Controlling business risk with indemnities and limited liability clauses

Indemnities and limited liability clauses are often the most negotiated provisions in business contracts. It is a fine balance between agreeing appropriate risk and allocating protections, while at the same time remaining reasonable in order to conclude the deal.

The two legal provisions have different purposes and sit on opposite sides of the contract. For example, it is easier to think of indemnities being useful for the customer or client in a contract: their prime purpose being protection. On the other hand, limited liability clauses are more useful for the supplier in a contract in order to limit their exposure. That being said, either party can request an indemnity or seek a limited liability clause if there are reasonable grounds to do so.

‘While it is important to understand the benefits and disadvantages of these provisions, seeking professional legal advice can ensure you optimise your negotiating position,’ comments Robert Hurst, a commercial solicitor with Talbot Walker LLP in Hampshire.

Robert illustrates the differences with a case study for a brand owner who is negotiating a contract for the production of a new line of cakes.

What are the benefits of asking for an indemnity?

The brand owner will request indemnities to address risks that are not readily or comprehensively covered in the contract with the cake manufacturer. For example, they may want the manufacturer to agree an indemnity to cover:

  • any product recalls as a direct result of contamination during manufacturing;
  • breach or misuse of intellectual property rights; or
  • inventory shortages for materials.

If they are launching the new cake with a competition, they may ask their marketing agency for an indemnity regarding a breach of confidentiality or a data breach.

Some important benefits of asking for an indemnity from a supplier include the following:

  • Indemnities provide a right to compensation without needing to go through the breach of contract litigation process, so this is a quicker way to recover losses as it is a right which is hard coded into the contract.
  • The brand owner can focus on their key concerns and list the losses or triggers to include within an indemnity in order to provide the protection needed. If there is a risk that you are not otherwise covered for (for example, you do not have product recall insurance but there is a risk you may be liable for this) you can seek to be compensated for those specified losses.
  • With the right professional guidance, you could end up with an indemnity clause that is broader and more beneficial to you. Consideration must always be given to whether one targets direct losses only, a list of losses, the most likely losses, or all losses within the parameter of reasonableness.

Sometimes, it is possible to draft indemnities so that they fall outside of the limited liability provisions. In other words, despite the manufacturer (in our example) benefitting from a limited liability clause, one can exclude any indemnity you receive from the manufacturer from their limited liability clause (meaning any losses you can recover under the indemnity will not be capped). This will, of course, depend on the bargaining position of both parties, the value of the contract and other risk and reward allocations; it is a possibility, nonetheless.

What are the benefits of having a limited liability clause?

It is always prudent to limit your liability as a supplier, and usually the limits should reflect your insurance coverage and contract value. However, limited liability clauses are not just about limiting monetary values, as they provide further protection by limiting the extent of your liability. As an example, it may be advisable to exclude all non-foreseeable losses from your liability or losses arising from triggers out of your control – such as loss of business reputation or future income. For example, the cake manufacturer may not cover the brand owner for loss of future income if there was a breach under the manufacturing agreement because the manufacturer failed to get a shipment out to a customer on time.

Limited liability clauses, therefore, are beneficial in several ways, including:

  • By limiting your liability to the contract value or insurance coverage limits, you are not exposing yourself to unlimited liability or risking your business’s viability as a result of a claim against you.
  • By limiting the circumstances in which you will be liable in the first place, you can further benefit from protection against certain claims and liability for losses. The narrower the claim scope, the better you will have managed your liability risk.
  • If you are able to successfully negotiate limiting liability to indemnities which you give, this would further boost your position as a supplier.
  • Securing a limited liability clause does not prevent you from also asking for an indemnity from your customer or client.

A good example of the last point is that the cake manufacturer may be at risk of a claim if they use images supplied by their customer to design packaging, but the images were not properly licensed and paid for. The cake manufacturer may wish to seek an indemnity from the brand owner against third party claims arising from the use of unlicensed images.

The reasonableness test

English law often uses the test of reasonableness (as defined further in the Unfair Contracts Terms Act 1977) to decide if a clause is valid and enforceable, taking into consideration the circumstances at the time the contract was entered into.

In relation to indemnities, this test may look at whether the clause and losses claimed for are excessive. Many factors would be considered here. For example, if the cake company is a startup, it will have less bargaining power, and if it is being asked to cover all losses (direct and indirect) including loss of revenue of the other larger supplier or manufacturer, that could be considered too onerous.

Similarly, a limited liability clause would also need to pass the reasonableness test. For example, if the contract value for one batch of cakes is £100,000 and the manufacturer is seeking to limit its liability to £1,000, there is a strong possibility the clause could be rendered unenforceable for not being reasonable and then the supplier will, by default, expose itself to unlimited liability.

While these decisions are ultimately down to courts to adjudicate upon in the event of a dispute, it is better to avoid getting to that position. Seeking the expertise of lawyers who can ensure any negotiation of these clauses is fair, while addressing genuine risk, will help to protect your interests.

How we can help

It is clear that safeguarding and aligning party interests, rights, and obligations in the context of indemnities and limited liability clauses requires careful drafting and negotiation. We have a strong team of commercial law experts who can help you navigate these clauses to achieve appropriate protection.

For an informal discussion, please contact Robert Hurst in the corporate and commercial team on 01264 721 787 or email roberth@talbotwalker.co.uk.

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.