There are five basic steps you can take to ensure your contractual indemnity works the way you intended it to.

An indemnity is little more than an agreement to cover loss and damage suffered by another. Despite being a seemingly straightforward concept, contractual indemnities are often a source of disputes. They can also be a prominent talking point during contract negotiations, in large part because of the significant consequences that may flow if you don’t get the drafting right.

The object and effect of a contractual indemnity are to alter the common law or statutory rights of parties. It does not matter whether you act for the party giving or receiving the indemnity — it is essential that you consider the extent to which a contracting party seeks to alter those existing rights. This will help you to draft an effective indemnity clause.

The existing position at common law and under statute

The nature of any loss or damage that is recoverable in connection with a contract varies depending on the subject matter of the contract. Often the subject matter of a contract will be such as to give rise to loss or damage from breach of the contract, property damage or personal injury.

Common law and statutory rights of recovery for loss or damage can be extensive. However, there are some limitations on the type of loss or damage that is recoverable. For example, damages may not be recoverable from a party in respect of a breach of contract if they are too remote. A party’s liability may also be reduced to the extent that a concurrent wrongdoer is also liable for the loss or damage, and proportionate liability legislation applies. A party who suffers a loss may need to take steps to mitigate their loss. If they do not, their rights of recovery may be impacted. Finally, statutory limitation periods bring to an end causes of action to recover loss.

So how can indemnities alter the existing position under common law and statute?

Remoteness principles do not apply

Liability under an indemnity may extend to cover loss or damage that is not ordinarily recoverable for breach of contract because of the concept of remoteness of damage and the rule in Hadley v Baxendale. [1] Loss or damage which does not usually flow from a breach of contract, or which was not contemplated by the parties at the time the contract was entered, may be recoverable under an indemnity. This will depend on the wording of the indemnity.

Extending the limitation period

The statutory limitation period that would ordinarily apply in respect of cause of action can, in effect, be extended under a contractual indemnity. For example, the statutory limitation period for a breach of contract is six years and begins to run from the time of the breach. If there is an indemnity under which the party who breaches the contract is obliged to indemnify the other party for losses incurred as a result of the breach, the rights of that other party under the indemnity will continue for as long as the indemnity remains in force. If the party in breach refuses to honour its obligations under the indemnity, there will be a cause of action for breach of the obligation to indemnify. The limitation period will begin to run from the time of the refusal to indemnify, which may occur long after the original breach of contract.

No obligation to mitigate

Ordinarily a party to a contract has an obligation to mitigate any loss suffered as a result of a breach of contract. However, this obligation is unlikely to apply to a party claiming under an indemnity (unless the indemnity expressly requires them to mitigate losses). This is because the obligation to mitigate arises in respect of damages following a breach of contract. In the case of an indemnity, the relevant breach of contract will be the refusal to indemnify, rather than the event giving rise to the right to claim under the indemnity in the first place. In this context, it could be said that a party with a claim for breach of an indemnity cannot be expected to mitigate its loss, where that loss represents the very amount for which it should be indemnified.

Tips and traps when drafting indemnity clauses

It is not possible to list all issues to take into account when drafting an indemnity clause. This article highlights a few tips and traps.

Tailor the clause to the particular circumstances of the contracting parties

The most important tip for drafting an effective indemnity is to ensure that the clause is worded to suit the particular circumstances of the contracting parties. If there is a dispute about the operation of a contractual indemnity, the balance of the contract will help to identify how the indemnity operates.

In the Erect Safe Scaffolding case, Giles JA stated that:

"… the operation of any contractual indemnity must be found in the application to the facts of the relevant clause, construed as part of the contract as a whole. Decisions on the operation of contractual indemnities in different words in different contracts are likely to be of limited assistance. [2] "

Therefore a drafter should be cautious when relying on precedent indemnity clauses.

Hold harmless or make good?

In Sunbird Plaza Pty Ltd v Maloney, the High Court described an indemnity as “a promise by the promisor that he will keep the promisee harmless against loss as a result of entering into a transaction with a third party”.[3] In Andar Transport Pty Ltd v Brambles Ltd, the High Court said that indemnities “are designed to satisfy a liability owed by someone other than the guarantor or indemnifier to a third person”.[4] Both descriptions are accurate. However, different outcomes may flow from the obligation to “hold harmless” the indemnified party as opposed to the obligation to “make good” any loss or damage suffered.

In the case of a “hold harmless” obligation, the party giving the indemnity will effectively be in breach of the contract as soon as the indemnified party suffers any loss or damage. The result is that a limitation period will start running immediately from the date of the loss or damage.

The “make good” obligation gives the indemnified party the right to claim indemnity when they suffer loss or damage. However, the party giving the indemnity is not obliged to do anything until called upon to make good the loss or damage. Therefore the party giving the indemnity will not be in breach of the contract until the indemnified party has made a claim under the indemnity and the claim is refused. It is only at this point that the limitation period will begin to run.

The form of an indemnity may therefore impact the operation of limitation periods. A drafter should consider the intended duration of any indemnity at the time of drafting, so that the indemnity clause reflects the intent of the parties.

Ensure the obligations under the indemnity can be met

It is important to take into account the capacity of the party giving the indemnity to meet the indemnity. A broadly worded indemnity clause will be worthless to an indemnified party if the party giving the indemnity does not have the financial resources to make good on its promise. Similarly, the party giving the indemnity would be well advised to consider how it will fund its promise. If it may not be capable of doing so itself, it may need protection through insurance or some other arrangement.

Many parties will be quick to identify that it may be necessary to require a guarantor to support the indemnity. It is also common to require responsibility for loss or damage to be covered under an insurance policy. The issue with insurance is how to make sure that the indemnity and insurance interact effectively.

If an indemnified party wants to rely on another party’s insurance policy, it should take steps to ensure that cover is adequate and will remain in place. The insurance must be valid for the period during which the indemnified party may call on the indemnity. In some cases, it may be appropriate to include the indemnified party as a named insured under the insurance policy.

Line up any insurance being relied upon and consider the extent to which there are gaps

Drafters often fall into the trap of assuming that access to an insurance policy will solve any potential recovery problems under a contractual indemnity. The reality is that the scope of cover under the particular insurance policies may not align with what is covered under the indemnity. This can create gaps which leave the contracting parties with uninsured exposures. For example, liability policies often exclude cover for contractually assumed liability. If a party assumes a liability under a contractual indemnity in circumstances where liability would not otherwise exist at common law or under statute, such an exclusion would leave that liability uninsured.

Include an obligation to mitigate loss where you act for the party giving the indemnity

The party giving an indemnity may argue against the principle that there is no obligation to mitigate loss under indemnity. Indeed, courts usually apply a strict interpretation to indemnity clauses so that they extend to protect against only those liabilities that are reasonably incurred. However, any party providing an indemnity should consider including a requirement that the party receiving the indemnity should take reasonable steps to mitigate its loss following a breach of contract.

Outline of steps to follow when drafting an indemnity clause

By way of a general guide, when drafting an indemnity clause in a contract the drafter should:

  • First, consider the source of any potential loss or damage which may arise in connection with the contract. For example, loss or damage may arise from: breach of the contract through non-performance or defective performance; damage to real or personal property of contracting parties or third parties; injuries suffered by employees, subcontractors or the general public, and so on.
  • Second, consider the nature and extent of potential loss or damage. Questions may include: Is there a potential liability in damages to a third party and, if so, for how much? If there is a risk of damage to property, and is it quantifiable? Will financial or consequential losses flow from a breach of the contract? If so, how significant would they be and can they be quantified?
  • Third, consider which party may cause loss and who would be responsible at law for each type of loss if there was no indemnity. This means having regard to the common law and statutory rights of each party.
  • Fourth, consider the extent to which responsibility for each type of loss ought to be allocated between the contracting parties.
  • Fifth, consider the ability of the responsible party to meet any obligation. Then consider whether that party’s liability will need to be limited in any way or supported by a guarantee from a third party or insurance.

It can seem onerous to work through this process to draft a clause. We would suggest that it is worth taking steps to get right the drafting of an indemnity. The consequences of getting it wrong might be dire.

This article was first published in Inhouse Counsel, Vol 16 No 7, May 2013