Indemnity – How the Supplier Can Reduce Their Liability

Purpose

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

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

Scope

The indemnity is a principal obligation; it does not depend on proof of a breach of a contractual obligation. This offers a number of 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 for causation and damage mitigation, which can otherwise make claims more difficult, can be bypassed.

  
  

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

  
  

• Claims for damages are considered more difficult to fend off, and it is more likely that the indemnifying contractual partner will make payments under an indemnity without having to initiate legal proceedings.

Notice

Every indemnity clause is therefore critically examined and - at least from the perspective of the indemnifying contract partner - reduced as much as possible (see example below). Depending on the design of the clause, further restrictions may be necessary (see below).

Jurisprudence

According to current jurisprudence of the U.S. courts, an indemnity clause generally covers only claims for damages by third parties and not those of the contractual partner.[1] This aspect must be considered when drafting the indemnity clause, as contractual partners are increasingly trying to significantly expand the actual scope of a typical indemnity clause.

In this context, the applicable limitation of liability clause ("Limitation of Liability") also plays an important role. Often, the indemnifying partner attempts to draft the limitation of liability so that it does not encompass the indemnity. The result would be that the liability in the case of indemnity is unlimited. From the perspective of the indemnifying partner, the limitation of liability should therefore also encompass 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 Revision of the Standard Indemnity Clause from the Perspective of the Indemnifying Contract Partner

(Notes: Deletions are highlighted, insertions are italicized, numbers in [] refer to 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] See 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); 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 obligations of the indemnifying partner. The term "defend" includes the obligation of the indemnifying partner to defend its contractual partner in a lawsuit with a third party. The term "hold harmless" results in the indemnifying partner not being able to assert claims against its partner (str.).

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

[4] Under U.S. procedural law, even in a successful case, the plaintiff has no right to reimbursement of attorney's fees (the so-called "American Rule"). For this reason, attorney's fees are listed as a compensable damage in indemnity clauses. However, these costs should at least be limited to a reasonable amount. See also Euro-Asian Oil SA v. Credit Suisse AG [2017] EWHC B7 (Comm) (23 January 2017).

[5] Limitation of liability to foreseeable damages or exclusion of consequential damages. Without this addition, there is controversy as to 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 causation between the breach of duty by the indemnifying partner and the claim of the third party. The usual phrase "directly or indirectly" should be avoided at all costs. This also applies to the unrestricted use of "arising out of or in connection with." Because this also includes consequential damages.

[7] An indemnity for all breaches of duty should be avoided at all costs. In addition to the usual regulations of an indemnity (violation of IP rights), it should - if at all - only cover breaches of confidentiality obligations. In addition, fault should be included as an additional requirement (the common law prevalent in many English-speaking countries does not have a fault requirement).

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

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

Formulation Example from the Perspective of the Indemnifying Contract Partner

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 Contract Partner

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

• the indemnified contract partner is obligated to inform the indemnifying contract partner immediately of any claims;

• the indemnified contract partner is not allowed to acknowledge the claim or enter into a settlement with the third party;

• the indemnifying contract partner has sole control over how to deal with the claim;

• the indemnified contract partner is obligated to assist the indemnifying contract partner in the defense (at its own expense);

• set a minimum amount that must be reached before the indemnification obligation takes effect ("basket");

• no indemnification if and as far as:

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

  • the contractual product (or service) has been used together with other products (or services) not approved by the indemnifying contract partner;

  • the contractual product (or service) has been used contrary to the specifications of the indemnifying contract partner;

• limit indemnification to certain types of intellectual property, for example, to patents rather than intellectual property in general; and

• limit indemnification to subject matter (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 contract partner, an indemnity makes sense. From the perspective of the indemnifying partner, it must be reduced to a reasonable extent to avoid unlimited (and unforeseeable) liability.