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Identify the subtext: Understanding indemnity clauses in commercial agreements

Indemnity clauses are commonly misunderstood by parties to commercial agreements, with potentially very costly implications. It pays to understand how indemnity clauses operate and what they are seeking to achieve so that you can harness their awesome power to your advantage while ensuring that you navigate the potential pitfalls.

So what is an indemnity?

An indemnity is a contractual promise given by one party to an agreement (known as the indemnifying party) to reimburse another party (known as the indemnified party) in respect of a specific type of loss.

An indemnity clause is an agreement between the indemnifying party and the indemnified party that if the indemnified party suffers a certain category of loss, for example damage suffered by the indemnified party due to the indemnifying party’s breach of contract, then the indemnifying party will be required to compensate the indemnified party for every dollar that the indemnified party has lost due to that category of loss arising.

Why are indemnity clauses feared?

By their nature, indemnity clauses can give rise to liabilities for the indemnifying party that are not quantifiable or foreseeable at the time that the parties entered into the agreement. This means that if any indemnity clause is not reviewed, considered, and where appropriate, properly negotiated, prior to execution of the agreement in which they have been included, the indemnifying party can later find itself in receipt of a nasty surprise, in the form of an unexpected demand for indemnification under the agreement.

Why are indemnity clauses used in commercial agreements?   

Indemnity clauses can be used to achieve a variety of specific objectives in commercial agreements, but one thing all indemnity clauses share in common is the intention of the parties to shift liability for a specific category of loss from the indemnified party to the indemnifying party.

For example, it is common in SaaS agreements for the supplier of the Saas services (Supplier) to indemnify the recipient of the SaaS services (Recipient) in respect of any loss or damage suffered or incurred by the Recipient in connection with a claim by a third party that the Recipient’s use of the SaaS services breaches that third party’s intellectual property rights.

In this example, the indemnity clause is designed to shift the liability for third-party intellectual property claims from the Recipient, which is merely an innocent user of the Supplier’s SaaS software, to the Supplier, who has an intimate knowledge of the intellectual property rights in the SaaS software that it has developed and now markets and operates for commercial gain.

By providing the indemnity, the Supplier is effectively saying to the Recipient “I’m so confident that my SaaS software will not breach the intellectual property rights of any third-party, that if I’m ever found to be wrong, I will bear all of the costs that you suffer or incur as a consequence.”

Behind every indemnity clause, there is a subtext; a conversation taking place between the indemnifying party and the indemnified party. To understand the utility of any indemnity clause, look to the underlying conversation taking place between the parties, behind the clause.

Jonathan Beran

26 October 2022

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