Demystifying Indemnities

Dr Sam De Silva assesses the effects of indemnities on IT contracts
Demystifying Indemnities

An often hotly debated topic when negotiating contracts is that of indemnities. Both parties strive to be indemnified for everything they can think of, while retreating from the prospect of giving an indemnity with fear. Is this preoccupation with indemnities really justified?

To answer as a typical lawyer…it depends. There are some circumstances where indemnities will make a significant difference. But there are also situations where an indemnity has less significance than it may appear. This article contrasts claims under indemnities with claims for ordinary breaches of contract to illustrate some of the key factors that will affect the value of an indemnity.

What is an Indemnity?

An indemnity is similar to insurance. For example, your home and contents insurer insures you against certain types of damage to your house such as fire or theft. The policy might actually be worded to say that the insurance company indemnifies you against certain types of losses like fire, theft etc. The concept is that you will not be "harmed" by these types of events, even if they do happen. Once the particular event occurs, the insurer must honour its promise by paying you the value of what has been burnt, stolen etc. This illustrates that anyone who provides an indemnity is accepting a responsibility like that of an insurer.

You often see language in contracts like: "Party A indemnifies party B from any loss, costs or damage suffered or incurred by Party B as a result of X". In essence, a party giving an indemnity of this nature is promising to "make good" any loss, costs or damage suffered or incurred by Party B as a result of X.

Indemnities in IT contracts

The most common indemnity in an IT contract is an IP indemnity. A customer or end-user will be concerned that its use of the software may involve the breach of a third party's intellectual property rights and in order to assist the customer controlling its liability, might require an indemnity from the licensor. The effect of this would be that even if the customer's use of the software infringes the IP rights of a third party, the licensor would make good any loss that the customer suffers as a result of the third party making an IP infringement claim against the customer.

However, IT contracts often include other indemnities as well. For example, some customers may also be granted a broad indemnity against any loss suffered by them, as a result of a breach by the supplier of its obligations. More specific indemnities are also relatively common, such as indemnities against any loss suffered as a result of the introduction of a virus by the supplier.

All such indemnities are valuable, because they allow the indemnified party to recover the losses against which it is indemnified. However the key issue in a negotiation will often be determining which party is most appropriate to bear the risk, which will also involve consideration of who is best placed to manage the risk, and how valuable the indemnities are in the particular arrangement being entered into.

Clearly, the value of an indemnity will be affected by the risk that the relevant loss will be suffered and the likely quantum of that loss. However, its value will also be affected by the extent to which the loss could have been recovered without the indemnity.

 

Contrasting breaches of contract and indemnities

The main alternative to claiming under an indemnity in a contract is suing for breach of contract. Consequently, the usefulness of an indemnity will often depend on the effect of the differences between indemnities and breach of contract claims.

The key differences between an indemnity and breach of contract claims are as follows:

  • To claim for breach of contract, a party must show that the contract has actually been breached. To claim under an indemnity a party must only show that it has suffered the loss against which it was indemnified.
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  • To recover loss in a breach of contract claim, the claimant must show that the loss was a reasonably foreseeable consequence of the breach of contract. To recover loss under an indemnity, a party must only show that the loss was that loss against which it was indemnified.
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  • A respondent in a breach of contract claim may not be required to compensate the claimant for all losses if it can show that the claimant did not take reasonable steps to mitigate its loss. In contrast an indemnifying party cannot reduce its liability by showing a failure by the indemnified party to mitigate its loss.

The significance of these differences is illustrated below with a series of examples.

Demonstration of breach versus loss suffered

A supplier provides software to two different customers. In its contract with Customer A, the supplier warrants that it has the appropriate intellectual property rights in the software to license Customer A to use that software. In contrast, in its contract with Customer B, the supplier indemnifies Customer B against any loss suffered as a result of any third party claiming that Customer B's use of the software breaches that third party's intellectual property rights.

A third party subsequently sues both customers for breaching its intellectual property rights for £250,000 each. Both customers receive legal advice that the third party has a 35% chance of succeeding, and both settle their respective claims out of court for £75,000.

Customer A wishes to sue the supplier for the loss it suffered in obtaining legal advice and settling the claim. However, it will find such a claim is very difficult. This is because it will need to show that the supplier's warranty was incorrect when, in fact, its own legal advice is that there was a 65% chance that it would have won against the third party and proved the warranty to be correct.

In contrast, Customer B only needs to show under its indemnity that there was a third party claim, and that it suffered a loss as a result, which it can easily show.

Summary

There is no doubt that in some situations an indemnity can add real value. However, parties to a negotiation should always consider exactly how an indemnity could apply in their particular situation, what risk is being addressed and who is best placed to manage that risk and therefore the appropriate party to carry that risk.

Indemnities are a very complex area of law. As with liability clauses, words used in indemnities have quite specific meanings and some minor changes in language can change the effect substantially. It is also very important to consider how they sit with other liability regimes (for example, damages) in any contract.

Demystifying Indemnities

by Dr Sam De Silva

Partner - Head of IT Law and Outsourcing Law, Penningtons Manches LLP

Dr Sam De Silva is a partner and the head of the IT and Outsourcing practice at leading UK law firm Penningtons Manches LLP. His main areas of practice are technology projects and the outsourcing of technology and business processes.  He has been published widely and speaks regularly on these topics and is Chair of the Law Society's Technology and Law Reference Group. Sam is also one of very few UK solicitors who is a Fellow of the Chartered Institute of Purchasing and Supply (FCIPS), Fellow of the British Computer Society (FBCS) and a Chartered IT Professional (CITP).  He is also an IT Law Accredited Member of the Society for Computers and Law.  

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