Limiting liability part 3: Drafting indemnities and allocating risk

In this third and final article of our series on limiting liability, we look at indemnity clauses and how they can be used to allocate risk. For more tips on limiting liability please see our two other articles in this series - 'Limiting liability part 1: How long is a piece of string?' and 'Limiting Liability part 2: What can be excluded?'

What is an indemnity clause?

An indemnity clause is an obligation to reimburse the other party on demand for a specific loss or liability. Indemnities seek to protect against specific commercial risks, and when used correctly are a useful form of protection. However, indemnity clauses are a misunderstood breed, and used indiscriminately can be very onerous obligations. Whether you are giving an indemnity or the beneficiary of one, indemnity clauses should always be given a great deal of attention when reviewing any contract you propose entering into.

It is important to note that an indemnity is a distinct right from the right to claim damages for breach of contract. Therefore any limitations under an indemnity will be for that indemnity only and will not operate to limit the common law right for damages for breach of contract. Conversely, if the indemnity is intended to be unlimited, then it is important that this is expressly stated in the contract so as to prevent any purported limitation of liability biting. 

Risk assessment

Indemnities in commercial contracts are all about allocating risk between the parties. Indemnities come in all shapes and sizes. They can be:

  • a third party indemnity, whereby the indemnifier agrees to hold the beneficiary harmless from loss or damage arising from a claim by a third party; or
  • a party to party indemnity, where the indemnifier accepts responsibility for losses arising from certain failures or risks.

The nature of indemnities vary from contract to contract but examples of common indemnities include those relating to personal injury, property damage and intellectual property infringements.

Drafting and negotiating

As with any contract term, precise drafting is key. Whether you are the beneficiary or indemnifying party, much time and consideration should be given to any indemnity clause.

When drafting or negotiating an indemnity there are a few key points which should always be considered:

  • Scope: The scope of the indemnity should always be clear. Any ambiguity could result in the clause being interpreted in a way that does not provide sufficient protection or conversely results in a higher level of indemnity than anticipated.
  • Context: The drafting of an indemnity clause will depend on the nature of the contract, for that reason it is important to always carefully consider the clause and its applicability to the wider commercial context of the agreement.
  • Extent: Who does the indemnity cover and are there any limitations to the indemnity? For example, if the indemnity relates to the indemnifier but not its contractors or representatives, then the extent to which this offers protection will be limited.
  • Insurance: An indemnity is only of value if the indemnifier is going to be able to pay out in the event of breach. An obligation to insure to a level consistent with the indemnity obligation will provide comfort that the indemnifier has the means to back up the indemnity given. Conversely, where you are giving the indemnity, always make sure that doing so is permitted under your insurance.
  • Caps: Indemnities can be capped but any such cap should be subject to careful consideration. Where an indemnity has a financial cap the indemnified party may, depending on any other limitation clauses, still have an uncapped claim in contract law for any breach of contract.
  • Duty to mitigate: Whether the beneficiary of an indemnity will have a duty to mitigate their loss will depend on if their claim is considered a debt claim or a damages claim. A wide indemnity for all losses or damages arising from any breach of the contract is unlikely to be quantifiable at the start of the contract and therefore the usual principles on duty of mitigation would apply. On the other hand, an indemnity given against a certain event may be considered a debt and therefore no duty to mitigate would apply. Ultimately this will depend on the facts. To avoid confusion it is advisable to always make it clear whether the beneficiary is under a duty to mitigate or not.
  • Hold harmless: Another often misunderstood term, an obligation to “hold harmless” amounts to an agreement by the party giving the indemnity not to seek to counterclaim against the party receiving the indemnity, even if they have contributed to the event which gave rise to the indemnity being triggered.

An indemnity clause is essentially a financial obligation and therefore it is vital to always take great care and attention in drafting and negotiating them. They can be a great tool for financial protection but can also cause issues if not drafted properly.

Recap: Limiting liability

As we reach the end of this three part series, we hope you now have a deeper understanding of liability clauses in commercial contracts. Both in terms of how they can be used to your advantage and the inherent issues that they can cause.

Unfortunately, there is no magic formula for agreeing your liability under a contract. There are a number of ways in which either party may try to limit their liability and it will differ from agreement to agreement. You must identify the real areas of risks, consider how much financial exposure you are willing to accept, and how best to protect your position in light of your bargaining power. What you do is ultimately a commercial decision. But, by understanding the implications and scope of these clauses you should feel confident in your ability to make an informed decision. 

Authors: Sophie McKibbin & Catherine Harrison

This information is intended as a general discussion surrounding the topics covered and is for guidance purposes only. It does not constitute legal advice and should not be regarded as a substitute for taking legal advice. DWF is not responsible for any activity undertaken based on this information.

Catherine Harrison

Senior Associate

I am a Senior Associate at DWF, specialising in working for clients across the retail, food, education, oil and gas and technology sectors.

Craig Chaplin

Partner - National Head of Commercial & Competition

I am a Partner and Head of the Commercial & Competition Team.