What is an indemnity?

In basic terms, an indemnity is an agreement to bear or reimburse the liability of another party.
An indemnity is often used in commercial transactions to manage the financial liability of a particular act or event occurring, including a contractual default such as non-payment, or another party’s negligence. Indemnities are commonly seen in agreements such as:
  • a lease or hire arrangement, where the tenant indemnifies the landlord for injury to a visitor while on the premises;
  • a towing contract;
  • a company director’s guarantee for an equipment finance loan; or
  • a software licence, where the vendor indemnifies the customer for a claim that the software infringes a third party’s intellectual property rights.
Below we outline 3 key issues to be aware of when giving an indemnity.
We also suggest several alternative approaches you can use to achieve a similar commercial outcome without the risks of giving an indemnity.

Traps

There are 3 main traps for giving an indemnity: Scope, duration and insurance.

1. Scope

It is common for a party to try to extend the scope of an indemnity from liability for a breach of contract to cover third-parties or a particular event.
By way of examples:
  • A venue owner might require a prospective hirer to indemnify the owner for any claim by a guest who is injured while attending a function at the venue. Then if a guest is injured and claims against the owner (or more likely, against both hirer and owner), the hirer would be liable to cover the owner’s liability (if any) for damages and its costs of defending the claim.
  • A body corporate which has a towing by-law (about removing a resident’s vehicle from a visitor carpark) may become liable to the resident if the car is damaged during towing. If the body corporate engages a tow truck operator pursuant to the by-law, it will be important that the towing operator is clearly instructed as to its duties and this is reflected in the contract between the body corporate and the towing operator. This would include the operator indemnifying the body corporate against liability for damage to the vehicle during the towing process.
  • A company director might agree to personally guarantee the company’s obligation to repay a lender’s equipment loan. If the terms of the guarantee also include an indemnity, the lender would be entitled to call on the director’s indemnity without needing to first exhaust its rights to recover the outstanding amount from the company, such as by enforcing the lender’s security interest (if any) under a goods mortgage or fixed charge over the equipment.
  • A software vendor might warrant to its customer that the software does not infringe any third-party intellectual property rights, and the licence agreement provides that the customer can claim damages on an indemnity basis for the vendor’s breach of that warranty. Then if a third-party claims against the customer for IP infringement, the customer could call on the vendor’s indemnity to cover any financial liability to the third-party.
In these examples, the common theme is that the indemnifier agrees to cover another party’s liability for loss or damage for which they would not otherwise be liable under a breach of contract.

2. Duration

An indemnity may inadvertently extend the length of time for which the granting party remains exposed to liability for loss or damage, as compared with a claim for breach of contract.
Statutes of limitation in all Australian states and territories cap the time by which a claim must be brought for breach of contract, usually within 6 years for an ordinary agreement and starting from the date of the breach. However, the limitation period for an indemnity clause starts from the date on which the indemnifier refuses to honour the indemnity. This gives the indemnified party a further 6 years from that date in which to start a claim to enforce the indemnity. This means the indemnified party would have a right to try to recover its loss many years after its rights to start a claim of damages for breach of contract have expired.

3. Insurance

There is a common misconception (or even an assumption) that an insurance policy will cover liability for a contractual indemnity. However, the wording of many insurance policies specifically exclude cover for purely contractual liabilities. This means that if you give an indemnity for loss or damage that otherwise would not arise at common law or under legislation, the insurance policy is unlikely to cover your liability.
For example, consider the following provision from a standard building contract:

The [Body Corporate] must indemnify the Contractor for any liability incurred by the Contractor to a third party in respect of any default or negligence of the Engineer or any other consultant the [Body Corporate] engages in relation to the Works.

If the Engineer is negligent in their design and the construction fails, an injured claimant would likely sue the Body Corporate, the Engineer and the Contractor.
The Contractor or its insurer would recover defence costs from the Body Corporate under the indemnity (which could be significant).
However, under the terms of the policy the insurer is not required to cover the Body Corporate’s claim because its liability was assumed by agreement only. Also, unless the Engineer has given an indemnity to the Body Corporate, the Body Corporate would be unable to recover its costs from the Engineer.
The likely end result is that the Body Corporate would need to pay the liability from its own pocket.

Alternatives

When negotiating an indemnity you may wish to consider one or more of the following alternative strategies:
  1. Remove the indemnity clause – and eliminate the risk;
  2. Omit the indemnity clause but offer principal’s liability insurance for the particular event or agreement – you will need to consider the costs of obtaining principal liability insurance; or
  3. Limit the scope or amount of your indemnity:
  • cap the indemnity to a particular amount – as a general guide, negotiate up to an overall liability cap of 100% of the contract price plus the proceeds of insurance policies;
  • require the indemnity to only cover loss or damage within your control, and to only apply to loss or damage that you actually caused or contributed to;
  • provide for a proportional reduction in liability for loss or damage caused or contributed to by the principal or another party; or
  • include an obligation on the principal to mitigate their loss or damage (although this is not always possible, for example if the indemnity is to protect the principal against the same loss or damage).
Above all, read your insurance policy. You must ensure that any indemnity provisions which are agreed to in contracts are covered by the insurances in place and do not invalidate the policies of insurance. For this reason we suggest that any negotiations and agreement of indemnity provisions should involve your insurance broker and be made subject to acceptable insurance cover being obtained.
If you are considering a transaction involving an indemnity or would like more information about this, please contact us.