How to advise clients on commercial contract indemnities

Commercial contracts often contain indemnities, and brokers should be prepared to address issues pertaining to indemnities within those contracts.

Some clients may ask what an indemnity is. Simply put, it’s a promise to compensate another person for certain costs and expenses. And brokers are, of course, deeply familiar with one type of indemnity — insurance policies.

An indemnity is used to transfer risks from one party to the other, and since it’s contractual in nature, the wording will determine its scope and effect. Potential variations are unlimited.

Before discussing the particulars of a contractual indemnity, brokers should consider whether they’re comfortable giving the relevant advice. They should ask themselves, ‘Does the needed advice cover ordinary business, or is the question unusual?’

Brokers should also determine whether their professional insurance would cover them in the event of an error. Sometimes, it can be advisable to ask the client to involve legal counsel or to introduce a lawyer, particularly since lawyers have insurance for errors made when interpreting contracts.

If the client is required to give an indemnity, a broker and client may discuss some questions, such as:

Is the policyholder signing the agreement? If so, then examining the policy’s coverage is warranted. If not, perhaps the policyholder is signing as an officer of a company, and the company may require insurance.
Does the existing policy cover the risk imposed by the indemnity?
Will the limit of the insurance held by the client cover the indemnified risks?

Depending on the situation, insurance may cover all or part of the indemnity obligations, or insurance could be used in place of an indemnity. If a specific risk is at stake, a policy could be purchased to manage that risk.

Many contracts require that service providers maintain workers’ compensation insurance (WSIB in Ontario), to cover workplace accidents. Or, for a contract involving data, one party may be required to have cyber liability coverage.

While those are just examples, interpreting or negotiating an indemnity’s specifics may require legal advice, so brokers should understand the indemnity to advise their clients properly.

Indemnities may be divided into two broad categories:

Losses and damages related to the performance of the contract.
Losses and damages related to third-party claims.

Regarding performance of the contract, a breach may be enforced by litigation, so the parties could rely instead on damages and remove the indemnity.

Meanwhile, third-party claims may arise through performance of the contract, such as a member of the public being injured and claiming damages from either or both parties.

Indemnity clauses may also include the obligation to ‘hold harmless,’ which means agreeing not to seek damages from the indemnified party for losses. While conceptually similar to ‘indemnify,’ it may actually give greater protection to the indemnified party.

Indemnity clauses may also include the obligation to defend, which means agreeing to pay to defend the indemnified party in litigation. It’s possible to negotiate who pays for or makes decisions related to court cases, so the obligation is an additional expense because costs to defend a claim must be paid regardless of whether the claim has merit.

The extent of an indemnity may be quite broad. It might be triggered only when a judgement is made by a court, or it may require repayment of “any losses arising out of or in connection with a claim.” This could be a greater liability and require payment in the event of a claim, even if no damages were actually incurred.

Like insurance policy coverage, a contract may have a limitation of liability clause that performs a similar function, such as capping the indemnity liability. Importantly, a limit of liability section may exclude punitive, special and consequential damages, which are costs over and above those directly caused by the breach.

To finance risks associated with the indemnity, the contract may also require the indemnifying party to obtain insurance.

If an indemnity is accepted, insurance is an important way to finance these additional risks. So, brokers should understand the risks in an indemnity, review the contract’s insurance clause to make sure the required coverage is in place, and see to it that limits are sufficient to cover the indemnity risks.

Michael Carey is a corporate commercial lawyer in Toronto. The article is excerpted from one that appeared in the May issue of Canadian Underwriter.

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