17 August 2006

Identifying and allocating risk in commercial contracts: role and nature of indemnities

One of the primary functions of any commercial agreement is to allocate risk between the parties¹.

This part of our presentation:

• outlines a simple framework to assist parties in identifying risks associated with a commercial transaction, evaluating the significance of those risks and allocating those risks effectively and efficiently;
• examines the roles of indemnities in allocating risk; and
• reviews indemnity clauses, including identifying key issues to consider when negotiating indemnity clauses, the form of indemnity clauses and the enforceability of indemnity clauses.

Identifying and allocating risks in commercial contracts

Risk Management Process

At the outset, we can identify five distinct components of the risk management process:

• identification of what the risks associated with a project are;
• assessment of the risks;
• allocation of risks between parties to a transaction;
• implementing strategies to mitigate the risks associated with a transaction; and
• managing risk on an ongoing basis¹.

What is risk?

“Risk” is defined in the Oxford English Dictionary as “the chance that is accepted in economic enterprise and considered the source of … profit.” This definition emphasises that risk is an inevitable part of economic enterprise. It can be minimised and allocated between parties, but it cannot be wholly avoided.

“Risk” has also been defined as “the probability of an event occurring coupled with the consequences if it does occur.”³ This definition is directed more at an evaluation of the significance of a risk than the nature of what risk itself is.

Different transactions in different industry sectors will present different sets of risks. Therefore, the process of identifying what risks there are in a particular transaction, and evaluating their significance, is an important part of negotiating any commercial agreement.

Identifying and evaluating risk

Identifying risk early

Project risk identification and allocation should be undertaken at an early stage in the project which is to be rendered into a commercial contract.⁴ If this is left to late in the negotiation process there is a real likelihood that an imbalanced or inappropriate allocation of risk will result.

There is no fully effective way of identifying all of the risks associated with a particular project. However, it is worthwhile for parties to come together at an early stage in the negotiation of the agreements which govern a transaction to determine what the potential risks associated with the transaction are. This has a dual purpose: first, it concentrates the attention of the parties onto what the risks of the transaction are in order that they can make an informed decision about whether the transaction is worth proceeding with; second, it gives the parties a list of matters that need to be negotiated and dealt with in the transaction agreements.

Evaluating risk

Risk analysis draws out two key questions in evaluating the significance of risks involved with a particular project - the probability of an event occurring and the consequences that flow from that event if it does occur. These are two very distinct matters.

Each party to a transaction will have its own views and sensitivities about the significance of the risks associated with the transaction based on their own internal policies, experiences and attitudes to risk.

Once the parties have a clear view of the risks associated with the project and their significance, they can begin to negotiate how the risks will be allocated.

Allocating risk

How should risk be allocated

Parties seek to allocate risk by agreeing rights and obligations in commercial agreements.⁵

Commonly cited principles of risk allocation are that a party to a commercial agreement should bear risk where:

• the risk is within that party’s control;
• that party can transfer the risk and it is most economically beneficial to deal with the risk in this manner;
• the main economic benefit of controlling the risk lies with that party;
• to place the risk upon that party is in the interests of efficiency; and/or
• if the risk eventuates, the loss falls on that party in the first instance and it is not practicable, or there is no reason under the above principles, to cause expense and uncertainty by transferring the loss to another.⁶

In general, the party which has the greatest control over the risk and the best ability to avoid or minimise that risk should bear that risk. However, a party may agree to assume a risk for a commercial benefit or because the party has a particularly weak negotiating position.

Techniques of allocating risk in commercial contracts

In more sophisticated transactions, risks are shared between the parties in a structured manner and this is reflected in the final commercial agreement.

There are several tools that may be used in a commercial agreement to allocate risks between the parties, including:

• Warranty clauses;
• Exclusion of liability clauses and liability caps ;
• Force majeure provisions;
• Guarantee clauses;
• Indemnity clauses (these are discussed further below);
• Payment mechanisms;
• Termination rights;
• Liquidated damages; and
• Obligations to obtain insurance

Indemnity Clauses

Indemnity clauses - a recap

An indemnity clause is an agreement by one party (“the indemnifier”) to keep the other party (“the beneficiary”) harmless against any loss or damage which the beneficiary may suffer.⁷

A clause of indemnity is different from a guarantee which is a promise by the guarantor to answer for the debt, default or miscarriage of another, and most often involves an undertaking to perform that other party’s obligations in the event of default. By contrast, an indemnity is an obligation to compensate for loss or liability. Sometimes, the term guarantee and indemnity are used interchangeably, but they are obviously different, as guarantees are a form of indemnity.

A clause of indemnity is also different from a right to claim damages which is the legal right of a plaintiff to be compensated for any legal injury suffered at the hands of another. By contrast, a right of indemnity may exist where the plaintiff has suffered no injury at the hands of the indemnifier, and even where any injury suffered by the plaintiff was caused by some third party.

There are two main types of indemnity clauses:

• third-party indemnities - here the indemnifier agrees to hold the beneficiary harmless against any loss or damage arising from a claim by a third party; and
• party to party indemnities - here that the indemnifier holds the beneficiary harmless against any loss suffered by the beneficiary in relation to specified matters, including losses suffered as a consequence of breach of contract.⁸

Key issues to consider in negotiating/drafting indemnity clauses

As a creature of contract, the effect of an indemnity clause depends upon the terms in which it is drafted.

On this basis, the following issues should be considered when negotiating and drafting an indemnity clause:

• Scope;
• Form;
• Third party defence;
• Legal costs;
• Extent;
• Caps;
• Carve-outs;
• Insurance;
• Insurance exclusions;
• Survival post-termination;
• Triggers; and
• Taxation issues.

Once each party has formed a view on each of these issues, they will be able to effectively negotiate the terms of an indemnity clause.

Form of indemnity clauses

The form of an indemnity most suitable for a particular agreement will depend, of course, on the particular circumstances of that agreement, the relationship of the parties to it and the industry or enterprise to which it relates.

Set out in schedule 1 to this paper are some sample indemnity clauses that may be sought by one party from the other to the particular agreement. The text of the suggested clauses is generic and requires tailoring for the particular circumstances of the particular agreement.

Enforceability

A number of the issues may affect the enforceability of an indemnity clause. Material factors include:

• Construction by the courts - recent case law⁹ confirms that where indemnity clauses are ambiguous in their drafting, they are to be construed in favour of the indemnifier. The courts will also have regard to the identity of the person drafting the indemnity clause. Indemnities drafted by the beneficiary of the indemnity are likely to be construed more narrowly than those drafted by the indemnifier. An indemnity clause may also be construed more narrowly if the indemnifier is an individual, as opposed to an experienced party with roughly the same bargaining power as the beneficiary. Where two or more indemnity clauses are used in one agreement, drafters should take care to ensure consistency between those clauses. Finally, the courts appear to have adopted a purposive, rather than a literal, approach to the construction of indemnity clauses. Clearly, care needs to be taken in drafting indemnity clauses to accurately reflect the requirements of both the indemnifier and the indemnified;
• Extent - if the indemnity relates to the conduct of the indemnifier but not to its contractors or representatives, the indemnity may not provide protection in relation to actions done on the indemnifier’s behalf;
• Caps - a party might not be able to recover the whole of its loss in relation to an event under that indemnity if the loss exceeds the amount of the cap. It is important to note that a party will be liable to another for damages arising from a breach of contract based on normal contractual principles. That is, an indemnity clause is not required to recover those damages. The common law does not impose any maximum monetary limit for those damages which can be recovered for breach of contract. If an indemnity is provided in relation to losses arising from breach of contract, care should be taken that any caps or restrictions on the right to recover under such an indemnity don’t unintentionally put the indemnified party in a worse position than they would otherwise have been at common law;
• Resources/financial capacity - an indemnity will be unenforceable in a practical sense if the indemnifier does not have the resources to make payments to indemnified parties. On this basis, an indemnified party may seek to have a third party guarantee the obligations of the indemnifier under the indemnity, or may require the indemnifier to obtain insurance in relation to the indemnity provided; and
• Insurance - parties often link indemnities to amounts able to be recovered under insurance policies. If the indemnifier is unable for some reason to bring a claim under its insurance policy or the level of deductible for the particular claim is high, then the indemnity would be of limited or no benefit to the indemnified party. If the insurance policy taken out by the indemnifying party is capped, then the indemnity will be similarly capped if the indemnity is tied to the amount the indemnifier is able to obtain under an insurance policy.

In summary, an indemnity is a very effective way of transferring risk, but its effectiveness will depend on its terms. Parties to a commercial agreement should carefully consider the terms of an indemnity and not assume that the existence of an indemnity itself offers adequate protection.

Dispute avoidance and minimisation strategies

Given that disputes are an ever-present risk in contracting relationships, contracting parties need to consider strategies for minimising the impact of disputes on the relationship. Two key issues which a dispute resolution strategy should address are:

The appropriate mechanism for resolving the dispute

A variety of mechanisms exist for resolving disputes, ranging from informal, low-cost negotiations to formal, high-cost proceedings.

Alternative Dispute Resolution mechanisms like mediation potentially offer several advantages over court proceedings, such as lower costs, fewer delays, confidentiality, and greater flexibility in reaching a win/win outcome for both parties. However, these advantages will not be present in every case, and in some disputes, court proceedings may be necessary, or tactically preferable.

Dispute resolution clauses in contract

Dispute resolution (“DR”) clauses require or enable parties to participate in ADR processes in the event of a dispute between them. These clauses provide guidelines, of varying degrees of specificity and compulsion, as to how disputes will be conducted. While DR clauses offer relative certainty for contracting parties, they may correspondingly limit dispute resolution flexibility. If flexibility is important, a clause that promotes good faith negotiations as to ADR process in the event of a dispute may be a more strategic option.

Schedule 1 - Sample Indemnity Clauses

Sample long form indemnity:

X indemnifies Y and its officers, employees and agents against any liability, loss or damage, arising directly or indirectly from, and any costs and expenses (including legal expenses on a full indemnity basis) incurred in connection with:

• any breach of this agreement by X;
• the cancellation of this agreement because of a breach by X;
• any wilful, unlawful or negligent act or omission by X or an officer, employee or agent of X;
• any illness, injury to, or death of any natural person caused or contributed to by X or an officer, employee or agent of X;
• any loss of or damage to real or personal property (including the loss of use thereof) of Y or a third party caused or contributed to by X or an officer, employee or agent of X;
• any claim, action, demand or proceeding by a third party against Y or its officers, employees or agents caused or contributed to by X;
• any claim, action, demand or proceeding made against Y by any of X’s officers, employees, agents, contractors and/or sub-contractors in respect of any relevant legislation concerning income tax, workers compensation, annual leave, long service leave, superannuation or any applicable award, determination or agreement of a competent industrial tribunal;
• any penalty imposed for breach of any applicable law in relation to X’s performance of this agreement;
• loss or damage to any plant, equipment, tools appliances or other property owned, tested or hired by X and used in relation to this agreement; or
• any act or omission by X or its officers, employees or agents in performing this agreement that results in a claim that X or Y is infringing or allegedly infringing the intellectual property rights of any person,

except to the extent that any liability, loss, damage, cost or expense is solely and directly caused by the negligence of Y or its officers, employees or agents, other than X.

Sample medium form indemnity:

X indemnifies Y and its officers, employees and agents against any liability, loss, damage, costs or expenses incurred or suffered by Y or its officers, employees or agents arising directly or indirectly from or in connection with:

• any breach of this agreement by X;
• the cancellation of this agreement because of a breach by X;
• any wilful, unlawful or negligent act or omission of X or an officer, employee or agent of X;
• any injury to, or death of a natural person and any loss of or damage to, a third party’s real or personal property caused or contributed to by X or an officer, employee or agent of X;
• any loss of or damage to real or personal property of Y, caused or contributed to by X or an officer, employee or agent of X; or
• any claim, action, demand or proceeding by a third party against Y or its officers, employees or agents caused or contributed to by X or an officer, employee or agent of X,

except to the extent that any liability, loss, damage, cost or expense is solely and directly caused by the negligence of Y or its officers, employees or agents, other than X.

Sample short form indemnity:

X indemnifies Y against any liability, loss, damage, costs or expenses incurred or suffered by Y arising directly or indirectly out of or in connection with:

• a breach of this agreement by X; or
• any act by or omission of X or an officer, employee or agent of X.

Sample “consequential loss” carve-out

Neither party will be liable to the other party under this agreement for any:

• damages or losses which are not direct or do not flow naturally from the relevant breach of this agreement, even if those damages or losses may reasonably be supposed to have been in contemplation of both parties as a probable result of the breach at the time they entered into this agreement;
• special loss or damage; or
• economic loss,

including loss of revenue, loss of production or loss of profit.

Additional clauses

Each indemnity in this agreement is a continuing obligation separate and independent from any other obligations and survives termination of this agreement.

It is not necessary for either party to incur expense or make payment before enforcing a right of indemnity conferred by this agreement.

Footnotes

1. Brett McGuire and Tony Grasso, “Pre-contractual negotiations - warranties and exclusion clauses” (2001) 44 Comp&L 43, 43.

2. Raphael Arndt, “Getting a fair deal: Efficient risk allocation in the private provision of infrastructure” (2000) PhD thesis.

3. Scott McConnel, “Project Financing in the Energy Industry and its Impact on Completion Risk” (2001) 20 AMPLJ 148, 152

4. Peter Megens, “Different perspectives of construction risk” (1996) 15 AMPLA Bulletin 179, 182.

5. Michael Mills, “Insurance and risk solutions for commercial projects” (2001) 20 AMPLJ 46, 47

6. NPWC/NBCC Report cited in Scott McConnel, “Project Financing in the Energy Industry and its Impact on Completion Risk” (2001) 148, 155

7. Sunbird Plaza v Maloney (1988) 166 CLR 245

8. Brett Mc Guire and Tony Grasso, “Pre-contractual negotiations - Warranties and exclusion clauses” (2001) 44 Comp&L 43, 44

9. See the High Court of Australia decision of Andar Transport v Brambles Limited (2004) 217 CLR 424