Indemnity – How the Supplier Can Reduce Their Liability

Purpose

If one contracting party breaches a contractual obligation, the other contracting party can generally claim damages under certain conditions.

A contractual "Indemnity" clause goes beyond this and extends the liability of the indemnifying party (usually the supplier). Conditions and legal consequences are subject to individual contract negotiations.

Scope of Application

The indemnity represents a primary obligation; it is not dependent on proving a breach of a contractual obligation. This offers several advantages over claiming damages for breach of contract:

• Compensation is usually triggered by the occurrence of damage, without the need to prove fault. This way, the rules on causation and damage mitigation can be circumvented, which might otherwise complicate recovery.

  
  

• If the scope of the indemnity is broadly defined, it can allow for a broader reimbursement of losses, such as legal costs and other related expenses, than would be possible in a lawsuit for breach of contract.

  
  

• Damage claims are considered more difficult to fend off, and it is more likely that the indemnifying party will make payments under an indemnity without legal proceedings.

Note

Each indemnity clause should therefore be critically examined and – from the perspective of the indemnifying party – reduced as much as possible (see example below). Depending on the design of the clause, further restrictions should be made (see below).

Legal Precedents

According to current U.S. court rulings, an indemnity clause generally only covers compensation claims of third parties and not compensation claims of the contracting party.[1] This aspect must be considered when drafting the indemnity clause, as contracting parties increasingly attempt to significantly expand the actual scope of a typical indemnity clause.

In this context, the respective limitation of liability clause ("Limitation of Liability") also plays an important role. Often, the indemnified party tries to structure the limitation of liability so that it does not include the indemnity. This would mean that in the case of indemnity, liability is unlimited. From the perspective of the indemnifying party, the limitation of liability should therefore also include the indemnity.

Example of a Standard Indemnity Clause

"The Supplier shall indemnify, defend, and hold harmless the Customer, its affiliates, officers, directors, employees, agents, and subcontractors ("Indemnitees") against all claims, demands, suits, liabilities, costs, expenses (including legal fees), damages, and losses suffered or incurred by the Indemnitees arising out of or in connection with:

a) Supplier’s breach or negligent performance or non-performance of this Agreement; or

b) Any actual or alleged infringement of a third-party’s intellectual property rights from the Customer’s use of the delivered products and performed services."

Example of a Revised Standard Indemnity Clause from the Perspective of the Indemnifying Party

(Notes: Deletions are marked in color, Insertions are italicized, and the numbers in [] refer to the footnotes below).

"The Supplier shall indemnify, defend, and hold harmless[2] the Customer, its affiliates, officers, directors, employees, agents, and subcontractors ("Indemnitees")[3] against all claims, demands, suits, liabilities, costs, expenses (including reasonably incurred[4] legal fees), damages, and losses, provided these are reasonably foreseeable at the time of the conclusion of the agreement,[5] suffered or incurred by the Indemnitees Customer arising out of or in connection with a third-party claim against the Customer caused directly by[6]:

a) Supplier's breach or negligent performance or non-performance of this Agreement The Supplier's culpable breach of its confidentiality obligations according to section [insert reference] of this agreement[7]; or

b) Any actual or alleged infringement of a third-party’s intellectual property rights by the Customer's use of the delivered products and performed services.

This indemnity shall not apply to the extent that a claim under it results from the Customer's negligence or willful misconduct.[8]

The Customer may not claim indemnity if it fails to take reasonable steps to mitigate its losses.[9]

Indemnification shall be the Customer's sole remedy for matters covered by the indemnity."

Notes and Further Reading

[1] Cf. Sarn Energy LLC v. Tatra Defence Vehicle A.S., C.A. No.: N17C-06-355 EMD CCLD, 2019 WL 6525256 (Del. Super. October 31, 2019); Winshall v. Viacom International, Inc., C.A. No.: N15C-06-137 EMD CCLD, 2019 WL 5787989 (Del. Super. November 6, 2019); contrast Collab9. LLC v. En Pointe Technologies Sales, LLC, C.A. NO. N16C-12-032 MMJ CCLD, C.A. NO. N19C-02-141 MMJ CCLD, 2019 WL 4454412 (Del. Super. September 17, 2019).

[2] Reduction of the indemnifying party's obligations. The term "defend" includes the indemnifying party's obligation to defend its contracting party in a lawsuit with a third party. The term "hold harmless" results in the indemnifying party not being able to assert claims against its contracting party (especially applicable here).

[3] Reduction of the very broad personal scope of the indemnity clause.

[4] According to U.S. litigation law, the plaintiff is not entitled to reimbursement of its attorney’s fees even if successful (so-called "American Rule"). For this reason, attorney's fees are listed as compensable damages in indemnity clauses. However, in this case, these costs should at least be limited to a reasonable amount. Concerning "reasonable" attorney's fees, see also Euro-Asian Oil SA v. Credit Suisse AG [2017] EWHC B7 (Comm) (23 January 2017).

[5] Limitation of liability to foreseeable damages and exclusion of consequential damages. Without this addition, it is disputed whether the "test of remoteness" (also called "test of reasonableness") – first in Hadley & Anor v Baxendale & Ors [1854] EWHC Exch J70 (23 February 1854) – also applies to an indemnity clause. See also Glenn D. West and Sara Duran, Reassessing the "Consequences" of Consequential Damage Waivers in Acquisition Agreements (2008). 63 Bus. Law. 777 (2008), https://ssrn.com/abstract=2660962.

[6] Restriction by the necessity of a causal connection between the indemnifying party’s breach and the third party’s claim. The usual phrasing "directly or indirectly" should be avoided. This also applies to the unrestricted use of "arising out of or in connection with", since it also covers consequential damages.

[7] An indemnification for all breaches should be avoided. Aside from the usual indemnity coverage (IP rights infringement), it should – if at all – only cover breaches of confidentiality obligations. Moreover, fault should be included as an additional element (Common Law prevailing in many English-speaking countries does not require fault).

[8] Restriction in case of contributory negligence (cf. section 254 (1) BGB if German law applies).

[9] Further restriction in case of contributory negligence (cf. section 254 (2) sentence 1 alt. 2 BGB if German law applies).

Example Wording from the Perspective of the Indemnifying Party

The Supplier shall indemnify the Customer against all claims, demands, suits, liabilities, costs, expenses (including reasonably incurred legal fees), damages, and losses, provided these are reasonably foreseeable at the time of the conclusion of the agreement, suffered or incurred by the Customer arising out of a third-party claim against Customer caused directly by:

a) the Supplier's culpable breach of its confidentiality obligations according to section [insert reference] of this agreement; or

b) Any infringement of a third party's intellectual property rights out of the Customer's use of the technology.

This indemnity shall not apply to the extent that a claim under it results from the Customer's negligence or willful misconduct.

The Customer may not claim indemnity if it fails to take reasonable steps to mitigate its losses.

Indemnification shall be the Customer's sole remedy for matters covered by the indemnity.

Additional Protection for the Indemnifying Party

The indemnifying party can further minimize its risk through a number of other mechanisms. In particular, the following conditions can be included in the contract:

• the indemnified party is obliged to inform the indemnifying party immediately about any claim;

• the indemnified party must not recognize the claim nor conclude a settlement with the third party;

• the indemnifying party has sole control over how the claim is handled;

• the indemnified party is required to assist the indemnifying party in the defense (at its own expense);

• set a minimum amount that must be reached before the indemnity obligation arises ("basket");

• no indemnity if and to the extent that:

  • the contract product (or service) has been modified;

  • the contract product (or service) is used together with other products (or services) that have not been approved by the indemnifying party;

  • the contract product (or service) is used contrary to the instructions of the indemnifying party;

• limit the indemnity to certain types of intellectual property, for example, patents instead of intellectual property in general; as well as

• limit the indemnity materially (e.g., only certain types of intellectual property), geographically (e.g., EU), and temporally (e.g., 1 year after delivery).

Recommendation

From the perspective of the indemnified contracting party, an indemnity is sensible. From the perspective of the indemnifying party, however, it must be reduced to a reasonable level to avoid unlimited (and unforeseeable) liability.