[EP 013] Demystifying indemnity clauses

Indemnity clauses often carry an enormous amount of risk, that often can far exceed the value of a contract. So in this episode we explore the main risks in indemnity clauses that you might be signing, and on the flip side, the way to use indemnity clauses best to provide protections.

EPISODE HIGHLIGHTS

00:47 Why are indemnity clauses important?

02:46 What is an indemnity?

04:34 Lessons Qantas and Aravco

08:05 Considerations for the party seeking protection

11:25 Considerations for those requiring an indemnity

13:36 Considerations for the party giving the indemnity

15:55 Limiting the impact of indemnities

16:53 Insurance

18:32 Action Steps

Why are indemnity clauses important?

Indemnity clauses often carry an enormous amount of risk that can often far exceed the value of a contract. But the thing is people often just don't understand what they're signing. I've seen countless indemnity clauses that clients have inadvertently accepted that create risks that are completely inappropriate. People are signing these clauses or signing up to these highly risky indemnities because they simply just don't understand what it is that they're reading. They don't understand the risk in what they're reading and sometimes they don't understand what they can do to reduce that risk.

On the flip side, often I see clients have clauses within their agreements that are inappropriate either because they overshoot the mark or because they're not sufficient enough and that can create large issues. Both of those approaches can create large issues.

Overreaching clauses

In cases where the indemnity is overreaching, you often find cases where clients or suppliers, whoever you're providing your agreement to, will constantly push back on that clause. It creates an ongoing friction for the people that you're providing your contracts to.

Weak clauses

On the flip side, if your indemnity clauses aren't strong enough, then the issues you're creating is that you are opening yourself up to the risk that you need not have if you had the appropriate indemnity clauses to begin with.

The point of today's discussion is to highlight some of the issues with indemnity clauses so that when you're looking at them you can understand the risks and the considerations that you should be bearing in mind. And then also giving you the tools to be able to consider whether or not you need to go and seek external or extra advice in relation to these clauses before you sign them.

What is an indemnity?

Essentially, an indemnity is a clause where one person agrees to compensate another if they suffer a loss. So we might see the wording something along the lines of Party X agrees to indemnify and hold harmless Party B from and against all loss that is suffered during the provision of the services. That's an example of an indemnity clause where X is protecting B against losses that might be caused by certain activities.

This is not necessarily always lining up with who has primary liability under a clause whereas one person might be responsible for something, another person might agree to cover the cost. And essentially, that's what an insurance policy is. If you think about it, an insurer hasn't caused a loss but they agree to indemnify or protect a party against any loss that they might suffer from a particular type of event in return for you paying an insurance policy premium. So an insurance policy is a great example of a very large indemnity clause. But we see indemnity clauses all the time in agreements. The point I want to make is that indemnity clauses can often go far further than simply saying that the person who has caused the loss is responsible for the loss. The element of who caused the loss isn't necessarily relevant for indemnity clauses because indemnity clauses are just all about who will pay for the loss.

Lessons from Qantas and Aravco

One of the cases that always comes to mind for me when I'm talking about indemnities is the case of Qantas and Aravco. This is a case back in the 90s but I've always thought it was particularly interesting because it deals with some really interesting concepts and has an outcome that is not necessarily expected. In fact, it can sometimes feel a little bit shocking.

Essentially, a plane flew in to Sydney Airport and required some work to be done on it. The pilot was handed an aircraft handling notice by Qantas and asked to sign it. The next day services were performed on the aircraft. Together with the fee for parking the aircraft overnight, the service charges amounted to around about $5000 so a fairly small bill. The following day however, while the aircraft was still parked, another aircraft driven by Qantas employees was driven into this aircraft causing damage between half a million and a million dollars in value. So subsequently the aircraft owner sued Qantas for the damage to the aircraft. Qantas admitted liability for the damage. They put up their hands and said yes we agree, we drove into your aircraft with ours. But Qantas then sought indemnity for the damages that it had to pay. A clause in that aircraft handling notice that it had handed over to the pilot, which he signed, essentially said that no matter whether or not it was negligent, that Qantas would be indemnified from and against all liabilities and losses that related to the services that Qantas was providing.

This is what we call a negative indemnity clause where a party seeks protection under an indemnity even for losses that it has caused. And the interesting answer in this case was that even though Qantas was negligent and that negligence caused the damage, it was protected for the value of all of the damages by way of this indemnity i.e. it was negligent but didn't have to pay because of this clause in its agreement.

I think that's a really important lesson for us when signing indemnities in this situation. Obviously, the aircraft handling notice was handed to someone who didn't have legal background and potentially didn't quite understand or maybe didn't even read what they were signing. These indemnity clauses can be captured or stuck in all sorts of agreements that were signed in a business on an ongoing basis. Some of the more nasty types of indemnity clauses that I've seen are often in cases of transport. But difficult indemnity clauses that are simply not appropriate for the situation in which they are used come up time and time again.

Issues to Consider

If you were the party seeking the protection of an indemnity clause

To explain what I mean by that, I mean you have an indemnity clause in the agreement that you have with another party (either client or supplier or other third party) where you have done a risk assessment and you have said to the other party that for whatever reason, they will be responsible for any of the loss that you might suffer in this situation. For example, you might be dealing with a supplier and you might say, “In relation to the things that the supplier is providing us, they will be responsible for damage that they caused during the period of time that they're providing us with these supplies.” That's an example of a way that you might use an indemnity clause.

If you are the party that wants to use an indemnity clause for your protection, one of the first things you need to remember is an indemnity is only as good as the party that's giving it. What that means is if you are using an indemnity for protection against some other risk or loss that you might suffer from a third party, you can't move that primary liability. So if you're using an indemnity to protect you against a situation where a third party is suing you, then this indemnity clause won't necessarily stop that third party from suing you.

But what it means is if that third party sues you, then you have the right to seek recovery from the party that is giving you the indemnity. If the party who is giving you the indemnity doesn't have the funds to meet the loss that you've suffered, then the indemnity is essentially worthless.

You need to ensure that the indemnity is being used appropriately and that you understand why you are using the indemnity and how it might be used. If it's going to be used to protect you from risk that you might be suffering in relation to third parties then you may need to make sure that the party that is giving you the indemnity has the sufficient resources to meet the costs of the indemnity or that it is properly insured. And so insurance is the most usual form of protection that we wouldn't be looking for to ensure that someone can meet their obligations under an indemnity.

That's often why in contracts you will see a provision that requires the other party to have a certain level of insurance or if you're the party providing the indemnity, you might find that there is a clause in the agreement requiring you to provide a certain level of insurance. But remember it's not enough just to have a clause that requires another party to have insurance. You really need to make sure that insurance is in place, which is also why if you're dealing with a large level of risk, you'll often see that one party will require the other to provide them with proof of insurance through handing over evidence of a certificate of currency of insurance. So that's the reasoning behind all of that. Essentially, it's making sure that the party who is giving the protection under me an indemnity has the ability to meet the value of that indemnity.

If you are requiring an indemnity

I think the very first thing that you should be doing is thinking about why you were requiring the indemnity. What risk are you trying to protect or reinforce? Then you need to make sure that the indemnity clause appropriately protects against that. Next you need to consider who has the benefit of the indemnity. Is it just the business or does it also cover other entities that might need also to be protected?

Say for example if the business you're part of is part of a wider group of companies, does it protect other companies within the group? Does it protect the directors and employees as well? Often we see indemnity clauses that will draw in other people to protect them as well under the indemnity clause. The next thing to consider is what are the types of losses that are covered by in the indemnity? Does it cover special or consequential losses for example loss of profits might sometimes be considered to be a consequential loss. And sometimes there will be clauses within the indemnities that seek to carve out consequential losses. So if you want to protect loss in certain ways, just make sure that the other party hasn't drafted in words that reduced the protection that you're getting. And then the final thing, is there any attempt to reduce the liability by the person that's providing the indemnity? So for example some ways this might happen is they might put a cap on the liability. The important thing to bear in mind in relation to a cap on a liability is that wherever there's a cap you will then continue to be responsible for anything that is above that cap. So you need to make sure that if there is a cap that the cap isn't too low or that you have the appropriate insurance that sits on the other side to make sure you're protected for the full value of the risk that sits outside of that cap.

If you're the party that is giving the indemnity

For example, if you other supplier in a particular relationship or for some other reason you're providing an indemnity to another party, all of the same issues that I've covered earlier would apply to you as well. But one of the biggest considerations are:

1) What does the indemnity relate to and what are the risks that relate to that so you need to have a bit of a think about what the indemnity actually means to you and what the risks are being created so that you can ensure that you i) make the right changes to the clause and ii) have the right commercial practices in place to protect you as much as possible from any of the risks that might be caused with the indemnity.

2) You need to consider who has the benefit of the indemnity. So in providing the indemnity, are you indemnifying a wide class of other people? And if so, is that really appropriate?

3) You need to think about what types of losses are covered by the indemnity. So for example, you might need to add in some clauses that limit your liability in relation to consequential loss. For example you might say, Well we might be happy to be responsible for any damage that is caused by us to your systems in providing some sort of services to you but we won't be responsible for any lost income that you have suffered during that period or any brand damage that you might suffer during that period because we have no control over what you might claim in that regard. That's an example of the sorts of clauses that you might put in there to protect yourself.

4) Are there any other ways that you can reduce your liability? Once again one of the options that might be open to you is putting a cap on that liability. Maybe a cap that relates to one of the services that you provided or the goods that you provided in a particular period of time i.e. capping it to the contract value. You might have some other cap. The important thing to bear in mind here is that you must make sure that your indemnity clauses line up with your insurance which is something that we would talk about a little bit more in a couple of minutes.

Limiting the Impact of Indemnities

Reducing the scope of the subject matter

Reducing what it is that you're protecting under indemnity, limiting the losses to those that you directly cause and only to the extent that you caused those losses. Words like "directly caused by" reduce your liability to the extent that the other party has caused or contributed to any loss. In this sense we're talking about ensuring that if the other party has also helped to contribute to the loss, you're not going to be fully liable for the full amount of the loss. And as I said before, you might want to exclude consequential losses and add in a cap.

Insurance

Both parties should be thinking about insurance because this is an important element that relates to indemnity clauses for both people who are giving indemnities and for people who are receiving the indemnities.

If you are giving indemnities, then insurance is a mitigation tool that you can use to minimize the risks associated with you giving broad indemnities. It's important that you don't agree to any indemnity that might impact your ability to make a claim on any insurance policy that you have in place. You don't want to be in the position where you have insurance cover for an indemnity you've agreed to give but then end up in the situation where you have done something within that clause that limits your ability to use your insurance policy. Worse still you don't want the situation where you have completely contracted outside of what your insurance policy would normally cover. You need to understand your insurance and understand how it will interact with your indemnity clauses.

On the flip side if you are the party that is receiving the protection of indemnity then you also need to check that there's nothing within that clause that creates an insurance requirement for you. As I said before, that might be the case if there is a cap on an indemnity that you are signing, an indemnity you're receiving. You might want to ensure that you have insurance that covers you for the value of the risk that you still have that sits above the value of that cap.

Action Steps

Indemnities are a really tricky topic. Hopefully I've helped to make some of the risks that are sitting in indemnity clause clear and not too confusing. I've got some fairly simple action steps that we can take out of this moving forward.

Make sure you don’t sign something you don’t understand.

I think that's an absolutely crucial and critical point because that's usually where problems arise. People have simply signed something that they don't understand and they've created a whole heap of risk and liability that they didn't need to create had they understood it and made the appropriate changes.

If you don’t fully understand, get help.

Get assistance. Don't bumble along or worse still, don't just simply see the heading indemnity and figure it must be OK because everyone signs them and skip over it. Seek advice from someone who really deeply understands the indemnity environment in relation to your business.

Make sure you get appropriate protection.

If you are receiving an indemnity, consider whether it's broad enough to protect you. And on the flip side, if you're giving an indemnity, ensure that you are building appropriate protections in relation to the sorts of things that I've talked about all through this episode and if you're not sure thing get advice.

Consider Insurance Implications

If you want a bit more of information about this topic head over to our website at talkinglaw.com.au for a free download on everything that we covered today. Through that web site you'll also be able to download some other tools that may assist you in dealing with clauses like this and in other areas in agreements that you deal with and you'll also find details of how to contact our lawyers at Aspect Legal if you'd like help with any of your indemnity clauses or if you'd just like a general or discussion in relation to how the things I've spoken about today apply in particular to your business that you're dealing with or the contracts that you're dealing with. And finally, if you enjoyed what you heard today please pop over to iTunes and leave us a review. We would be very grateful and thanks for listening in. See you next time!