Indemnities are often one of the most heavily negotiated elements of a transaction, yet they are commonly misunderstood. Used as a key mechanism for allocating risk, it is important that both parties to a transaction understand what an indemnity is and how it could affect future liability.
What is an indemnity?
An indemnity is a legally enforceable promise to pay for another party’s loss on the occurrence of a specific event. It protects a party from loss by allocating the risk to the other party. For example, a supplier of goods may indemnify its customer against third party claims over faulty goods.
When should an indemnity be given?
A party will be keen to receive the benefit of an indemnity but will be very reluctant to give one. A buyer will usually attempt to protect itself through indemnities, whilst a seller will try to avoid giving an indemnity as this may expose it to future claims.
The giving of an indemnity will depend on the particular circumstances, the level of risk involved in the transaction and the bargaining power of each party. Unsurprisingly, the party in the strongest position is likely to see the benefit of more indemnities and will also be in a better position to push back on giving any.
Where an indemnity is given, its wording needs to be drafted with precision. Vague language and ambiguity risks leaving the party giving the indemnity open to unanticipated claims. It may also be deemed too imprecise to cover the loss it was intended to cover. Unhelpfully, the law offers very little guidance on indemnities which makes drafting them particularly difficult. As a starting point for considering whether or not to give an indemnity it is useful to debate what losses could occur and who should be liable to cover the costs of those losses.
An indemnity should not be given if it would not add any extra protection to what is already available, such as a claim for breach of contract. An indemnity will be invalid and unenforceable if it relates to a category of loss that cannot be indemnified. These include losses caused by the indemnified party’s own deliberate acts. Therefore, if the indemnity would be contrary to public policy, it should not be agreed. Other situations where an indemnity should not be agreed include when they are unfair or where it would force a party to essentially act as the other party’s insurer.
Tips for your business
Although indemnities can be a difficult concept, it is helpful for companies to have a clear policy on indemnities from the outset. Being sure about what indemnities your company is and is not prepared to give will help to guide negotiations from the early stages.
The party giving the indemnity should aim to limit the number and scope of indemnities it offers. For example, limiting the period in which a claim could be brought under the indemnity could reduce vulnerability to future claims. Ensuring the indemnity is not too broad could reduce the costs payable under it. Requiring the indemnified party to take reasonable steps to minimise loss should also help reduce the potential liability under the indemnity.
The indemnified party should also avoid drafting overly wide indemnity clauses as they may not hold up. There is a risk that the indemnity clause will not offer the protection the indemnified party expected and as such, it could be left to cover the costs of the loss.
If drafted correctly, indemnities can offer much welcomed certainty and risk management to contractual agreements. But before an indemnity is agreed, both parties should ensure they are certain what loss is covered and to what extent.
This blog post was written by Katie Rice. For further information, please contact:
Sophie Brookes, partner, Corporate team
T: 0161 836 7823