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4 Risks Associated with Contract Indemnity Clauses

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When it comes to drafting commercial contracts, you should be mindful of what terms and clauses you include to ensure you best protect your interests. These clauses serve as legal mechanisms outlining the responsibilities and liabilities of the parties involved. New Zealand businesses, regardless of size, frequently deal with indemnity clauses. This article explains what constitutes an indemnity clause, the associated risks, and how to protect your business against those risks. 

What Are Indemnity Clauses?

Contract indemnity clauses play a vital role in allocating risks between parties. They come into effect when one party commits to compensating the other for specified losses or damages, acting as a shield against potential legal or financial liabilities. This compensation serves as a protective measure. Further, they are often triggered by a specific event, such as a breach of contract or fault on the part of one party. 

Understanding the fundamental purpose of these clauses is paramount for establishing fair and transparent agreements.

In indemnity clauses, the party providing protection is termed the indemnifier, while the party benefiting from this safeguard is the indemnified party. Under this arrangement, the indemnifier is responsible for covering any expenses or losses the indemnified party incurs, reinforcing the contractual protection established by the indemnity clause.

Commonly, you would draft indemnity clauses to protect against: 

  • breaches of contract
  • intellectual property disputes;  
  • third-party claims; and 
  • losses arising from product or service use. 
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Potential Risks

Ambiguity and Misinterpretation

Vague language in indemnity clauses can create confusion and potential disputes. For example, consider the following clauses:

  • “to the fullest extent permitted by law”; and
  • “the Indemnitor shall be responsible for all losses during the term of this agreement.”

While these phrases may appear all-encompassing, they can be subject to diverse interpretations. Notably, they lack specificity, failing to outline the types of losses the clause covers and the limitations on indemnification. 

Additionally, the second phrase leaves room for ambiguity by not specifying whether the indemnity extends beyond the duration of the contract agreement. Therefore, unclear language may subject both parties involved in the contract to possible risks and disputes regarding the specified extent of liability and responsibility within the indemnity clause.

Unforeseen Liabilities and Expansion Beyond the Intended Scope

Poorly written indemnity clauses that fail to consider the possibility of emerging risks can expose your business to unforeseen consequences. If you do not draft them carefully, these clauses can inadvertently extend their scope beyond their intended purpose. Consequently, they might lead to unexpected liabilities and financial burdens for the party responsible for indemnification.

For example, suppose two companies agree to a business acquisition deal. In the contract, parties fail to specify how intellectual property rights will transfer to the acquired company. Subsequently, the acquiring company can face unforeseen consequences if legal disputes arise over the ownership of crucial patents.

Inadequate Insurance Coverage 

You might assume that having strong indemnity clauses in a contract can eliminate the need for insurance coverage. However, it is important to remember that both of these measures should work together to provide protection. Failing to align these two measures can lead to financial burdens for the party responsible for indemnifying or compensating the other party in the contract.

Failure to Address Third-Party Claims

Indemnity clauses may not provide sufficient coverage for third-party claims, exposing the indemnified party to legal and financial consequences resulting from interactions with individuals or entities not involved in the contract.

For example, suppose your consulting business provides an indemnity to your client that all work is free of intellectual property claims. If you unintentionally infringe upon the intellectual property rights of a third party, your client may face legal action. Without a clear, comprehensive indemnity clause in your contract, it may be unclear who should bear the potential legal and financial consequences of that copyright infringement. An effective indemnity clause should specify responsibility for third-party claims, providing broader protection for your client.

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Risk Protection 

Ultimately, clear and precise drafting prevents misunderstandings and unintended consequences.

Including a limitation of liability clause alongside indemnity clauses can cap the total loss that can be protected by an indemnity clause. As a strategy, your business might limit liability to a maximum loss and exclude specific types or causes of loss. Also, imposing mitigation obligations on the indemnified party can help manage risks effectively.

Importantly, thorough negotiations during contract formation are crucial to ensure your indemnity clauses effectively cover your business interests or the amount of risk you take is within your appetite.

Key considerations include:

  • defining the scope of indemnity;
  • determining control over risks; and
  • assessing financial standing.

Further, proactive discussions help strike a fair balance between risk and benefit, preventing disputes in the future.

Key Takeaways 

Indemnity clauses are an essential part of contracts. A thorough understanding of these clauses can help you protect your business interests and prevent legal or financial consequences in the future. It is important to keep in mind that effective indemnity clauses require legal expertise, clear communication, and proactive risk management. Therefore, finding a lawyer to draft or review your indemnity clause can ensure proper articulation.

If you need assistance drafting your indemnity clauses, LegalVision’s experienced contract lawyers can assist as part of our LegalVision membership.  For a low monthly fee, you will have unlimited access to lawyers to answer your questions and draft and review your documents. Call us today on 0800 005 570 or visit our membership page.

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