Indemnity Clauses: The breakdown and build-up
The term "indemnity" has its roots in the Latin word "indemni(s)," which means a pledge to protect against loss or harm. Essentially, the party providing this protection is referred to as the "Indemnifier," while the one receiving it is called the "Indemnity Holder." This clause serves a crucial function by guaranteeing compensation for any losses incurred by the Indemnity Holder. Legally, the foundational principle of indemnity can be found in section 78 of the Contracts Act 1950.
In the context of business agreements, such clauses are typically found towards the end of these documents (just before the beginning of boiler plate clauses). This is ironic, as indemnity clauses do often times lead to heated discussions and negotiations.
The salient purpose of this article is to briefly dissect the scope of an indemnity clause (also known as an indemnity contract) and provide an insight as to what makes an effective indemnity clause for the party relying on it, be it an indemnity holder or the indemnifier.
Scope of indemnification
Section 78 of the Contracts Act provides that an indemnity holder is entitled to recover fromthe indemnifier:
(a)all damages which he may be compelled to pay in any suit in respect of any matter to which the promise to indemnify applies;
(b) all costs which he may be compelled to pay in any such suit if, in bringing or defending it, he did not contravene the orders of the promisor, and acted as it would have been prudent for him to act in the absence of any contract of indemnity, or if the promisor authorized him to bring ordefend the suit;
(c) all sums which he may have paid under the terms of any compromise of any such suit, if thecompromise was not contrary to the orders of the promisor, and was one which it would havebeen prudent for the promisee to make in the absence of any contract of indemnity, or if thepromisor authorized him to compromise the suit.
Essentially the extent of rights of an indemnity holder to be indemnified is as wide as it isexpressed to be in an indemnity clause, (subject to any express restrictions in equity and underthe law) and this principle was affirmed in the case of BPI International Finance Ltd v TengkuAbdullah Ibni Sultan Abu Bakar  4 MLJ 821.
It is for this reason that indemnity clauses are frequently used in business contracts and suchclauses can serve the following practical purposes:
Indemnity clauses help allocate and manage risks between the parties involvedin a contract. They provide a mechanism for one party to protect themselves from potentialfinancial losses or liabilities that might arise from the actions or omissions of the other party;
Protection against Third Party Claims
These clauses can safeguard one party from claimsbrought by third parties. For example, in a vendor-client relationship, the client may require thevendor to indemnify them against any legal claims made by customers related to the vendor'sproducts or services.
Contractual Breach Compensation
Indemnity clauses can be used to specify the consequencesand compensation for breaches of contract. If one party fails to fulfill their obligations, theother party may seek indemnification for resulting losses or damages.
Mergers and Acquisitions
In M&A transactions, indemnity clauses can play a significant role.They may be used to allocate responsibility for undisclosed liabilities or legal issues thatemerge after the acquisition.
Indemnity clauses are commonly used in service agreements, where oneparty provides services to another. They can cover issues such as service disruptions, databreaches, or other service-related problems, with one party indemnifying the other for anyresulting losses.
Drafting an Indemnity Clause
Drafting indemnity clauses requires meticulous attention to detail to guarantee clarity and thorough safeguarding. The following steps may be incorporated:
For Indemnity Holders:
A. Choosing the correct terminology
1. Instead of using phrases like 'making good' or 'compensate,' it is recommended to employ the term 'hold harmless.' This terminology serves to avoid the misunderstanding that indemnification exclusively pertains to compensating for actual losses incurred. Furthermore, it encompasses scenarios where a loss occurs or a liability arises, even if the actual payment has not been made at that point. The 'hold harmless' clause imposes an obligation on the indemnifier to assume all liability and exonerates the Indemnity Holder from any liability arising from specific acts or circumstances.
2. Incorporate the term 'protect from liability' verbatim to underscore an additional responsibility on the indemnifier's part, which involves shielding the Indemnity Holder from bothfirst-party and third-party claims, contingent upon how the clause is drafted.
3. Opt for terminology that allows for a comprehensive interpretation, such as 'arising out of
' or 'including but not limited to ,' instead of 'as a result of' or 'in connection with/to.' The latter options have a narrower scope and necessitate a closer connection with the occurrence of anevent to fall within the realm of indemnity. This can also place the Indemnity Holder underpressure to establish a direct connection between the loss and the breach.
4. While the Contracts Act does cover third-party claims, it is advisable to leverage this andconstruct clause(s) specifying that the indemnifier is obligated to defend the indemnity holderagainst any third-party claims that may arise.
B. Defining "Losses"
Carefully define the concept of "Losses," as indemnity clauses can encompass indirect, consequential, and remote losses. It is crucial to exercise prudence when crafting the definition of losses or liability. The definition should avoid being overly restrictive, opting instead for terms like 'Losses includes' rather than 'Losses mean' to formulate a more all-encompassing definition.
C. Claim triggers
Parties have the option to stipulate and mutually decide that the responsibility for indemnity payment is activated upon the issuance of a claim notice. If this clause is incorporated, it should explicitly state that the Indemnifier's duty to make the payment becomes effective and payable upon the receipt of the claim notice, or within a designated timeframe following receipt. Additionally, it should clarify that any delay in filing claims or providing notice does not absolve the indemnifying party of this obligation.
D. Securing monetary surety
In the event that the Indemnifier contests the amount, you may contemplate incorporating a provision mandating the deposit of the disputed claim amount with an arbitrator, court, or escrow agent.
A. Duty to mitigate
It is recommended to incorporate a "duty to mitigate losses" provision. This clause compels the Indemnity Holder to take reasonable measures to reduce losses and avoid actions that unreasonably worsen the extent of the loss. The rationale behind this is that the Indemnity Holder cannot seek compensation for losses (whether resulting from a contract breach or duty breach) that could have been prevented through reasonable actions.
B. Limitation/exclusion of liability
The Indemnifier must be cautious in avoiding an overly broad liability clause that encompasses specific types of liabilities, such as loss of production, loss of use, loss of profit, loss of information, data, and any indirect or consequential damages. However, the specifics of these inclusions and exclusions should be tailored to the terms and nature of the agreement. Additionally, it is recommended to restrict the Indemnifier's liability for all losses, claims, or damages arising from the agreement, subject to a predetermined maximum limit.
If you have any questions on this topic or seek advise on commercial and business related matters, please feel free to contact us to schedule a complementary consultation.