Ever wondered how businesses protect themselves from unexpected costs and liabilities? Enter the world of indemnities, a legal concept that, while not a household term, is largely responsible for risk management between commercial parties.

Put simply, an indemnity is a promise, typically a clause in a contract, to pay the other party money if specific acts or events happen.

For example, a business may require its suppliers to indemnify it against claims related to defective products. The indemnity means that if the products are defective and customers want refunds or replacements, the supplier is required to pay the business money. Likewise, insurance is an example of an indemnity agreement.

In this sense, the concept of “indemnity” can be described:

1. from the business’ perspective, as legal protection against liabilities that may arise; and
2. from the supplier’s perspective, as compensation paid to the other party (the business) to “make good” the loss they suffered.

Indemnity in action

The ideas of protection and compensation form the basis for how indemnity clauses operate in contracts, making them a key mechanism used by businesses to mitigate risk. Because of this crucial risk mitigating role, indemnity clauses are often important negotiation points in any commercial relationship.

Typically, if a business has suffered loss its main remedy involves a claim for damages where it must prove the other party breached the contract, caused the loss and the business mitigated its loss. These are often challenging arguments to successfully make.

However, indemnities offer broader coverage than a standard claim for damages, as such, indemnities:

• may not require proof of fault, causation, mitigation or that the contract was breached, only that loss occurred;
• often apply regardless of whether the loss was foreseeable; and
• can be triggered by third party actions or by regulatory compliance.

While written indemnity clauses are not always required for a party to be obligated to indemnify the other, relying on a verbal or implied indemnity carries risk and is not recommended due to a lack of certainty and challenges with enforcement.

Although, on rare occasions the courts may find that the conduct between the parties gave rise to an obligation to indemnify because one party relied on the other’s conduct.

However, caution must be exercised when incorporating an indemnity, whether written or verbal, because misapplying the term carries its own risks.

Indemnity issues

Indemnity clauses are interpreted strictly by the courts, if not expressed precisely, the clause may be given a meaning contrary to what the parties believed they had agreed to.

If an indemnity clause is not written clearly, the courts are reluctant to enforce compensation when the loss:

• occurred due to the indemnified party’s own negligence;
• is consequential to the specified type of risk, such as a loss of opportunity, reputation or income; and
• is caused by a third party not privy to the indemnity clause.

Additionally, if an indemnity clause is written clearly but is broader than the parties intended, the indemnifier may find themselves liable for more than they expected.

Therefore, it is crucial to ensure precise wording around:

• the triggering events that give rise to indemnity;
• the scope of loss the indemnity covers;
• the exclusions for unwanted coverage and compensation limits to a set amount; and
• the way the indemnity clause will interact with other terms in the contract.

Due to the risks associated with drafting and agreeing to an indemnity clause, it is important to receive legal advice to ensure that the clause is drafted appropriately.

When is it appropriate to use an indemnity clause?

It is appropriate to use an indemnity clause when:

• Parties want to allocate responsibility for loss before it occurs; e.g. a subcontractor may indemnify the main contractor for damage they might cause on site.
• Parties may be exposed to claims from a third party; e.g. a supplier may agree to indemnify a retailer for any product liability claims brought by customers.
• One party is in a better position to mitigate the risk; e.g. an event organiser may indemnify a venue for crowd-related damage

An indemnity clause frequently seeks to compensate for situations such as a party’s own negligence, personal injury or death connected to the agreement (although claims for personal injury and death in New Zealand are generally covered by Accident Compensation legislation and therefore difficult to enforce separately), property damage, intellectual property infringements, associated legal expenses and other common risks associated with the relevant business activity.

Most parties want to mitigate as much of their own business risk as possible, but how an indemnity clause is worded depends on the negotiating power and position between the parties (as with any contract negotiation).

If you are dealing with an indemnity clause:

Seek expert legal advice and ensure that:

• The clause is specific and unambiguous to reflect your intentions.
• You are in the best position to negotiate the terms of the indemnity clause.
• You have considered the risks when agreeing to the clause.
• You understand how the clause will work in your business arrangement.

(Article by Bethany Sweeney, Solicitor and Daniel Crawford, Law Clerk).