Indemnity clauses tend to be some of the most hotly debated clauses in a commercial contract negotiation. Indeed, the mere mention of indemnity protection can put a strain on the positive atmosphere that commercial teams work hard to create at the outset of a business relationship.
Against this backdrop, it is perhaps unsurprising that non-lawyers are loath to dwell on the exact risks that an indemnity clause is designed to deal with, the scope of the losses it is intended to cover and the circumstances in which it can be triggered. For this reason, even indemnity provisions in otherwise relatively sophisticated contracts are often generic and broadly drafted, with heavy reliance being placed on the word indemnity itself.
One problem with this approach is that courts can be left with the unenviable task of working out how an indemnity should be interpreted in circumstances where the parties themselves did not give the matter much thought at the time the contract was entered into. The fact that indemnities tend to be broad and unspecific also arguably militates against a literal construction by the courts of the words used. This scope for interpretation by the courts has led to a number of judicial decisions which can appear contradictory.
While it is often said that indemnities are 'sensitive to context' and that the words used are of vital importance, this is not particularly helpful guidance for those tasked with negotiating and drafting indemnity clauses. Given that the over-arching purpose of an indemnity clause is usually to create a clear risk transfer mechanism, this level of uncertainty is of course unsatisfactory.
Yet indemnities are being used in an ever-increasing range of situations. Not only are indemnities being used to re-allocate the risk of third party claims, but it is now also common for indemnities to be 'bolted-on' to contractual obligations between parties.
In the face of these challenges, how should commercial lawyers approach the negotiation and drafting of indemnities? What techniques can be used to give your indemnity real 'bite'? Although recent judicial decisions do not provide any silver bullet solutions, they do provide guidance on the kinds of questions that commercial lawyers should consider when negotiating and drafting indemnities. We have highlighted five such key questions below:
- Is the indemnity intended to be enforceable as a debt? As debt claims tend to be procedurally and evidentially more straightforward, indemnified parties will often want indemnities to be enforceable as debt claims. But the use of the word indemnity does not automatically mean that the obligation will be treated as a debt claim by the courts.
- Is the indemnity intended to be 'protective' or 'compensatory' in nature? Depending on the drafting, an indemnity can be interpreted as 'pre-emptive' or 'protective' in the sense that the indemnified party does not itself need to incur a loss before claiming against the indemnifying party under the indemnity.
- What losses or liabilities are intended to fall within the scope of the indemnity? Unless parties are clear about the types of losses that are recoverable under the indemnity, it can be difficult for a court to assess what the parties intended it to cover. Although the starting point is the natural meaning of the words used, in practice any ambiguity tends to be resolved in favour of the indemnifying party.
- Are the usual rules on mitigation and remoteness intended to apply? If these rules are meant to be excluded, should there be any restrictions on proximity of loss and/or the conduct of the indemnified party in an enforcement scenario? While indemnified parties often talk of the need for 'pound for pound' protection, an indemnifying party is likely to baulk at the suggestion that it should be liable for a loss that the indemnified party has brought upon itself or could easily have avoided.
- How is enforcement of the indemnity intended to work in practice? While it is often hoped that an indemnity will be easier to enforce than a claim for breach of contract, many indemnities do not set out clearly what the trigger for enforcement is and what the indemnified party will need to do in order to prove its loss.