direct damages, consequential losses, legal costs etc.)
3. DURATION AND TIME LIMITS
Period during which claims can be made
Notice period: how quickly must the indemnified party notify the indemnifying party of a claim
4. LIABILITY CAP – limits on the indemnity (if any)
5. COOPERATION OBLIGATION -the level of cooperation required from the indemnified party in the event of a claim (if required)
6. CONTROL OF CLAIMS – who controls the defence and settlement of claims (usually the indemnifying party may want to manage claims to control costs and outcomes) (if required)
7. CLARITY AND PRECISION
Note: In consumer contracts, indemnities must be clear and precise in order to be enforceable. Due to the high level of protection for consumers, any attempt to impose unfair or one-sided indemnity terms may be considered unenforceable by UK courts. For example, even word ‘indemnity’ itself may be unintelligible to an average consumer, potentially rendering it unenforceable. Instead of using the word indemnity, the Competition and Markets Authority therefore recommends using something like: consumer is responsible for losses incurred by the business which are caused by a specific event.
The importance of wording and interpretation
The actual effect of indemnity clauses in contracts depends more on its wording and interpretation than on its classification as an indemnity. In Gwynt y Môr OFTO Ltd v Gwynt y Môr Offshore Wind Farm Ltd [2020] EWHC 850 (Comm), the Court emphasised the importance of parties’ intention when interpreting the indemnity clause.
This case involved the sale of a company that managed an electrical transmission link from the Gwynt y Môr wind farm in Wales. The Sale and Purchase Agreement (SPA) included following indemnity terms: “if any of the Assets are destroyed or damaged prior to Completion (Pre-Completion Damage), then, following the Completion, the [defendants] shall indemnify the [claimant] against the full cost of reinstatement of any Assets affected by the Pre-Completion Damage”.
The parties disagreed whether this meant at any time before Completion or only between the execution of the SPA and Completion.
The Court decided (based on the objective meaning of the language of the clause) that the parties intended to only cover damage that occurred between the execution of the SPA and Completion and not historic damage that occurred before that. If parties intended otherwise, the clause would use a different wording. This emphasises how important is the wording and precision of indemnity clauses.
Benefits of including indemnity clauses in contracts
Indemnity clauses offer benefits that enhance stability and predictability of business and professional relationships. Key advantages include:
- Financial protection: indemnity ensures that one party can recover losses or damages from the other, providing a financial safeguard
- Risk allocation: indemnity clearly defines responsibilities and expectations, reducing ambiguities and potential disputes – it is an opportunity to tailor the amount of risk
- Trust building: indemnity promotes trust and collaboration by minimising the fear of unforeseen liabilities
- Operational efficiency: indemnity facilitates smoother operations and long-term partnerships by managing risks efficiently and transparently
Additionally, indemnities often provide quicker and more straightforward recovery compared to other legal claims. Especially if the amount recoverable under an indemnity is a fixed sum, which means that the indemnity would be a claim for debt and not a claim for damages. If the amount to be recovered under an indemnity is not fixed, courts will typically treat it as a claim for damages.
Indemnity vs damages
While both indemnity and damages serve to compensate for losses, they differ significantly in their application and timing.
- Indemnity: A proactive approach where one party commits to cover specific losses or liabilities incurred by another. This can include claims from third parties and indirect damages, offering broad protection. The exact coverage depends on how the indemnity is worded—some phrases can make it broader, while others can make it narrower.
- Damages: A retrospective remedy awarded by a court after a breach of contract, aimed at restoring the injured party to the position they would have been in had the contract been performed as agreed. Damages are compensatory and determined through legal proceedings. In order to claim damages in a breach of contract, the lost suffered must have been caused by the breach (causal link requirement).
Unlike damages, indemnity clauses do not typically require the injured party to mitigate their loss.
Indemnity vs warranty
Indemnity and warranty serve distinct but complimentary roles in contract law.
- Indemnity: Commitment by one party to compensate the other for specific losses or damages, providing financial protection against potential liabilities arising from trigger events. It offers a direct remedy for the indemnified party to recover costs without needing to prove a breach of contract.
- Warranty: A contractual promise that provides assurances that certain facts or conditions about goods or services are true and will be fulfilled. Warranties usually cover specific aspects of the goods or services such as functionality, durability etc. If breached, the affected party can seek remedies in damages such as repair, replacement, or financial compensation. Proof is required that the warranty has been breached.
While indemnity offers a financial safety net against a broad range of risks, a warranty ensures that contractual promises regarding quality and performance are upheld.
Indemnity vs guarantee
Indemnity and guarantee are both mechanisms used to allocate financial responsibility, but they serve different purposes.
- Indemnity: Primary obligation where one contractual party agrees to compensate another for specific losses or damages, often without regard to fault. It directly addresses the risk of loss and provides a straightforward path to financial recovery when a trigger event occurs.
- Guarantee: Secondary obligation where a third party (the guarantor) promises to fulfil the obligations of one party to the contract if that party fails to meet their contractual commitments. Guarantee ensures performance by another party, offering a safety net if the primary party defaults. Liability is triggered by another party’s failure to meet its obligations. For example, someone who takes a loan from a bank (borrower) would usually have a guarantor who would be responsible for paying for the loan in case the borrower does not pay.
Indemnity FAQs
Does an indemnity need to be in writing?
No, an indemnity does not need to be in writing to be enforceable. An oral agreement can also be valid. However, given the complexities involved, we advise to always have indemnities in writing. A written indemnity ensures clarity on the terms and conditions, provides a clear record for parties and can help prevent misunderstandings or disputes in the future.
Does a liability cap in the contract limit indemnities too?
There is no universal rule regarding this issue, so the wording of the indemnity will be crucial. The recommended approach, if you don’t want to apply the liability cap to indemnities, is to explicitly state in the contract something like ‘nothing in this contract limits or excludes liability under the indemnity clause’. This will ensure that indemnities remain unaffected by liability caps.
Can an indemnity clause help me recover 100% of the losses?
It is a common misconception that indemnity gives 100% recovery for loss suffered as a consequence of the trigger event. The extent of recovery depends on the drafting and the context of the entire agreement.
How can I easily spot an indemnity?
Indemnity clauses are sometimes not explicitly labelled as such and in some agreements, they may be spread throughout. Therefore, it is important to properly read the whole agreement or ask a lawyer to review it for you.
Conclusion
Understanding indemnity is crucial for anyone involved in drafting, negotiating or signing contracts. This legal tool provides a robust mechanism for risk management and financial protection. By clearly defining responsibilities and expectations, indemnity clauses reduce ambiguities, minimise disputes and foster trust between parties.
Whether explicitly stated in the contract or implied by law, indemnity remains a vital element in safeguarding interests and promoting fair outcomes in legal and business contexts. Knowing how to effectively use indemnity clauses, you can enhance the security and reliability of your contractual agreements, ensuring protection against potential losses and liabilities.
If you need expert assistance in drafting or reviewing contracts with indemnity clauses, or if you have any questions about indemnities in the UK, our experienced contract lawyers are here to help. Contact us today to ensure your interests are fully protected and to navigate the complexities of contract law with confidence.
