Purpose

If a contractual partner breaches a contractual obligation, the other contractual partner can in principle demand compensation under certain conditions.

A contractual indemnity clause goes beyond this and extends the liability of the indemnifying contractual partner (usually the supplier). Prerequisites and legal consequences are subject to the contractual negotiations in each individual case.

Indemnity is a primary obligation; it is not dependent on proving a breach of a contractual obligation. This offers a number of advantages over the assertion of claims for damages for breach of contract:

  • Compensation is generally triggered by the occurrence of a loss without the need to prove fault. In this way, it is also possible to circumvent the rules on causation and mitigation, which can otherwise make recovery more difficult.
  • If the scope of indemnity is broad, it may allow for more extensive recovery of losses such as legal fees and other related costs than would be possible in a breach of contract action.
  • Claims for damages are considered more difficult to defend against and it is more likely that the indemnifying contractual partner will make payments as part of compensation without having to initiate legal proceedings.

Each indemnity clause must therefore be critically examined and - at least from the perspective of the indemnifying contractual partner - reduced as far as possible (see example below). Depending on the structure of the clause, further restrictions must be made (see below).

According to current case law of the U.S. courts, an indemnity clause generally only covers claims for damages by third parties and not claims for damages by the contracting party.[1] This aspect must be taken into account when drafting the indemnity clause, as contractual partners are increasingly trying to significantly expand the actual scope of application of a typical indemnity clause.

In this context, the respective limitation of liability clause also plays an important role. The indemnified contractual partner often attempts to structure the limitation of liability in such a way that it does not include indemnity. This would result in unlimited liability in the event of indemnity. From the point of view of the indemnifying contractual partner, 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 revision of the standard indemnity clause from the perspective of the indemnifying contracting party

"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); a.A. 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. Sept. 17, 2019). ︎

  2. Reduction of the obligations of the indemnifying contractual partner. The term "defend" contains the duty of the indemnifying contractual partner to defend its contractual partner in the context of a legal dispute with a third party. The term "hold harmless" means that the indemnifying contractual partner cannot assert any claims against its contractual partner (str.). ︎

  3. Reduction of the very broad personal scope of application of the indemnity clause. ︎

  4. Under U.S. procedural law, the plaintiff is not entitled to reimbursement of his legal fees even in the event of success (so-called "American Rule"). For this reason, attorney's fees are listed as recoverable damages in indemnity clauses. In this case, however, these costs should at least be limited to a reasonable amount. On "reasonable" legal 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 or exclusion of consequential damages. Without this addition, it is debatable whether the "test of remoteness" (also known as the "test of reasonableness") - first set out 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. Limitation due to the necessity of causality between the breach of duty of the indemnifying contractual partner and the claim of the third party. The usual wording "directly or indirectly" should be avoided at all costs. This also applies to the unrestricted use of "arising out of or in connection with". This is because consequential damages are also included. ︎

  7. Indemnification for all breaches of duty should be avoided at all costs. In addition to the usual scope of an indemnity (infringement of IP rights), it should - if at all - only cover breaches of confidentiality obligations. In addition, fault should be included as a further requirement (the common law prevailing in many English-speaking countries does not recognize a fault requirement). ︎

  8. Limitation in the case of contributory negligence (see Section 254 (1) BGB if German law applies). ︎

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

Example wording from the perspective of the exempting contractual 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 contractual partner

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 contractual partner is obliged to inform the indemnifying contractual partner immediately of any claim
  • the indemnified contractual partner may neither recognize the claim nor conclude a settlement with the third party
  • the indemnifying contractual partner has sole control over how the claim is to be handled
  • the indemnified contracting party is obliged to support the indemnifying contracting party in its defense (at its own expense)
  • specify a minimum amount that must be reached before the obligation to pay compensation arises ("basket")
  • no exemption if and insofar as:
    • the contractual product (or service) has been modified
    • the contractual product (or service) has been used together with other products (or services) that were not approved by the exempting contractual partner
    • the contractual product (or service) has been used contrary to the specifications of the exempting contractual partner
  • Limit exemption to certain types of intellectual property, for example patents rather than intellectual property in general
  • Restrict exemption in terms of subject matter (e.g. only certain types of intellectual property), geography (e.g. EU) and time (e.g. 1 year after delivery)

Recommendation

From the point of view of the indemnified contractual partner, indemnity makes sense. From the point of view of the indemnifying contractual partner, however, this must be reduced to an appropriate level in order to avoid unlimited (and incalculable) liability.

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