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Although many business contracts refer to ‘indemnities’, many business owners are unaware of the implications of an indemnity clause. Put simply, an indemnity clause is where you promise to compensate the other contracting party for potential losses they might experience. Indemnities typically provide a means of recourse or remedy to contracting parties from the negative effects of a contractual breach. Before agreeing to an indemnity clause, you should remember that it will bind you under the contract to indemnify the other party. 

If you attempt to avoid this obligation, you may breach the contract. To ensure you gain a better understanding of what liability certain contractual arrangements expose you to, this article outlines three points you should consider before agreeing to an indemnity clause. First, remember that indemnities can be very tricky and are often your most significant risk in a contract. Therefore, you should seek legal advice on whether to accept them or propose changes back to the counterparty. 

The Scope of the Indemnity Clause

Before outlining the scope of an indemnity clause, you must understand the following terms.

Note: When reading an indemnification clause, the term ‘indemnifier’ refers to the person who provides the indemnity. On the other hand, the term ‘indemnified party’ refers to the person the other party will compensate for their potential losses under the clause.

Now, it is important you fully understand the scope of indemnification. This is because the scope of an indemnity will, amongst other things, determine:

  • what losses you can and cannot compensate;
  • who is responsible for the indemnification and to what extent (i.e. the defaulting party);
  • any limits to your liability, including the maximum amount the defaulting party is required to compensate subject to any exclusions to this limit; and
  • any requirements for the affected party to take, such as reasonable steps to mitigate their losses if a breach arises.

A well-drafted indemnity clause will clearly set out your obligations. However, if you are unsure about the substance of your indemnity clause, you should seek legal advice. A lawyer can clarify your rights and obligations under the indemnity, alert you to any unfavourable provisions and ultimately provide you with greater certainty when deciding to enter the commercial arrangement or not.

The Nature of the Indemnity

The nature of indemnity clauses will vary depending on your commercial arrangement. Indeed, the extent to which you are liable for losses you cause will depend on the nature of the indemnity clause. Alternatively, the extent to which you can claim the compensation will also depend on the nature of your indemnity clause. The three most common clauses are below.

Bare Indemnity

A bare indemnity is where one party indemnifies the other for losses caused by a set of specific circumstances under the contract. For example, a supplier can agree to indemnify you against any loss you suffer in connection with their obligation to deliver your goods and services. However, you will not be compensated for any losses arising from events not covered in the indemnity clause.

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Proportionate Indemnities

A proportionate indemnity is where one party indemnifies the other for only losses the party’s fault causes. The idea behind proportionate indemnities is that your liability is proportionate to the losses you cause or contribute to. For example, a supplier can agree to indemnify you against the loss you suffer as a direct consequence of their actions, such as a fault in their production machinery. However, matters outside the manufacturer’s control might not be indemnified, such as delays brought on by an extended lockdown during the COVID-19 pandemic. 

Third Party Indemnities

A third party indemnity is where one party agrees to be responsible for any losses you suffer from a third party external to the contract. For example, your supplier can agree to indemnify you if your customer finds that their goods are defective. 

Standard Indemnities

It is not unusual to find businesses reusing standard form contracts when entering into similar arrangements. However, often these terms will not always reflect the responsibilities you are prepared to assume. For this reason, if you are in the position to renegotiate the terms of an indemnity clause, you should do so.

When negotiating the terms of the indemnity, you should consider:

  • what losses can and cannot be compensated;
  • who is responsible for the indemnification;
  • the limits to your liability (if any); and
  • any requirements for the affected party to mitigate their losses.

Above all, it would be wise to seek legal advice when renegotiating the terms of a standard indemnity clause. An experienced lawyer can alert you to any additional points to consider and help you draft an indemnity that is suited to what you are prepared to undertake.

Key Takeaways

An indemnity clause ensures that one party (the indemnifier) will compensate the other party (the indemnified) for any loss or damage they suffer due to the indemnifier’s actions. Before agreeing to an indemnity clause, you should clarify:

  • the substance and scope of the indemnity clause; 
  • your rights and obligations depending on the nature of the indemnity clause; and
  • whether you should renegotiate the terms of a standard indemnity. 

If you need help with indemnity clauses, our experienced commercial contract lawyers can assist as part of our LegalVision membership. For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 1300 544 755 or visit our membership page.

Frequently Asked Questions

What is an award of damages?

A court will typically order a party in breach of a contract to pay the affected party damages. Damages aim to put the affected party in the same position as they would be in if there was no breach.

I signed a contract but did not read the terms in full. Am I only bound by the terms I read? 

In most cases, if you sign a contract, you are bound by its terms and conditions.

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