November 2008

01 Nov 2008

Is That Indemnity Really Worth Fighting For?

One of the great areas of debate when negotiating an IT contract is the area of indemnities. Both parties commonly drive to be indemnified for everything they can think of, while retreating from the prospect of giving an indemnity with fear and a faint smell of panic. The question is, is this great preoccupation with indemnities really justified?

To answer as a typical lawyer…it depends. There are some circumstances in which the existence of an indemnity will make a significant difference. However, there are also situations where the existence of an indemnity has less significance than it may appear. This article contrasts claims under indemnities with claims for ordinary breaches of contract to illustrate some of the key factors which will affect the value of an indemnity.

What is an Indemnity?

A right of indemnity exists where one party is obliged to make good certain losses suffered by the other party. The losses which the indemnifying party must make good will depend on the wording of the indemnity. For example, Peter may indemnify Paul against any losses suffered by Paul if a tree on Peter's neighbouring property blows over. If the tree then blows over and damages Paul's fence, Peter will be liable for the cost of fixing the fence.

Indemnities in IT contracts

The most common indemnity in an IT contract is the so-called "IP indemnity". This is an indemnity which a supplier of hardware or software grants to a customer against any loss suffered by that customer as a result of third party claims that the customer's use of that hardware or software breaches the third party's intellectual property rights.

However, IT contracts are often littered with other indemnities as well. For example, some customers may also be granted a broad indemnity against any loss suffered by them as a result of a breach by the supplier of its obligations. More specific indemnities are also relatively common, such as indemnities against any loss suffered as a result of the introduction of a virus by the supplier or against any damage caused to the customer's computer systems during installation.

All such indemnities are valuable, because they allow the indemnified party to recover the losses against which it is indemnified, but the key issue in a negotiation will often be determining which party is most appropriate to bear the risk, which will also involve consideration of who is best placed to manage the risk, and how valuable the indemnities are in the particular arrangement being entered into.

Clearly, the value of an indemnity will be affected by the risk that the relevant loss will be suffered and the likely quantum of that loss. However, its value will also be affected by the extent to which the loss could have been recovered without the indemnity. That issue is the focus of this article.

Contrasting Breaches of Contract and Indemnities

The main alternative to claiming under an indemnity in an IT contract is suing for breach of a term of that contract. Consequently, the value of an indemnity will often depend on  the effect of the differences between indemnities on the one hand, and breach of contract claims on the other hand, in the particular circumstances.

The key differences between the two are as follows:

1. to claim for breach of contract, a party must show that the contract has actually been breached, while to claim under an indemnity a party must only show that it has suffered the loss against which it was indemnified;
2. to recover loss in a breach of contract claim, the claimant must show that the loss was a reasonably foreseeable consequence of the breach of contract, while to recover loss under an indemnity, a party must only show that the loss was that loss against which it was indemnified; and
3. a defendant in a breach of contract claim may not be required to compensate the claimant for all losses if it can show that the claimant did not take reasonable steps to mitigate its loss, while an indemnifying party cannot reduce its liability by showing a failure by the indemnified party to mitigate its loss.

The significance of these differences is illustrated below with a series of simple examples.

Example to Illustrate the first Difference - Demonstration of Breach Versus Loss Suffered

A supplier supplies software to two different customers. In its contract with Customer A, it warrants that it has sufficient intellectual property rights in the software to license Customer A to use that software as contemplated by the supply contract. In contrast, in its contract with Customer B, the supplier indemnifies Customer B against any loss suffered as a result of any third party claiming that Customer B's use of the software as contemplated by the supply contract breaches that third party's intellectual property rights.

A third party subsequently sues both customers for breaching its intellectual property rights for $100,000 each. Both customers receive legal advice that the third party has a 40% chance of succeeding, and both settle their respective claims out of court for $30,000.

Customer A wishes to sue the supplier for the loss it suffered in obtaining legal advice and settling the claim. However, it will find such a claim is very difficult. This is because it will need to show that the supplier's warranty was incorrect when, in fact, its own legal advice is that there was a 60% chance that it would have won against the third party and proved the warranty to be correct.

In contrast, Customer B only needs to show under its indemnity that there was a third party claim, and that it suffered a loss as a result, which it can easily show.

In this example, Customer B has the classic "IP indemnity". Usually a customer is relying on a supplier to ensure that the supplier has all necessary intellectual property rights necessary to provide the customer with the required deliverables and this example illustrates how valuable such an indemnity can be.

However, although this example illustrates a way in which an indemnity can provide an advantage, not all indemnities allow the issue of fault to be so easily avoided. For example, an indemnity against any loss suffered as a result of a breach by a supplier of any of its obligations will require a claimant to show such a breach, much in the way it would need to if it was to sue for breach of contract.

Example to Illustrate the Second Difference - Foreseeability of Loss Suffered

A supplier supplies software to two different customers. In its contract with Customer A, it warrants that the software does not contain any viruses. In contrast, in its contract with Customer B, it indemnifies customer B against any loss suffered as a result of the software containing any viruses.

The software contains a previously unknown virus, which does far more damage than any known virus would have done. Customer A can easily show a breach of contract because the warranty was clearly incorrect. However, the damage goes far beyond that which was reasonably foreseeable, so it only manages to recover a portion of its losses. In contrast, Customer B only needs to show that the loss was a result of the software containing a virus, and can claim under the indemnity for the full loss.

Again, this example illustrates how the differences between the two types of claim can be significant. However, once again, the additional value of the indemnity will depend on how the indemnity is framed, and will also depend on the context. If the indemnity is only against loss which is reasonably foreseeable, its additional value will be significantly reduced. Finally, it is worth remembering that loss which is not reasonably foreseeable is usually so because it is unlikely. The value of guarding against something which is unlikely is limited unless the loss which it would cause is substantial.

Example to Illustrate the Third Difference - Obligation to Mitigate Losses

A supplier supplies software to two different customers. In its contract with Customer A, it warrants that the software does not contain any viruses. In contrast, in its contract with Customer B, the supplier indemnifies Customer B against any loss suffered as a result of the software containing any viruses.

The software contains a virus, which begins infecting other computers in the customers' networks. Both customers realise this is happening before many computers are infected, and have an opportunity to stop the spread reasonably easily. However, both decide it is not their problem and simply log a call with a company they know disinfects computers. By the time that company receives the message and has been able to deploy people to fix the problem, many computers are infected and the expense is substantial.

Both customers pass the invoice from the disinfectant company to the supplier. However, while the supplier pays the invoice for Customer B under its indemnity, it refuses to pay the full amount for Customer A, claiming that Customer A should have taken steps to mitigate the loss.

This example illustrates how the absence of a requirement to mitigate can be valuable. However, in many situations, a customer will be incentivised to mitigate its loss in any event. Therefore, in a negotiation, it is important whether you will have an incentive to mitigate any loss against which you are indemnified.

Conclusion

There is no doubt that in some situations an indemnity can add real value. However, parties to a negotiation should always consider exactly how an indemnity could apply in their particular situation, what risk is being addressed and who is best placed to manage that risk and therefore the appropriate party to carry that risk. 

Authors

Karen Ngan

Partner - Corporate & Commercial

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Michael Sage

Partner - Corporate & Commercial

DDI: +64 9 977 5006

Mobile: +64 21 664 993

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Richard Watts

Partner - Intellectual Property

DDI: +64 9 977 5182

Mobile: +64 21 895 931

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Sonya Hill

Senior Associate - Corporate & Commercial

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