5 Reasons No-Fault Indemnities are a Problem

Indemnity clauses in contracts are a common feature.

There are a number of reasons why no-fault indemnities are a problem. In this article, we’re going to look at five of those reasons and explain, in practical terms, why they can create issues for the party giving the indemnity.

Those five reasons are that the indemnity may:

1. require the breaching party to provide an indemnity for loss caused by someone else
2. be a reversionary indemnity
3. extend to loss that is not ordinarily recoverable at law
4. extend to potential (rather than actual) loss
5. not cover some or all of the loss recoverable under the indemnity

Before we jump in, we should explain what an indemnity is. It is a right to be reimbursed for the things the indemnity applies to. An indemnity entitles the party receiving the indemnity to call upon its right to reimbursement once the relevant event(s) have happened. Unlike a claim for breach of contract or negligence, a party calling upon an indemnity does not need to show:

In the case of breach of contract

1. that there was a contractual duty owed;
2. that the contractual duty was breached; and
3. the party suffered a loss that is recoverable under general legal principles.

In the case of negligence

1. that there was a duty of care owed in tort;
2. that the duty of care was breached; and
3. the party suffered a a loss that is recoverable under general legal principles.

This leads us to our first problem…

Problem number one – the indemnity may require the breaching party to provide an indemnity for loss caused by someone else

Let’s start with an example.

There are five consultants engaged on a construction project. One consultant has been very unfortunate and found themselves with the following indemnity clause in their consultancy agreement:

The Consultant agrees to indemnify the Principal for any loss, howsoever arising, suffered by the Principal in respect of:

1. any design that is defective;
2. lack of coordination and integration between consultants engaged on the Project;
3. the Project not being able to be constructed in accordance with the Principal’s budget and brief.

If you look closely at the clause, you’ll notice that it doesn’t say who has caused the loss that the Consultant is required to indemnify the Principal for. It doesn’t say which consultant’s design is defective, which means it could be the design of another consultant. It doesn’t say which consultant’s lack of coordination or integration and it doesn’t specify who has caused the Project not to be able to be constructed in accordance with the Principal’s budget and brief.

Indemnity clauses (other than in a small business context or consumer context) are to be strictly read. If a party signs up to an indemnity clause, they cannot later argue that they were not aware of or were mistaken as to how the clause was to apply.

In this case, our poor consultant may well find themselves being required to indemnify the Principal for loss that is actually caused by another consultant.

Problem number two – the indemnity may be a reversionary indemnity

A reversionary indemnity is an extension of the above scenario. A reversionary indemnity requires you to reimburse the other party for the loss they have caused. This should be avoided where possible. Instead, each party should only be responsible for the loss they have caused.

Problem number three – the indemnity clause may extend to loss that is not ordinarily recoverable at law

Under general legal principles, only foreseeable loss that is the direct result of the harm caused is recoverable by the injured party. They cannot recover the loss that was unforeseen or that does not flow naturally from the breach.

On the other hand, an indemnity can extend to loss that goes far beyond direct and foreseeable loss. And they often do.

An indemnity has been described as a contract by one party to keep the other “harmless” against loss. And because indemnity clauses in contracts can be classified as an obligation to reimburse the indemnified party, the loss that is reimbursable is solely determined by the indemnity wording itself.

Problem number four – indemnity clauses in contracts may extend to potential (rather than actual) loss

A contract may include a clause that says something like:

The Principal does not need to have incurred any cost or made any payment in respect of any amount that it claims by way of indemnity.

It may also say something like:

Party A must indemnify Party B for any Loss.

And then in the definitions clause, it might define Loss as ‘Loss includes any loss, damage, cost or expense, whether contingent, prospective or unascertained’.

Party A may well consider this clause to be unfair, because Party B may call upon the indemnity in circumstances where it has not yet (and may not ever) suffered the loss claimed.

Problem number five – insurance may not cover some or all of the loss recoverable under the indemnity clause

Insurance is unlikely to cover everything you sign up for in a contract. This is why indemnity clauses in contracts need careful review.

It’s important to ensure that – if all goes wrong – you have your insurance to fall back on.

This means you have to carefully review your insurance policy against the wording of the indemnity clause. Consider what the indemnity clause is asking you to reimburse the other party for. And you should then consider whether your insurance policy covers that risk.

How Can Prosper Law Help?

Prosper Law is Australia’s online law firm. We provide legal services to businesses and individuals across Australia. Our practice areas include contracts, eCommerce, publishing, legal counsel, and employment law.

Because indemnity clauses are complex and can lead to unintended consequences, it’s always helpful to engage a lawyer before you sign the contract.

Contact the team at Prosper Law today if you need help with an indemnity clause. We also provide contract review services. The best part? We only charge fixed fees for this service.