IP indemnities tend to cause a certain amount of concern to commercial parties in the context of commercial agreements. However, when used and drafted properly, they serve a vital purpose.

What is an indemnity?

An indemnity is an obligation given by one party to a contract to compensate the other for some defined loss. Typically the obligation relates to a specific clause within a wider commercial agreement e.g. within an IP licence agreement. Its chief purpose is to appropriately allocate risk between the contracting parties – although the appropriateness of that risk allocation will be coloured by the bargaining position of the parties.

Risk allocation

However, indemnities are not the principal mode of allocating risk within a contract – warranties are. To understand the role of an indemnity it is important to first understand the purpose of warranties. Warranties are promises of the truth of certain statements e.g. "the use of my product does not infringe third party IP".

A warranty that is caveated by disclosure will be ineffective in respect of the matter disclosed.

The recipient of a warranty who knows it to be untrue at the time it is given, may not be able to rely on the warranty as the basis for a breach of contract claim (Eurocopy plc v. Teesdale and others [1992] BCLC 1067). Equally the giver of a warranty will not want to give a warranty that it knows is untrue without caveating the warranty by making a suitable disclosure. Doing so would automatically put the giver in breach of contract. It is in these circumstances, where warranties cannot be given or relied upon, that indemnities are particularly important.

Difference between a warranty claim and an indemnity claim

A warranty claim is a claim for breach of contract. If successful, the innocent party is entitled to:

  • damages – subject to common law rules of causation and foreseeability of the loss, and also the obligation to mitigate the loss caused by the breach; and
  • if the breach is serious enough (or if the contract otherwise provides), to terminate the contract.

An indemnity claim on the other hand gives rise to a debt. There is no breach of contract and therefore no right to terminate. All that is required is that the loss suffered by the claiming party falls within the category of losses described in the contractual terms of the indemnity itself. There is no need to show that the loss incurred was caused by any default of the other party or that the loss was foreseeable. There is also no need to mitigate the loss suffered.

Accordingly, where they cover the same loss, indemnities can potentially give rise to claims that are higher in quantum than warranty claims.

In light of this, one often sees the same risk issue being covered both by a warranty and an indemnity, for example:

Party A warrants that use of its technology does not infringe third party IP, and also indemnifies Party B if it does in fact infringe third party IP.

On the face of it, this looks like a belt and braces approach for Party B, but is it really necessary? The indemnity will provide financial protection against any loss that Party B may suffer in the event of an infringement of third party IP, and that is usually Party B's primary concern. The inclusion of the warranty, however, also potentially gives Party B the right to terminate for breach of contract. This may be unduly punitive.

Anatomy of an indemnity

The party giving an indemnity will seek to draft it narrowly whereas the recipient will want to draft it broadly. When drafting/amending an indemnity it is important to assess its scope and the meaning of the words used. This can be done by considering its constituent parts separately, namely:

  1. What is the obligation?
  2. Who is the beneficiary?
  3. What is being indemnified
  4. Under what circumstances does the obligation to indemnify arise?

Consider the following indemnity clause:

Party A shall indemnify, defend and hold harmless Party B its affiliates and its and their officers, directors, employees, agents and subcontractors ("Indemnitees") against all claims, demands, suits, liabilities, costs, expenses (including legal fees), damages and losses suffered or incurred by the Indemnitees arising out of or in connection with:

a) Party A's breach or negligent performance or non-performance of this agreement; or

b) Any actual or alleged infringement of a third party's intellectual property rights arising out of Party B's use of the technology.

This indemnity shall apply whether or not the Indemnitee has been negligent or at fault.

It is a relatively standard form indemnity albeit drafted in a pro-indemnified party manner.

What is the obligation?

In this instance it is to "indemnify, defend and hold harmless". However, the giver of this indemnity should seek to limit the obligation simply to "indemnify". Since, if the obligation includes the obligation to defend – the indemnifier will also be liable for the costs of defending allegations of infringement and not just proved cases of infringement. As regards the "hold harmless" language, there are two schools of thought as to what this means, either:

  1. it adds nothing to the term "indemnify" (in which case why add it?); or
  2. it entitles the indemnified party to indemnification even when the indemnified party has itself caused the loss (in which case is it reasonable to include it?).

Who is being indemnified

In this instance it is Party B, Party B's affiliates and other defined third parties. As the indemnifier it is important to check as to whether an obligation to indemnify all of these persons is appropriate.

What is being indemnified?

Since indemnity claims are in essence debt claims and so therefore only cover financial losses – reference to "claims, demands and suits" necessarily relates to the obligation to "defend" rather than the obligation to "indemnify". Accordingly, if the obligation to defend is to be resisted then references to claims, suits and demands and other similar language should also be removed.

Under what circumstances does the obligation to indemnify arise?

This is the most important part of the indemnity. In the example, the IP part of the indemnity (part (b)) is not limited to losses etc. suffered as a result of third party claims, so there does not necessarily have to be a claim brought by a third party in respect of its own IP. Furthermore, it is not limited to actual infringement but merely allegations of infringement.

This is a practice that crept in from US drafting convention, which developed in the US because the parties' legal costs in a breach of contract claim are not usually recovered by the winning party. This is not the case under English law. Indemnity claims do not require the injured party to show that the loss was foreseeable or to mitigate its loss – is this reasonable for a breach of contract claim the rules for recovery of which have been formulated over centuries? The IP indemnity is phrased in terms of any claim for actual or alleged infringement. As an indemnifier it is preferable to only indemnify any infringement if such infringement is proven. Finally, in terms of negligence, if it is the intention of the parties that the indemnified party should be indemnified even if it has contributed to the loss, then under English law this must be clearly stated.

Consider this marked-up version of the previous indemnity drafted from the indemnifier's perspective:

An indemnifier can further minimise its risk through a number of other mechanisms. A sophisticated indemnifier would also draft into the contract conditions precedent such as:

  • requiring immediate notice of any claim;
  • requiring the indemnified party not to admit fault or settle;
  • requiring that the indemnifier has sole conduct of the claim;
  • requiring the indemnified party's assistance in defending;
  • inserting in an express contractual obligation to mitigate loss – negating part of the appeal of indemnities; and
  • inserting exclusions such as:
    • no indemnity to the extent that the:
      • product has been modified;
      • product is used in combination with another product that has not been approved by the indemnifier;
      • product is used otherwise than in accordance with the indemnifier's instructions;
    • limit indemnification to certain types of IP e.g. Patents rather than IP generally;
    • limit to certain geographical location; and
    • limit the time for bringing a claim e.g. within a certain period of launch.

Common pitfalls

It is easy to assume that indemnities are stand-alone clauses and that they deserve special treatment. However, they generally sit within a wider commercial contract and so English law rules of contractual interpretation apply. As with any other clause, an indemnity will have to be interpreted within the context of the contract as a whole. This means that an indemnity's meaning and scope is coloured by the rest of the contract. Words used in the indemnity and the rest of the contract will be given their natural and ordinary meaning. This is particularly important when determining what, if any, the limit to the indemnifying party's liability under an indemnity will be.

Limitation of Liability

Consider these examples:

  • "All liability under this agreement limited to [X]" – "all liability" will include any indemnities.
  • "All damages under this agreement limited to [X]" – "all damages" will not include indemnities.
  • "Neither party shall be liable to the other for any indirect or consequential loss" – this will require the indemnified party to show that the particular loss was foreseeable (and depending on the scope of such an exclusion of liability clause prevent recovery for things such as loss of profits – that may otherwise have been recoverable under the indemnity.
  • "Party A will indemnify Party B against Party A's breach of contract up to a maximum amount of [X]" – if the indemnifier has had to concede that breaches of contract (e.g. of warranty) are indemnified, then this formulation will limit the indemnity claim but will not limit the breach of contract claim.
  • "Indemnification shall be Party B's sole remedy in respect of matters covered by the indemnity" – This will only be the case if a clause to this effect is inserted.

Conclusion

As can be seen, the devil is in the detail of the drafting. More importantly, however, before going to the effort of drafting and amending the indemnities, it is vital to note that the value of an indemnity is entirely dependent on the indemnifier's ability to pay. It may be imperative, therefore, to consider (as a recipient of an indemnity) whether the indemnifier should be required to take out insurance.