In this article
How indemnity works.
Indemnity is written into a contract using something called an ‘indemnity clause’. What is covered within this clause depends entirely on the specifics of each agreement.
Furthermore, some contracts may also include a letter of indemnity. This letter guarantees that both parties will meet the terms and conditions of the contract. If these terms and conditions aren’t met, the repayment will need to be made to the indemnified party.
For instance, when indemnity must be paid, the repayment is made in the form of cash, repairs or replacements. The type of compensation depends entirely on the terms of the agreement.
What is an indemnity clause?
Indemnity clauses are written into contracts to allow an indemnifier to take on any losses incurred by a party in the contract. They can also be used to absolve the indemnifier or the other party of liability if a breach of contract occurs, or damages/loss of goods are incurred. Most commonly, indemnity clauses are used to compensate service providers in the event their goods are damaged.
An increasingly common example of a simple indemnity clause is in the sign up documentation for 24-hour gyms who often will not have staff working while gymgoers are on the gym floor. In these agreements, there is normally wording along the lines of ‘use of the gym equipment is at your own risk and XYZ gym takes no responsibility for any injury or death caused by its use’.
Indemnity clauses do not have to involve any element of financial compensation. They can simply be used to remove liability from a party in the contract, as per the example above.
However, indemnity clauses do see widespread use in commercial contracts for financial reasons. A buyer may wish to seek indemnification against poor quality goods from a manufacturer, to protect cash flow, or to enable them to place a new order elsewhere.
What is the difference between an indemnity clause and a guarantee?
Many people mix up indemnity clauses with guarantees. Although similar, the difference between an indemnity clause and guarantee lies in the ‘obligation’. Indemnity creates a primary obligation, whereas guarantees create a secondary obligation.
In practice, this means an indemnity clause offers compensation to you if you suffer a loss or future loss, and a guarantee offers you either compensation or fulfilment of a contract as a guarantor will take on responsibility if the other party is unable to perform.
Confused? Here's an example...
John books a package holiday through a travel agent, which includes a hotel stay. As part of his package holiday contract, there’s an indemnity clause stating if John causes any damage to his hotel room, he’s required to compensate the hotel. There’s also a guarantee in the contract signed by the travel agent that says if John is unable to indemnify the hotel for the damage, the travel agent promises to compensate the hotel on John’s behalf.
In this case, the hotel is protected against any losses, either through John directly, or by a third party, the travel agent. The guarantee only comes into effect if the primary obligation identified by the indemnity clause (in this case, John paying for the damages he caused) cannot be fulfilled. Indemnity and guarantees are not ‘either/or’ scenarios; instead, they offer layers of protection.
Considerations of indemnity.
One of the main things to consider with putting an indemnity clause into a contract is the increased costs. An indemnity clause adds another complication to a contract, which can increase the time it takes to negotiate an agreement. As a result, incorporating this clause can become increasingly expensive, especially when no compromise is in sight.
A poorly-worded indemnity clause can cause more harm than good, particularly if it needs to be relied upon and is challenged. Even if you successfully challenge a poorly-worded indemnity clause and receive the agreed sum of indemnification, you may well find that you have paid more in litigation costs than you have recovered.
And for businesses that rely on good cashflow, a long litigation case can leave a significant sum of money out of the business for an extended period of time.
This is why it is crucial that any indemnity clauses in an agreement are either drafted or reviewed by an experienced contract solicitor.
Conversely, the reverse is also true, and a well-written indemnity clause will work to protect your business.
1. Who is the indemnified?
Indemnity clauses can only be made between two parties; the indemnifier and the beneficiary of a contract. Indemnity will only extend to the person or company that is listed as a beneficiary in the written agreement (including any person mentioned in the third-party rights clause). The indemnity will always identify the beneficiary (the person or company who is indemnified).
2. What can indemnity clauses cover?
Indemnities usually cover liabilities in two ways:
- Third-party claims against the indemnified party, such as intellectual property infringement.
- Claims made between the indemnifier and the beneficiary. For example, for breach of contractual provisions like warranties or a failure to pay an invoice.
Indemnity clauses can include ‘hold harmless‘ wording under which one party agrees that the other will not be liable for any losses that the first party suffers arising from the specified events. It is always advisable that you seek independent legal advice on all contracts from a contract solicitor.
3. What losses are covered under the indemnity clause?
A contract solicitor will first look at the indemnity clause to see what losses are recoverable under the clause, which in turn will depend on how it is defined.
When our contract solicitors draft indemnity clauses, we ensure that the wording will cover all the covers all the types of losses that the parties have agreed.
At Britton and Time Solicitors in London and Brighton, we consider whether the indemnity clause will cover indirect and consequential losses and draft accordingly.
A broad definition of losses may be drafted as follows:
‘all damages, liabilities, demands, costs, expenses, claims, actions and proceedings (including all consequential, direct, indirect, special or incidental loss or punitive damages or loss, legal and other professional fees, cost and expenses, fines, penalties, interest and loss of profit or any other form of economic loss (including loss of reputation))’
When our contract solicitors act for the party giving the indemnity, the scope of losses will be limited as much as possible and only to direct losses.
Following the case of Total Transport Corp v Arcadia Petroleum Ltd in 1997, we would usually add wording into the indemnity clause that specifies that losses are recoverable under the indemnity whether they were foreseeable or not.
4. How does the Unfair Contractual Terms Act 1977 apply?
An indemnity clause transfers liability and may, in certain circumstances, be treated as a term excluding or limiting liability; this means that it may fall under the remit of the Unfair Contract Terms Act 1977 (UCTA 1977).
Having said that, the Unfair Contract Terms Act 1977 only applies in relation to business-to-business contracts when dealing on one party’s standard terms and conditions.
At Britton and Time Solicitors, we consider and advise on whether the Unfair Contract Terms Act 1977 is likely to apply to the indemnity clause. If so, we ensure that it is drafted to satisfy the requirement of reasonableness.
5. What is indemnity insurance?
Indemnity can add significant assurance if the person giving it has the means to pay by way of an insurance policy. Forcing the indemnity provider to maintain insurance of a certain level can mitigate the risk of them being unable to pay and meet any liability to you or your organisation.
Going back to the buyer/manufacturer example, a retailer buying goods from a factory may be required to sign an indemnity clause in their contract stating the retailer must indemnify against any losses suffered by the factory if they decide not to take the goods. If the retailer has a reputation for being unreliable or financially unstable, the factory may ask that they take out indemnity insurance. This insurance ensures the factory receives payment, regardless of whether the retailer can pay. Indemnity insurance, in effect, acts as a guarantee of indemnity.
As a matter of course, Britton and Time Solicitors recommend to all clients that they undertake credit checks alongside other searches. For example, a search at a Companies’ House is to be done before the contract is signed and agreed.
Britton and Time Solicitors can check whether the contract contains an insurance clause and whether the type and amount of insurance is enough to meet any liability which is likely under the indemnity clause. We always request copies of the insurance documentation.