Indemnity clauses are common practice in commercial contracts, employed to manage contractual risk. Their role in risk management means they are often a key point of negotiation, particularly in merger and acquisition transactions.

What is an Indemnity?

An indemnity is, in simple terms, a promise from one party to compensate the other party for losses arising from a particular event. They are used as a form of security to transfer liability from one party to another when a known risk occurs and are essential to managing contractual risk.

Indemnity Events and Breaches

Indemnities play a reactive role within the contractual framework. When an indemnity event occurs, as stipulated in a contract, the indemnifier (the party responsible for the loss) will be liable to compensate the indemnitee (the party who suffers the loss) for the entirety of the loss suffered. The indemnitee may recover this loss as a debt (as opposed to damages for breach of contract), streamlining the compensation process. An indemnity clause will be breached if the indemnifier fails to compensate the indemnitee for losses suffered due to an indemnity event.

Key Considerations

Indemnity clauses differ significantly from standard contractual terms, carrying distinct implications for contracting parties. Parties negotiating an indemnity clause should consider (among other things):

1. limitation periods;

2. the obligation to mitigate loss;

3. remoteness of breaches;

4. ongoing losses; and

5. coverage of insurance policies.

Limitation Periods

In the absence of a contractual limitation, indemnities apply for an indefinite period of time. This is because a party does not breach an indemnity simply because an indemnity event occurs. There must be a refusal to indemnify by the indemnifier. However, under section 10 of the Limitations Act 1974 (Qld), once an indemnity clause has been breached, the indemnified party has a period of 6 years to bring legal proceedings for breach of contract against the party responsible for the indemnity event. Parties seeking to restrict either of these limitation periods should do so explicitly in their indemnity provisions.

Obligation to Mitigate Loss

The requirement to mitigate loss does not apply to indemnity clauses. This means that parties who have suffered loss are not required to mitigate their loss unless explicitly prescribed in the relevant contract. Parties seeking to ensure that this obligation to mitigate loss applies should do so explicitly in their indemnity provisions.

Remoteness of Breaches

The requirement for losses not to be too remote does not apply to indemnity clauses. This means that parties who have suffered losses may recover compensation for losses that were not reasonably foreseeable to the parties at the time the contract was made. Parties seeking to ensure that this requirement for a loss to be reasonably foreseeable applies should do so explicitly in their indemnity provisions by excluding all forms of consequential and indirect loss.

Ongoing Losses

Parties may bring multiple claims for compensation under an indemnity clause. However, each claim must be based on a separate indemnifying event. Parties seeking to restraint the number of times an indemnity clause may be invoked should do so explicitly in their indemnity provisions.

Coverage of Insurance Policies

Insurance policies do not always cover losses arising from contractually assumed liabilities. A party that assumes liability under an indemnity clause, for which they would not otherwise be liable, can sometimes be excluded from insurance coverage. This includes any liability for losses resulting from the acts or omissions of third parties. It is important that contracting parties consider the coverage of the other party’s insurance to ensure that they are properly remunerated should an indemnity event or breach of an indemnity clause occur.

Conclusion

Indemnity clauses serve as a crucial mechanism for managing contractual risk, allowing parties to allocate and address potential liabilities. However, these provisions differ significantly from ordinary contractual terms, carrying distinct implications for those involved. It is important that parties entering into commercial agreements gain an understanding of indemnities and their unique outcomes to effectively safeguard their legal positions.