The case for indemnities - how they work in practice

Indemnity clauses are often used in contracts to define who bears risk. They are a promise by one party to cover the costs or loss incurred by the other party as a result of certain events.

It is important when wording or negotiating an indemnity to consider how wide the clause is, whether it will be effective, and even if one is needed at all.

Different form, different wording

Indemnity clauses can take different forms. For example:

• A indemnifies B against all losses that B may suffer except those arising out of B’s own acts and omissions

• A indemnifies B against any liabilities and claims made by a third party that is in any way related to the contract

• A indemnifies B against any losses B may suffer if C fails to make payment

• Each party indemnifies the other from any loss arising from a breach of contract by the indemnifying party.

Common pitfalls

Indemnity clauses may come unstuck when they are drafted too widely and extend beyond ordinary breach of contract. For example:

• a clause that has a party providing indemnification for things beyond their control such as the act, default or breach of a third party

• an indemnity by A of loss suffered by B, regardless of whether B caused or contributed to that loss.

When an indemity clause may be an unfair contract term

If your other contracting party is a consumer or small business an indemnity in a standard form contract may be challenged as

an unfair contract term under the Australian Consumer Law. A clause in a contract with a consumer or small business may be found to be unfair if it:

• would cause a significant imbalance in the parties’ rights and obligations

• is not reasonably necessary to protect the legitimate interests of the party advantaged by the term

• would cause detriment (financial or otherwise) if relied on.

In making such an assessment, a court or tribunal would consider the contract as a whole and the transparency of the term. Case law provides the following examples of where an indemnity clause in a standard form contract was considered to be too wide:

Example 1: ACCC v JJ Richards & Sons Pty Ltd [2017] FCA 1224

The customer had to indemnify the supplier for all liabilities, claims, damages, actions, costs and expenses (on a full indemnity basis and whether successful or not) as a result of, or arising out of, or otherwise in connection with the contract, including any breach of warranties, covenants and conditions. The effect of the clause was to require the customer to indemnify the supplier even if:

• the loss was not the customer’s fault

• the loss could have been mitigated by the indemnified party

• the customer enjoyed no reciprocal indemnity.

Example 2: ASIC v Bendigo and Adelaide Bank Limited [2020] FCA 716

A finance contract required the borrower to indemnify the bank for losses not caused by the borrower, and including losses caused by the bank’s own mistake or negligence which could have been avoided or mitigated by the bank. The borrower had no corresponding rights. The bank accepted in this case that the indemnity should be narrowed in scope and agreed to a rewording.

Mitigating the risk when dealing with a consumer or small business

When negotiating a contract with a consumer or small business, consider whether indemnity clauses are even necessary. Assuming a breach of contract occurs, you could still sue on that basis as long as you could prove each of the following:

• there was a legally binding contract

• there was a breach of the contract’s terms by the other party

• you suffered loss or damage as a result of the breach

• you took steps to mitigate that loss.

If going ahead with an indemnity, consider these points:

• Are you comfortable agreeing to a mutual indemnity clause? Note that in some circumstances a non-mutual indemnity may be appropriate, such as where you have provided materials to the other party that breaches a third party’s intellectual property rights

• Can you limit the application of the clause to specific kinds of loss, for example, to breach of contract?

• Can you exclude from the indemnity unintended consequences such as the indemnity applying even if the indemnified party causes or contributes to the loss. Or if the loss results from a third party’s acts or omissions over which the indemnifying party had no control?

• Does your contract give rise to other consequences for breach, such as a right to terminate the contract with payment of liquidated damages (which is a pre-determined amount of damages considered reasonable for the loss that may be suffered)?

How long do I have to bring action based on an indemnity?

With a few exceptions, New South Wales law allows six years from the date the cause of action first arose to bring action against the other party. If the indemnity is contained in a deed, it will be 12 years. (Note that all states and territories have their own limitations legislation which may differ from the New South Wales position).

The cause of action arises at the time you make demand under the indemnity and the other party refuses or fails to comply. This means that in practice, the right to commence action could extend well beyond 6 or 12 years. This is one of the advantages of having an indemnity.

Key takeaways

Indemnity clauses can be useful, but it is important to examine an indemnity clause with a critical eye – whether you are including it within a contract or are on the receiving end of one. This is because courts will interpret the clause narrowly and if there is any ambiguity in the clause, will interpret it in favour of the party giving the indemnity.

If including an indemnity in a contract, unless there is a reason it should be given only in favour of one party, consider how broadly the indemnity is worded. The better indemnity clauses are balanced and not of such breadth that it may be found to be unreasonable.

Author: Rebecca Hegarty

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This publication is intended as a source of information only. No reader should act on any matter without first obtaining professional advice.