What a contractual indemnity means for your business and why do you need to retain legal services to negotiate an indemnity clause?

By Natik Mamedov (Member of the New York State Bar)

In today’s increasingly litigious world, businesses and corporate entities, across industries and around the world, pay a particular attention to managing various risks arising in connection with certain commercial transactions and dealings with their counterparties and business customers. Businesses achieve and maintain the needed balance, mostly, by hedging their investment and insuring their assets and liabilities. But these means, alone, are not always sufficient and, in certain circumstances, not the right tools to manage and balance these risks. Rather, they operate as derivative instruments, i.e., form the basis for the underlying contractual obligations.

Indemnity clauses are typically seen in the context of corporate mergers and acquisitions, with sellers indemnifying buyers for any hidden or undisclosed liabilities attached to the assets or businesses acquired. Certain professional service providers are required to obtain a professional indemnity insurance before they can provide their services. Indemnity clauses are found in the context of a number of finance related products and transactions, mostly, protecting lenders and financiers in connection with the underlying funding. Just to name few more, indemnities, including mutual or reciprocal indemnities, are also sought in commercial leases, commercial agency, franchising and distributorship agreements. As certain industry markets are growing, the industry and sector related services are also becoming subject to heavily negotiated indemnities. It is common to find such contractual indemnities, for instance, in a software license, web design and development, online services and web hosting contracts.

What is a third party contractual indemnity and why it is indispensable in all these commercial transactions?    

Simply put, a contractual indemnity is an obligation of a party to a contract, an indemnifying party, to reimburse or compensate certain costs incurred by the other party – an indemnified party. The compensation obligation may even extend to cover damages, including consequential (indirect) damages and lost profit suffered by the indemnified party. This is why it is vital to limit a contractual indemnity liability – a much needed shift in the market trend claimed to be an established practice in certain industries.

Which party to a services contract has a vested right to claim an indemnity?     

This is no simple answer to this question. While this fundamental issue should be addressed on the basis of the commercial logic and the prevailing legal doctrines, in practice, the answer is not always straightforward as the contractual indemnities, largely, become a byproduct of the leverage and the bargaining power. It is a commonly accepted argument that a party providing services should be an indemnifying party because a business customer paying for these services relies on these services being genuine, creating and adding value, not infringing third parties’ intellectual property rights. This reliance forms a basis for reasonable expectations that the results of the rendered services should not be subject to any challenges of third parties or the additional costs related to such challenges and that the party rendering such services should be solely responsible for any such costs, not vice versa. Yet, this fundamental principle is not always a basis of the contractual indemnities.

Is a breach the ground for an indemnity claim?

An indemnity is an obligation to compensate the costs incurred by an indemnified party. If the costs are the result of a contract breach or default, a defaulting party, by operation of the governing law, would be responsible to cover these costs, including any direct or indirect damage. So, an indemnity is not always associated with a breach and this is why an indemnity come across as an independent clause which becomes subject to heavy negotiations centered about a fair distribution of various commercial risks arising in connection with the underlying transaction. These risks are associated with and derivative of the counterparty’s businesses and an indemnifying party should be conscious of a number of these commercial risks before agreeing to assume them.

Should there be an indemnification cap?

Indemnities are drafted, generally, not to include any cap. With no such cap included, an indemnifying party is fully exposed as it becomes responsible to pay all costs incurred by an indemnified party. While in certain cases, the amount of the indemnifiable expenses may, to a certain extent, be predictable, in many other cases, this is not so obvious. Large-scale business projects are often associated with very complex expense structure, where the amount of potential expenses may be so devastating that they can undermine the benefits of the proposed projects. While businesses are, generally, insurable and the project finance deals, commonly called, limited recourse financing, seemingly have this indemnity cap protection, most indemnity based commercial transactions are structured to create a full indemnity liability exposure for one of the contacting party – a market gap and the legal issue to be tackled in a contract negotiation in line with the prevailing legal doctrines and the commercial sense.

What should be the term for an indemnity?

An indemnity cap and an indemnity duration are two sides of the same coin. An indemnity amount cannot be limited without a reasonable period needed to enforce it. This issue, ultimately, becomes subject the governing law on the statute of limitations, i.e., the statutorily prescribed period within which the indemnified party should be able to bring a claim against the indemnifying party. This is why indemnity clauses are drafted to survive the termination or the expiration of a contract.

Are there any drafting suggestions or sample draft language to follow?

Yes, there are always abundant resources publicly available on the subject matter which are worth of reviewing but a successful negotiation of indemnities can be quite challenging and risky task for a business without an adequate qualified legal assistance.

© Aecor Ltd. This article is contributed by Natik Mamedov, Esq. and owned by Aecor Ltd.