How to review an indemnity in a construction contract

The key to negotiating indemnities is understanding how they work in the first place. This post covers the basics, with practical suggestions.

What is an indemnity?

An indemnity transfers risk from one party to another, regardless of who is at fault.

For example, an insurance policy is a contract of indemnity. The insurer will assume liability for an incident even though they had nothing to do with it.

Why do construction contracts contain indemnities?

Given the numerous obligations placed on the contractor by construction contracts, the question arises – why are indemnities necessary? The short answer is that, to a large extent, they are not.

If the contractor breaches the contract - for example, by failing to perform the work according to the drawings or by not applying tradesmanlike workmanship - the principal will have a claim against the contractor arising from that breach.

Indemnities in construction contracts are typically incorporated for two reasons:

1. to increase the quantum of the contractor's exposure where there is a breach; or
2. to transfer particular risks to the contractor, even where the contractor may not be at fault.

The measure of damages under an indemnity is different to the measure of damages for breach of contract. An indemnity will typically result in the contractor facing a higher liability.

Also be aware that, where an indemnity is triggered, there is no obligation on the principal to mitigate its loss (unless there is an express term of the contract to this effect). That is different to the position for a breach of contract.

A standard indemnity

Clause 15.1 of AS 4000 begins as follows:

"Insofar as this subclause applies to property, it applies to property other than WUC.

The Contractor shall indemnify the Principal against:

a) loss of or damage to the Principal’s property; and

b) claims in respect of personal injury or death or loss of, or damage to, any other property,

arising out of or as a consequence of the carrying out of WUC, but the indemnity shall be reduced proportionally to the extent that the act or omission of the Superintendent, the Principal or its consultants, agents or other contractors (not being employed by the Contractor) may have contributed to the injury, death, loss or damage."

The clause continues to exclude certain things from the scope of the indemnity, including damage which is the unavoidable result of the construction of the works and claims in respect of the principal’s right to have the work carried out.

The idea behind this clause is that if any property (other than the work itself) is damaged or anyone is injured during the performance of the work, the assumption is that the contractor will be responsible for it. This applies even if the principal cannot demonstrate the contractor has been negligent.

The contractor can only avoid liability under the indemnity if it can show that the damage or injury has been caused by an act or omission of the superintendent, the principal or its consultants, agents or other contractors.

This type of indemnity makes good sense. This is because, as between the principal and the contractor, the contractor is best placed to prevent the risk from occurring in the first place. If any damage or injury occurs, it is reasonable to assume that the contractor is at fault. The onus is on the contractor to prove otherwise.

A more aggressive indemnity

Consider the following indemnity:

"The Contractor must indemnify the Principal against any loss or claim suffered or incurred by the Principal directly or indirectly arising from, or otherwise in connection with:

(a)  the Contractor's activities, including the performance of work;

(b)  any breach of contract; or

(c)  the project as a whole."

There are a number of things to observe about this clause.

First, unlike the indemnity in AS 4000 mentioned above, it is not limited to third party property damage or personal injury. It applies to any loss suffered by the principal in connection with the project. This is a substantially broader form of indemnity.

For example, where the contractor is late, the principal could potentially rely on this indemnity to recover compensation (in addition to any liability the contractor may have for liquidated damages elsewhere in the contract).

Second, the obligation on the contractor to indemnify the principal does not depend on there being any wrongdoing or fault on the part of the contractor.

For example, say the execution of the work in accordance with the principal's design causes damage to property (ie because of a design defect). This indemnity would transfer the risk of that damage onto the contractor, even if it was not involved in preparing the design.

What to look for

From the contractor’s perspective, the indemnities to be wary of are those that:

• are triggered without there having to be any negligent, unlawful or otherwise wrongful act or omission by the contractor;
• are not limited to situations involving property damage or personal injury;
• indemnify the principal against loss or damage to the works (as opposed to third party property), as this could increase the contractor's exposure above its usual obligation to reinstate the works and pay liquidated damages for any consequent delay;
• expose the contractor to claims for economic or indirect losses, including indemnities that may apply for losses suffered as a result of delay;
• are applied in an environment where the contractor's liability is uncapped;
• are not reduced to reflect the proportionate contribution of others, and particularly the principal and those for whom it is responsible;
• are not reduced to reflect any failure by the principal to mitigate its losses.

It's also important to understand the scope of your insurance policy. For example, some policies will exclude liability imposed under an indemnity. If you're not sure how your insurance might be affected by indemnities, this is a point worth investigating.

How to deal with indemnities

Conversely, when faced with an indemnity, it may be worth seeking to have it removed from the contract (on the basis that common law damages will often be an appropriate remedy). Failing this, you might consider modifying the indemnity so that:

• it is only triggered by a breach of contract or other unlawful act or omission on your part;
• it does not expose you to indirect or consequential losses, appropriately defined;
• it does not apply to damage to the work itself (on the basis that the contractor's obligation to reinstate the work and pay liquidated damages should be sufficient);
• it does not apply in connection with any losses suffered as a result of a delay;
• it is reduced to reflect the proportionate contribution of persons outside of your control;
• it is reduced to the extent the principal fails to take reasonable steps to mitigate its losses.

At the same time, it may be worth considering whether to try to cap your liability - either under the indemnity or, more commonly, under the contract generally.

Concluding observations and suggestions

Indemnity provisions are often some of the trickiest provisions to negotiate. This is chiefly because:

• they can be drafted in ways that make them difficult to understand;
• they raise a number of complex legal issues; and
• they can have significant commercial consequences, and therefore need to be understood by the parties to the deal (not just the lawyers).

There are some types of indemnity you may be willing to accept, and others you may not.

Again, it comes back to having a commercial understanding of what the particular clause means, in a practical sense, and then deciding how best to manage the risk (assuming you are willing to accept it).