Indemnity clauses, what they do, what they cover, and the traps for small business

What is an indemnity clause?

An indemnity clause is a term of a contract in which one party promises to compensate the other for loss, damage or liability that arises in connection with the contract. In plain terms, one party agrees to make good the other party's loss. A supplier who agrees to pay for damage their goods cause to a customer's premises, or a tenant who agrees to cover the landlord's repair costs, is giving an indemnity.

The purpose of the clause is to allocate risk. Instead of leaving each party to bear its own losses, the contract moves the financial consequences of specified events onto one party. That is why indemnities are a standard feature of commercial agreements: leases, supply and distribution agreements, construction and fit-out contracts, website terms and conditions, and contracts for the sale of a business. It is also why the clause is so often the subject of negotiation. Whoever carries the indemnity carries the risk, and with it the cost of insuring against that risk.

An indemnity does not work in isolation. It sits alongside the contract's other risk controls, such as limitation of liability clauses, exclusion clauses, and any requirement that a party hold particular insurance. Read together, those terms determine who actually bears the cost when something goes wrong.

Who gives an indemnity and who holds it

The party who promises to compensate is the indemnifier. The party who receives the protection is the indemnified party, sometimes called the indemnity holder. In a standard commercial contract, the party being handed the document to sign is often the one being asked to give the indemnity, which is worth checking before you sign.

An indemnity is a primary obligation. The indemnifier must pay once the loss is suffered, regardless of whether anyone else was at fault. That distinguishes it from a guarantee, which is secondary: a guarantor promises to answer for the default of someone else, so the guarantor's obligation only arises if the underlying debtor fails to pay. Because an indemnity is not dependent on another person's default, it is generally easier to enforce than a guarantee.

Most indemnities are written into the contract as express terms. Some, however, arise by law without any clause at all. Agents are entitled to be indemnified by their principals for liabilities properly incurred in carrying out the agency, and a surety who pays a creditor is entitled to be indemnified by the principal debtor. The High Court considered these implied rights in Bofinger v Kingsway Group Ltd [2009] HCA 44. Even where no clause exists, the parties' relationship can create an obligation to make good another's loss.

What an indemnity can cover

The scope of an indemnity is set by its drafting. A well-drawn clause will identify:

• The events covered: which acts, omissions, breaches or circumstances trigger the indemnity.
• The loss covered: property damage, personal injury, economic loss, legal costs, or all of them.
• The caps and exclusions: any dollar limit on the indemnifier's liability, and any losses carved out.
• The duration: how long the indemnity survives the end of the contract.
• The parties protected: whether it also covers the other party's officers, employees, agents or related entities.

Two drafting points deserve particular attention. First, an indemnity that is drawn very broadly, covering all loss "however caused", may not do what it appears to do. Courts are cautious about reading an indemnity as covering loss caused by the indemnified party's own negligence, and clear words are generally required before a party will be taken to have agreed to cover that. Second, an indemnity generally cannot protect a party from the consequences of its own fraud or deliberate wrongdoing; clauses that purport to do so will not be enforced.

How courts read an indemnity clause

When an indemnity clause is disputed, the court applies the ordinary principles of contractual construction, together with specific principles for indemnities. In Central Coast Council v Norcross Pictorial Calendars Pty Ltd [2021] NSWCA 75 at [123], Bathurst CJ, with whom Macfarlan JA and Gleeson JA agreed, summarised them, drawing on Andar Transport Pty Ltd v Brambles Ltd (2004) 217 CLR 424:

• Words in an indemnity clause are read in the context of the contract as a whole.
• If, after applying the usual principles of construction, the clause remains ambiguous, it is construed in favour of the indemnifier.
• The contra proferentem rule, under which ambiguity is resolved against the party who drafted the clause, is a rule of last resort.

The practical effect cuts both ways. An indemnified party cannot rely on vague or sweeping language to extend the clause beyond what the contract as a whole supports. And an indemnifier cannot assume that a broad-sounding clause will be read down; if the words clearly cover the loss, the indemnifier pays.

An indemnity clause in action: a worked example

Brightspace Interiors Pty Ltd, a Sydney fit-out business with 15 employees, signs a standard form fit-out agreement with a shopping centre landlord to refurbish a tenancy. Clause 14 provides that Brightspace indemnifies the landlord against all loss, damage, claims and legal costs arising out of or in connection with the fit-out works.

During the works, a Brightspace tradesperson's ladder falls and shatters the glass front of an adjoining tenancy. The adjoining tenant sues the landlord, the landlord settles, and it claims the settlement and its legal costs from Brightspace under clause 14. There is no real contest: the loss plainly arose from the fit-out works, and Brightspace's own liability insurance responds to the claim. That is the indemnity working as intended, moving the risk of the works onto the party carrying them out.

The clause becomes more contentious when the loss is not Brightspace's fault. Suppose, after handover, the landlord's own maintenance contractor damages the new joinery, and the landlord invokes clause 14 to recover the repair cost from Brightspace. Whether Brightspace is liable depends on the construction of "all loss in connection with the fit-out works". Read in the context of the whole contract, and construed against the landlord if genuinely ambiguous, the clause may or may not reach that loss. And if the agreement is a standard form contract and Brightspace is a small business, the one-sidedness of the clause may expose it to challenge under the unfair contract terms laws discussed below.

Common misconceptions about indemnities

Four misconceptions about indemnities are worth dispelling:

• "An indemnity is the same as a guarantee": It is not. A guarantee is secondary, conditioned on another person's default. An indemnity is a primary promise to pay, independent of anyone else's fault. The distinction matters when the indemnified party tries to enforce the promise: with an indemnity, there is no underlying debtor default to prove.
• "A broad indemnity covers me for everything": The broader the words, the more they invite argument. Ambiguity is resolved against the party seeking to rely on the indemnity, and courts require clear words before an indemnity will cover the indemnified party's own negligence. A clause that says "all loss however caused" can be the most expensive drafting of all, because both sides will litigate what it means.
• "An indemnity is the same as insurance": The two are related but different. Insurance is a regulated contract governed by the Insurance Contracts Act 1984 (Cth), founded on the insurer's promise to pay on the occurrence of an insured event, with obligations of utmost good faith on both sides. An indemnity is an ordinary contractual promise between the parties, with no such statutory overlay. Businesses often use indemnities and insurance together: the indemnity shifts the risk, and the indemnifier's insurance funds the payment.
• "If the clause is in the signed contract, it is enforceable as written": Not always. An unfair term in a standard form consumer or small business contract can be void, regardless of what was signed.

When an indemnity clause is unfair: the Australian Consumer Law

The unfair contract terms regime is part of the Australian Consumer Law (ACL), which is Schedule 2 of the Competition and Consumer Act 2010 (Cth). Section 24(1) of the ACL defines a term as unfair where three conditions are met: it causes a significant imbalance in the parties' rights and obligations; it is not reasonably necessary to protect the legitimate interests of the party advantaged by it; and it would cause detriment to the other party if applied or relied on. In deciding whether a term is unfair, the court must also take into account how transparent the term is and the contract as a whole. Under s 24(4), a term is presumed not to be reasonably necessary unless the party relying on it proves otherwise.

Section 23(1) provides that an unfair term in a standard form consumer contract or small business contract is void, although the rest of the contract continues to bind the parties if it can operate without the term. A small business contract is, relevantly, a contract where at least one party employs fewer than 100 persons or has a turnover of less than $10 million in its last income year (s 23(4)).

Indemnity clauses are a recognised target of the regime. A one-sided indemnity under which one party's liability is limited but the other party gets no corresponding protection, or under which the indemnifier must compensate the indemnified party for loss caused by the indemnified party's own conduct, can satisfy the s 24 test.

The stakes have risen since 9 November 2023. Before then, an unfair term was simply void. Now, proposing an unfair term in a standard form contract, or applying or relying on one, is itself a contravention of s 23(2A) and (2C), exposing the business to pecuniary penalties under s 224 of the ACL. For a body corporate the maximum penalty is the greater of $100 million, three times the value of the benefit obtained, or 30% of the business's adjusted turnover during the breach period; for an individual the maximum is $2.5 million.

Getting help with your indemnity clause

A commercial lawyer can do more than tell you whether the clause is fair. In reviewing or drafting an indemnity, a practitioner will map the clause against the commercial deal: what events realistically trigger it, whether it covers the other party's own negligence, whether the caps, exclusions and duration match the risk being transferred, and whether the contract's insurance requirements line up with the indemnity. Where the clause is one-sided, a lawyer will negotiate mutuality, scope and limits before the contract is signed.

That review is worth doing before signature rather than after a loss. Once a dispute arises, the questions become questions of construction and enforceability: does the clause reach the loss, and if it sits in a standard form contract, is it vulnerable under the ACL? A lawyer can also advise on how the indemnity interacts with other rights and statutory regimes, such as contribution between co-sureties or proportionate liability legislation. The certainty that comes from a properly drafted clause is itself valuable: you can price the risk, insure it, or refuse to carry it at all.

The question to ask before you sign

Before you sign a contract containing an indemnity, ask one question: if the other party caused the loss, does this clause still put it on me? If the answer is yes, you are carrying risk you do not control, and the clause may not survive scrutiny anyway. If the answer is unclear, that is the problem: ambiguity in an indemnity is resolved against the party relying on it, so an unclear clause is a bet, not protection. A clause you understand, capped, mutual and aligned with your insurance, is a risk you can manage. A clause you have not read that way is a liability you are signing up to carry.