An indemnity clause can look like another dense paragraph in a commercial contract. The problem is that a few lines of wording can decide who pays when a third party makes a claim against your business.
You may be looking at an agreement that says you must “indemnify and hold harmless” the other party. Or you may want the contract to protect you if someone else’s actions cause your business to face a claim, legal costs or another financial loss. Either way, you need to understand exactly what triggers the indemnity and how far it reaches.
The wording matters because indemnities do not all work in the same way. Some focus on third-party claims. Others cover identified contractual risks, intellectual property issues, employment liabilities or other defined losses. The contract may also contain separate liability limits that affect how the indemnity operates.
By the end of this article, you will know what an indemnity clause does, how third-party claims fit into it, which wording deserves closer attention and what to check before you agree to take on the risk.
In This Article
What is an indemnity clause?
An indemnity clause is a contractual promise by one party to cover specified loss or liability suffered by another party when an agreed event happens. In commercial contracts, businesses use indemnities to decide in advance who should bear particular risks.
The key word is specified. An indemnity should not be treated as a general promise to pay for anything that goes wrong. Its effect depends on the trigger, the type of loss covered and the wording surrounding it.
For example, one party might agree to indemnify the other against certain claims brought by third parties. Another indemnity might deal with intellectual property infringement, employment liabilities, defective products or data-related claims. Practical Law identifies third-party claims, intellectual property issues, defective products or services, data protection and TUPE liabilities as areas where indemnities may be used.
That is why you should not skim the clause because the heading says “Indemnity”. You need to understand what you are agreeing to pay for and when the obligation begins.
Onyx already explains the wider relationship between contractual risk and liability in Limiting Contractual Liability. That is worth reading alongside an indemnity because the two provisions often need to be considered together.
How does an indemnity protect against third-party claims?
A third-party claim is a claim involving somebody outside the contract between you and the other business. That third party might be a customer, employee, intellectual property owner or another person affected by what one of the contracting parties has done.
An indemnity can allocate responsibility for that risk before a claim arises. The contract can say that if a defined third-party claim occurs because of an identified event, one party must cover specified losses suffered by the other.
Imagine that Business A supplies something to Business B. A third party later alleges that an aspect of what Business A supplied infringes its intellectual property rights. If the contract contains an appropriately drafted indemnity covering that risk, it may determine who has to bear the resulting financial exposure.
That does not mean the words “third-party claims” are enough on their own. The clause should make clear which claims are covered, what must have caused them and which losses fall within the indemnity.
You should also check whether the clause covers legal costs, settlements, damages, investigation costs or other expenses. Do not assume every loss connected with the claim will automatically be recoverable.
The practical question is not simply, “Do I have an indemnity?” It is, “Does this indemnity cover the particular claim and loss I am worried about?”
What should you check in an indemnity clause?
Start with the trigger. The clause should tell you what needs to happen before the indemnifying party becomes responsible. Broad wording can create a much wider exposure than wording tied to a specific event or breach.
You should then identify the losses covered. Words such as “losses”, “costs”, “claims”, “expenses”, “damages” and “liabilities” may appear together, but their effect needs to be considered in the context of the complete clause.
Next, look at who benefits from the indemnity. Is it only the company signing the contract, or does the clause attempt to protect directors, employees, associated companies or other parties as well?
You should also check the connection required between the trigger and the loss. Wording such as “arising from”, “arising out of” or “in connection with” can matter when deciding how widely the provision operates. Practical Law specifically identifies this type of drafting as important when interpreting commercial indemnities.
Finally, ask whether the risk allocation makes commercial sense. If the indemnity places responsibility on you for events outside your control, or gives the other party a much wider remedy than the rest of the agreement suggests, that should be understood before you sign.
For wider help with reviewing and negotiating business agreements, Onyx’s Commercial Contract Solicitors page explains its approach to contracts covering relationships with customers, suppliers, distributors and other business parties.
Who controls a third-party claim?
The financial promise is only one part of a well-drafted third-party indemnity. You should also know what happens when an actual claim arrives.
A contract may require the protected party to notify the other party promptly. This gives the indemnifying party an opportunity to understand the allegation and decide how the matter should be handled.
Control of the defence can become particularly important. The party paying for a claim may want the right to defend it, appoint advisers or take part in negotiations. The protected party may be reluctant to give complete control where a settlement could affect its reputation or ongoing commercial relationships.
Settlement provisions also deserve attention. You do not want to discover after a settlement has been agreed that the other party says the indemnity no longer applies because the contract required its consent.
A third-party claims procedure may therefore deal with notice, access to information, cooperation, defence costs and settlement decisions. Practical Law notes that negotiated third-party claim provisions often address notification, consultation and who has rights over settlement or compromise.
This is one reason a short indemnity clause is not always a simple one. The wording needs to deal with the financial risk and the practical process if that risk becomes real.
How does an indemnity interact with liability limits?
Do not read an indemnity in isolation from the rest of the contract. Commercial agreements often contain a limitation of liability clause dealing with financial caps, excluded types of loss and circumstances where liability is treated differently. You need to establish whether those provisions apply to the indemnity.
A common assumption is that every indemnity automatically sits outside the contractual liability cap. That is not a safe assumption. Practical Law specifically identifies the interaction between indemnities and liability limitations as an issue that depends on the contract’s drafting.
This can make a significant difference to the risk you accept.
Suppose the agreement contains a general cap on liability but the indemnity is expressly excluded from that cap. The financial exposure under the indemnity could be very different from the exposure created by an ordinary breach of contract.
The opposite can also happen. The agreement may make clear that the cap applies to indemnity claims as well.
You should therefore read the definitions, indemnity wording and limitation clause together. Check for exclusions from the cap and consider whether separate financial limits apply to particular risks.
Onyx’s existing Limiting Contractual Liability article covers contractual caps, exclusions and the types of liability businesses need to consider when allocating commercial risk.
Does an indemnity mean you automatically have to pay every claim?
No. The fact that a third party has made an allegation does not automatically answer whether the indemnity applies. The wording still needs to be checked against the circumstances. You need to identify the trigger, whether the claim falls within the defined scope and whether the required connection exists between the event and the claimed loss.
The contract may also impose procedural requirements. For example, one party may have to give notice of a third-party claim or allow the other party to become involved in its defence.
There may also be arguments about whether particular costs or losses fall within the indemnity. This is why broad phrases should not be treated as self-explanatory.
Where disagreement develops, start with the written contract and the documents connected with the claim. Onyx’s guide to Commercial Contract Dispute Resolution explains why contractual notice requirements and agreed dispute procedures should be checked before formal steps are taken.
When should you negotiate an indemnity clause?
The best time to question an indemnity is before the agreement is signed. Start by asking why the indemnity is there. What risk is the other party trying to allocate, and why should your business carry it?
If the underlying risk belongs within your control, some form of protection for the other party may be commercially understandable. You still need to consider whether the clause goes further than necessary.
If the wording captures matters outside your control, unrelated losses or claims caused partly by the other party, it may need closer negotiation.
You should also consider insurance. A contract can create an exposure that your insurance policy does not cover, or it may require a level or type of insurance that you do not currently hold.
The commercial question is whether the risk, contract value and potential exposure remain proportionate. You should know the answer before the contract becomes binding, rather than discovering it when a third-party claim arrives.
Frequently asked questions about indemnity clauses
What does an indemnity clause mean in a commercial contract?
An indemnity clause allocates responsibility for defined losses or liabilities between the parties. One party agrees to compensate the other if a stated event occurs and the clause covers the resulting loss.
The precise effect depends on the wording. You should check the trigger, losses covered, beneficiaries and any conditions attached to making a claim.
What is a third-party indemnity?
A third-party indemnity is designed to deal with claims made by somebody outside the contract.
For example, it may allocate responsibility if a third party claims that one party’s products, services or actions infringed its rights. The clause should explain which third-party claims fall within its scope.
Is an indemnity the same as damages for breach of contract?
Not necessarily.
An indemnity is a contractual obligation drafted to deal with a particular risk, while a damages claim normally follows a breach and is governed by the relevant principles applying to contractual damages. The exact consequences depend on the drafting and circumstances.
Are indemnities always unlimited?
No.
Whether an indemnity is subject to a contractual cap or other limitation depends on the agreement. Do not assume that the clause is either capped or uncapped without reading the liability provisions alongside it.
What should happen when a third party makes a claim?
Check the contract before responding.
The agreement may contain requirements around notice, access to documents, control of the defence and settlement. Following the agreed process can be important when relying on the indemnity.
Should both parties give indemnities?
There is no rule that an indemnity has to be mutual.
The correct position depends on the risks each party creates or controls. A balanced contract does not necessarily contain identical indemnities, but each provision should have a clear commercial reason.
Should I sign a contract with a broad indemnity clause?
First understand the exposure.
A broad indemnity may affect the level of risk your business takes on, particularly if it covers wide categories of claims or sits outside the main liability cap. Get the wording checked if you are unsure what the provision could require you to pay.
Understand the risk before you sign
An indemnity clause can be useful when a commercial contract needs to allocate a particular risk. The problem comes when the clause is read quickly and its financial effect is only considered after a claim has been made.
For third-party claims, you need to understand more than who pays. The contract should also tell you what claims are covered, which losses fall within the indemnity and how the parties will manage the claim when it arises.
Read the clause alongside the liability cap, insurance requirements and dispute provisions. That gives you a clearer view of the risk you are accepting and whether the wording matches the commercial deal.
If you have received a commercial contract containing an indemnity and you are unsure what it means for your business, get the clause checked before you commit.
Book a consultation
Speak to Onyx Solicitors about the agreement, the indemnity clause and the risk you are being asked to accept. Their commercial contract solicitors can review the wording and explain what needs attention before you sign.