Indemnity clauses are often added to contracts in order to transfer risk from one party to the other in the case of a specific event.

In other words, Party B agrees to keep Party A 'unharmed' from loss or damage.

All types of contracts can include indemnity clauses including land, construction, manufacturing, business, leases, sale of goods and service agreements.

In this article we explore the reasons why such indemnity clauses are used, the different types of indemnities, how they differ from warranty clauses and also things to consider when drafting the clauses.

Why employ them?

When one party fails to comply with its obligations under a contract, the other party may be entitled to damages that would leave them in the same position they would have been in had the contract been performed as originally intended by the parties.

Under common law, however, the award of damages can be reduced (partly or in whole) for reasons such as causation, remoteness or mitigation.

An indemnity clause can allow parties to bypass the above limitations of the common law and allocate risk in cases where a breach of contract has occurred.

Such clauses therefore alter the common law or statutory rights of the parties.

Types of indemnity clauses

There are four types of indemnity clauses:

  1. bare - one party indemnifies the other against all liabilities or losses associated with given events or circumstances (without any limitations)
  2. proportionate - one party indemnifies the other against losses except those which occur due to the second party's own acts and/or omissions
  3. reverse - one party indemnifies the other against losses resulting from the second party's own acts and/or omissions
  4. third party - one party indemnifies the other in relation to liabilities or claims by a third party.

Not a warranty

A warranty is a statement of fact, or assurance, made by one party (the "warrantor") to the other party (the "warrantee") under a contract.

An indemnity is not a statement of fact, but a promise by one party (the "indemnifier") to the other party (the "indemnified") to reimburse the second in respect of liability or loss suffered by the second party.

Generally, a warranty guards against the unknown while an indemnity apportions risk in respect of a known liability.

Not to be taken lightly

Indemnity clauses are onerous and usually drafted in broad terms. They should not be overlooked and treated as 'boilerplate provisions'.

They generally cover circumstances and actions of third parties that are outside the breach circumstances actionable under common law. In practice, they typically favour those with the most bargaining power and influence in a transaction.

For those reasons, the party providing the indemnity should carefully consider the wording of the relevant clause, ensuring it allocates risk at an appropriate level. Poorly drafted indemnity clauses frequently lead to disputes, and the party providing the indemnity should assume any ruling will likely go against it.

Such a ruling occurred in Woolworths Group Ltd v Twentieth Super Pace Nominees Pty Ltd [2021], where the NSW Supreme Court confirmed that agreements which include indemnity clauses should be construed ".on the assumption that the parties intended to produce a commercial result, one which avoids making commercial nonsense or working commercial inconvenience".

In circumstances where there is uncertainty regarding the interpretation of an indemnity clause either because it is ambiguous in its meaning or it is unclear as to the width of its possible application, a court can be expected to apply the clause in favour of the indemnified party.

Tips

When negotiating indemnity clauses, the indemnifier should consider the following points:

  1. Is the indemnity needed at all? If each party is satisfied with the level of cover afforded by common law, the answer is probably 'no'. The clause should be deleted from the contract.
  2. Are the indemnities which are being requested open ended or uncapped? If so, the indemnifier should not agree to them, but insist on a monetary limit after first consulting its insurance provider to ensure any agreed amount does not void its cover.
  3. What is the duration of the indemnity? The indemnifier should limit the time during which any claims can be brought - for example, within six years from the completion of the works.
  4. The clause should exclude any damage or loss caused by (or contributed to) the indemnified party, including those caused by (or contributed to) by that party's own negligence, breach of contract, fraud or wilful acts.
  5. There should be an expressly written obligation on the indemnified party to mitigate any of its loss. This will reduce the indemnifier's exposure in a claim under the indemnity provision.
  6. Can the indemnifier meet the indemnity should the clause be triggered? Does it have the financial resources to make good on its promise and has it planned how such a payment will be funded? The indemnifier may require additional protection through insurance or some other arrangement (such as a third-party guarantor).
  7. Avoid words that may lead to confusion or ambiguity, such as:
    • 'arising out of' "The words 'arising out of' are wide. The relevant relationship should not be remote, but one of substance albeit less than required by words such as 'caused by' or 'as a result of'. The phrase connotes a weak causal relationship" [Erect Safe Scaffolding (Australia) Pty Ltd v Sutton (supra) at [11]].
    • 'in connection with' "The expression 'in connection with' is capable of having a wide meaning, but its meaning must be derived from the context in which it is used. The words 'in connection with' have been accepted as capable of describing a spectrum of relationships between things, one of which is bound up with or involved in another. The question that remains in a particular case is what kind of relationship will suffice to establish the connection contemplated by the contract. In the present context there must be a sufficient nexus between the use of the plant and the injury." [Fraser v The Irish Restaurant and Bar Co Pty Ltd [2008] QCA 270 at [40].]

Contractual indemnities are a powerful tool to transfer risk for certain events from one party to the other. However, they are not always necessary, and parties should carefully consider the specific circumstances before agreeing to them. If an indemnity is to be provided, care should be taken when drafting the clause to ensure it clearly reflects the intention of the parties.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.