The contents of this article are intended to convey general information only, and this is not legal advice.
Drafting and negotiating contractual indemnities is the primary focus of what follows. After all, contractual indemnities play a significant role in managing commercial risks for many organizations throughout all industries around the world. Interestingly, the term contractual indemnities is also a highly contested term in almost every commercial contract. So, keeping that conundrum in mind, how would you effectively negotiate contractual indemnities to conform with the WorldCC Contracting Principles1 and other common practices?
Not an easy question.
So, perhaps, for starters, let’s keep it simple: A contractual indemnity “obligates one party to pay the damages or losses sustained by another party because of certain future occurrences. An indemnification situation arises when a third party (not a party to the contract) is harmed and makes a claim against one or all the parties to the contract.”2
In today’s increasingly contentious business environment across industries around the world, business entities pay particular attention to saving time and costs in negotiating indemnities. The reason? Manage costs associated with a potential business deal.
Conventionally, businesses manage these cost and time risks by obtaining insurance coverage for the risks concerned. Hedging, generally defined as a strategy to limit risks in financial assets, as in investors hedging one investment to trade in another,3 may also offer some comfort, but it gets a bit complicated…
The insurance coverage and hedging have limits in their respective applications and, standing alone, neither one is sufficient enough to manage all commercial contract risks. For example, while hull or property insurance may cover the risk of a total loss of the ensured asset, legal fees and costs incurred by an insured are not covered.
At the same time, although third-party liability insurance covers the insured’s liability for damage to property -- or injuries caused to third parties and their claims against an insured -- a party’s contractual liability is uninsurable per the insurers’ general policies. But allowing this would incentivize a breach of a contract.
In this situation, one may receive a transactional risk reduction by expertly negotiating contractual indemnities in accordance with the WorldCC Contracting Principles.1
So, what are the golden rules for drafting the contractual indemnity clause?
As mentioned, a contractual indemnity is an obligation of an indemnifying party to reimburse or compensate certain costs incurred by an indemnified party. Under the WorldCC Contracting Principles, indemnification must be tied to direct damage caused by an indemnitor (compensator for losses) and must be proportionate to the agreed losses. However, indemnitees (the persons or organizations held harmless in a contract by the indemnitor) are often seeking a much larger extent of indemnitor’s liability for costs incurred by the indemnitee not always caused by the indemnitor but, say, for events outside the indemnitor’s control, such as a regulatory change.
Certain types of indemnifiable costs should be limited to the documented reasonable costs (this rule (principle) would not apply to damages caused for the breach of intellectual property rights or, say, tax related indemnities) -- but if these limits are not specifically included in an indemnity clause, an indemnifying party may have to deal with liability to compensate catastrophically unlimited costs. Even where this specific language is negotiated, what is reasonable and documented may not always be straightforward but may require an interpretation of this language based on the law governing a contract.
For instance, laws of certain jurisdictions (mostly civil law jurisdictions) require documented evidence of the costs incurred such as invoices of third parties or court judgements against an indemnifying party. A burden would be on an indemnified party to prove that the costs are properly documented under the governing law. Similarly, costs to be reasonably incurred are expected to be reasonable in the amount and proportionate to the cause. The determination of the reasonableness of the costs often becomes subject to restrictions of the governing law.
A second, yet much more significant principle or rule to follow to include in an indemnity clause is carving out gross negligence and willful misconduct of an indemnified party. Although it may look obvious to do so, boilerplate contracts unfortunately do not have these carved out and, more often, parties lacking leverage in negotiation have difficulties in negotiating these carve outs. This is so significant because losses incurred through gross negligence and willful misconduct are not covered by insurance and, as a result, are not recoverable.
Finally, if an indemnity clause language is vaguely stated in a contract -- and unless consequential damages are specifically excluded in the indemnity clause -- the indemnifying party’s compensation obligation might even extend to cover such consequential damages but might not be limited to direct damages as recommended in the WorldCC Contracting Principles.
What are the typical transactional risks and indemnity triggering events?
The value of a contractual indemnity depends on the types of transactional risks it is contracted to cover. Indemnity clauses appear in a wide range of commercial contracts. To name just a few:
- In a sale of goods, an indemnity is usually sought to compensate costs incurred by a buyer for shipping and repair, whereas, conversely, goods sold are subject to the seller’s contractual or statutory warranty.
- In agreement for partnership, joint venture and business alliances, an indemnity will usually cover for losses or expenses incurred by an indemnified member to benefit a firm or partnership, whereas, conversely cover for losses and costs incurred by an indemnified firm resulting from actions taken by an indemnifying member outside the scope of the indemnifying member’s authority.
- In mergers and acquisitions, sellers will often be asked to indemnify buyers for tax and environmental law risks, product liability or any hidden or undisclosed liabilities attached to the assets or businesses acquired.
- In large asset financing deals, lenders and secured parties are typically looking to recover:
- increased costs resulting from regulatory compliance with subsequent change of law; and
- funding losses resulting from mandatory or voluntary prepayment losses incurred by lenders in obtaining, liquidating or employing deposits from third parties for prematurely unwinding funding transactions.
- In intellectual property (IP) related licensing (such as software and trademark licenses) and services agreements, a licensor would usually be asked to indemnify a licensee for all damages arising from infringement, misappropriation or violation of the patent, copyright, trade secret or other proprietary rights of a third party caused solely by the use of the licensed products or services. This is so because a party which pays for the use of licensed services, or the licensed products does so based on either express or implied representation that:
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- intellectual property rights with regard to these services and products belong to a licensor and service provider; and
- third parties’ intellectual property rights are not infringed in any way in the use of the services and products. In return, a licensee would indemnify a licensor for costs arising from misuse or modification of the licensed product.
How a contractual indemnity liability is different from liability arising from a breach of a contract?
An indemnity is an obligation to compensate losses incurred by an indemnified party. In contrast with default, where losses are the result of such default, losses incurred by an indemnified party are unrelated to any default but rather incurred in the course of the performance of the contract and the ordinary business. Because losses incurred are not default-related, indemnities should not be expected to cover indirect damages per WorldCC Contracting Principles.
Should there be an indemnification cap?
Indemnities are drafted, generally, not to include any cap. With no such cap included, an indemnifying party is 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 a very complex expense structure, where the amount of potential expenses may be so devastating that they can undermine the benefits of the deals. Although businesses are generally insurable and project finance deals are commonly considered limited recourse financing and seemingly have indemnity cap protection -- most indemnity based commercial transactions are structured to create a full indemnity liability exposure for one of the contacting parties. But this creates a market gap that becomes problematic in contract negotiation in accordance with the WorldCC Contracting Principles and the commercial business sense.
The value that commercial contracts add to organizations is tremendous, becoming part of their assets. This helps build their reputation on the market. However, the value of contractual indemnities should not be determined based on benefits, because if indemnity events occur, losses resulting from indemnities may outweigh benefits of a commercial deal.
END NOTES
- WorldCC Contracting Principles
- Contractual Indemnity definition: Contractual Liability & Indemnity, Office of University Counsel, University of Illinois System (UIC)
- Hedging - Investopedia article: Beginners Guide to Hedging: Definition and Example of Hedges in Finance, 11 January 2024
ABOUT THE AUTHOR
Natig Mammadov is a member of the New York State Bar and the World Commerce and Contracting, EMBA graduate of Cambridge University Judge Business School. Natig practiced law with major US law firms for more than two decades, followed by business and commercial strategy consulting. His practice of law encompassed a wide range of areas, including corporate and M&S, restructuring, capital markets, Islamic financing, regulatory compliance, data privacy and protection, information technology, with sectoral and strong transactional experience in banks, oil and gas development, real estate development, insurance, hospitality, and hotel management, telecom, and civil aviation. In his current commercial strategy consultant capacity, he mostly supports and leads negotiation of various commercial contracts, including big scale and major assets’ acquisition and financing deals. While practicing law, he has published more than dozen articles on the topics relevant to his areas of expertise.
© 2024. Natig Mammadov, Esq. All rights reserved.