Indemnities in IT contracts

Should you include an indemnity in your IT contract?  And if so, what sort of indemnity?  Indemnities in IT contracts come in many different shapes and sizes.  Whether it is appropriate to include an indemnity in a given contract will depend upon a range of factors.  In this post, I explore some of these factors.

What is an indemnity?  Broadly, and indemnity is a compensation payment or an obligation to make a compensation payment.  The legal usage of the term is confused and confusing, but in the context of IT contracts, there are two main classes, which I have called:

• insurance-like indemnities; and
• indemnities on breach.

Insurance-like indemnities

The first type of contractual indemnity is concerned with providing cover from losses arising from a particular event, where the occurrence of the event is not itself a breach of contract.  This type of indemnity is a type of insurance, where one party is saying to the other, “If x happens, I will recompense you for the losses that result”.

It is not uncommon for software licences to include an indemnity benefiting the customer in the event that the software infringes some third party’s IP rights.  This is considered right and proper because first, the vendor should have made some efforts to sure that the software does not infringe anyone’s IP rights and, second, the customer is usually unable to make the assessment.  Why, then, should the customer suffer if the software turns out to include copied code?  I will consider IP-related indemnities further below.

Another situation where you might find this kind of indemnity in a customer-friendly hosting contract, where the host might undertake to indemnify the customer in the event of an outage caused by a third party service provider appointed by the host, even though the outage wouldn’t constitute a breach of contract.

In each of these cases, the vendor has a degree of control over the event that trips the indemnity: a large degree in the case of the software licence; a smaller degree in the case of the hosting contract; but in neither case absolute control.

Indemnities on breach

The other type of contractual indemnity is concerned with the amount of compensation that may be paid in the event of a breach of contract.  In a standard action for breach of contract, the amount of money that may be recovered by the claimant is limited by various legal filters, such as forseeability and remoteness.  Where a contract specifies that damages will be recoverable on an indemnity basis, then the level of damages will depend upon the drafting of the indemnity, and the damages need not be limited by forseeability etc.  

I refer above to IP indemnities in software licences.  These can take the form of indemnities on breach.  The usual structure is that the licensor will give a warranty that the software does not infringe, and the indemnity clause specifies that damages for breach of that warranty will be recoverable on an indemnity basis.  The key difference between the IP indemnity on breach and the insurance-like IP indemnity is that in the former case the vendor is in breach of contract.  This may mean that the contract is terminable by the other party in those circumstances.

Another type of breach that commonly might give rise to an obligation to indemnify is a breach of an obligation to keep information confidential.  Such breaches can be very serious, particularly for technology businesses, potentially causing damage far exceeding the value of a contract. 

Where a mission-criticial service is being provided, and the service provider fails to meet specific requirements of the service level agreement, then pro-customer contracts will sometimes include an indemnity on breach benefitting the customer.

Conditions

The right to an indemnity may be made subject to particular conditions.  The purpose of these conditions is (usually) to ensure that, in the event that an event giving rise to an obligation to indemnify occurs, the party benefiting from the indemnity does not exacerbate the losses suffered by the party giving the indemnity.

For example, where an indemnity relates to intellectual property infringement or some other matter that creates a liability to a third party, the indemnified party might only benefit from the indemnity if they:

• notify the indemnifier of an event that trips the indemnity;
• refrain from admitting liability in third party claims;
• refrain from settling any such claims; and
• give the indemnifier the right to conduct disputes and settle claims.

Insurance

Indemnities can cause problems with contracts of insurance.  Many contracts of insurance limit the amounts payable under the policy in such a way that amounts paid under and indemnity are not recoverable.  Check your contracts of insurance before agreeing to give an indemnity.

Unfair Contract Terms Act (UCTA)

Section 4 of UCTA regulates certain types of indemnity in consumer contracts:

(1) A person dealing as consumer cannot by reference to any contract term be made to indemnify another person (whether a party to the contract or not) in respect of liability that may be incurred by the other for negligence or breach of contract, except in so far as the contract term satisfies the requirement of reasonableness.

(2) This section applies whether the liability in question— (a) is directly that of the person to be indemnified or is incurred by him vicariously; (b) is to the person dealing as consumer or to someone else.

Insurance-like indemnities given by consumers will usually be unreasonable, and will therefore usually be unenforceable under Section 4.  Indemnities upon breach given by consumers could also be unreasonable, depending upon the circumstances.

Unfair Terms in Consumer Contracts Regulations 1999

These Regulations control unfair terms in consumer contracts.  Section 5 spells out the meaning of “unfair”:

(1) A contractual term which has not been individually negotiated shall be regarded as unfair if, contrary to the requirement of good faith, it causes a significant imbalance in the parties’ rights and obligations arising under the contract, to the detriment of the consumer.

(2) A term shall always be regarded as not having been individually negotiated where it has been drafted in advance and the consumer has therefore not been able to influence the substance of the term.

Clearly, some indemnities may be unfair on consumers.

Schedule 2 provides more guidance in the form of an “indicative and non-exhaustive list of terms which may be regarded as unfair”.  Included in this list, are any terms “requiring any consumer who fails to fulfil his obligation to pay a disproportionately high sum in compensation”.  This looks to be directed at penalty clauses, but if an indemnity upon breach is drafted in such a way that the consumer’s obligation to compensate goes well beyond what is required under the general law, such an indemnity may also be considered unfair under the Regulations.

Summary of factors

To conclude, the factors identified or implied above, to be considered in relation to the question of whether to include a particular indemnity in a contract, are:

Control – Where one party has a high degree of control over a particular matter, then it may be more appropriate for them to indemnify the other party.

Knowledge – Where one party has a monopoly on the information required to assess a particular matter, then it may be more appropriate for them to give an indemnity.

Resilience – Where one party is better able to bear the risks/losses associated with a particular event, for instance because of scale or because appropriate insurance is in practice available only to that party, then it may be more appropriate for that party to give an indemnity.

Bargaining power – Of course, while the above three factors are concerned with a fair apportionment of risk, there is also the question of bargaining power.  Where a business is not able to negotiate the terms of a contract, it may find itself indemnifying the other party for a risk that, in other circumstances, would fall upon the other party.

Legislation – Would the indemnity be enforceable at law?  In the case of consumer contracts, would the indemnity be lawful?

Practice – With the possible exception of legal compliance(!), marketplace practice is a good guide to the applicability of these factors.

The details of any indemnity – the events that trip the indemnity, kinds of losses covered, and the conditions placed upon the applicability of the indemnity – will vary from case to case.  However, there are some pretty standard situations, most notably where any indemnity protects against intellectual property rights infringement.

If you are unsure of what to include in an indemnity, or unsure whether an indemnity should be included at all, you should take professional advice.