Exclusions and Indemnities
Contracts are legal tools that individuals and organisations use to exchange promises. One function of contracts is to clarify which party pays (or doesn’t pay) for certain eventualities. This can include the cost of losses or liabilities that parties risk by doing business together.
The main provisions in contracts that deal with payment for such losses are:
- exclusions of liability; and
- limitations of liability.
Indemnities, exclusions and limitations distribute risk between parties to a contract. Advantageous indemnities, exclusions and limitations can mitigate risk very effectively. Adverse indemnities, exclusions or limitations can subject your business to massive risks. You also need to consider unenforceable exclusions or limitations.
The purpose of this article is to give you a basic working knowledge of these contractual tools. It does not address in detail the boundaries placed on them by the Australian Consumer Law.
2. What is an Indemnity?
An indemnity is a contractual promise by one party to cover the cost of a loss that the other party may face under the contract.
Here is an example of an indemnity. Jane supplies Pete with $100,000 worth of fridges for his hotel. An indemnity in the contract between Jane and Pete might state that Jane will indemnify Pete for the cost of replacing or repairing the fridges if they are faulty.
3. What is an Exclusion Clause?
An exclusion clause can do two main things:
- state the kinds of obligations that a party will not have to fulfill (exclusion of obligation); or
- state what kinds of costs one party to a contract will not have to pay (exclusion of liability).
A. Exclusion of Obligations
The first kind of exclusion modifies or excludes obligations that might otherwise be a matter of course. For example, instead of including an indemnity covering the cost of repair, Jane might do the opposite. She might put forward an exclusion clause stating that she does not have to pay for the repair of the fridges if they break.
B. Exclusions of Liability
The second kind of exclusion helps one party avoid a certain kinds of potential liability. Jane will want to avoid paying for new fridges if they break because Pete does not install them according to the instructions. She might include a clause that excludes liability for losses or damage caused by Pete failing to follow her installation instructions.
4. Consequential Loss
Sometimes parties try to exclude liability for indirect or ‘consequential’ losses. Exclusions for consequential loss do not always operate as planned. It may not always be clear what losses are ‘normal’ direct losses, and what losses are indirect. Suppose Jane relies on an exclusion for indirect or consequential loss in the contract with Pete. What happens if her fridges turn out to be faulty, and Pete cannot sell cold drinks for 2 weeks? It may be that Jane’s exclusion protects her from covering Pete’s loss of profits, but a court might decide that in the circumstances this is a normal direct loss. She would have more certainty if she specifically excluded liability for loss of profits from fridge sales.
5. What is a Limitation Clause?
Sometimes, instead of totally excluding certain costs or liabilities, parties cap liability at a certain amount. This is called a limitation of liability, or limitation clause. A party that gives an indemnity may also use a limitation clause to cap the amount of the indemnity.
Suppose Pete had managed to get Jane to indemnify him for loss of profits caused by faulty fridges. Jane might protect herself with a limitation clause, stating that the amount she pays to Pete for loss of profits will be capped at the total value of the contract for supplying fridges ($100,000).
6. Key Dangers of Exclusion Clauses
The biggest danger of exclusion and limitation clauses is ambiguity. If an exclusion is ambiguous, courts tend to interpret it against the interest of the party relying on it.
7. Takeaway Points
- Indemnities, exclusions and limitations are contract tools for managing and distributing risk.
- Such clauses set out who will pay, or not pay, for certain costs that may come up because of the performance or non-performance of a contract.
- Broad exclusions of liability for indirect or consequential loss do not always work as intended.
- Ambiguous exclusions may be interpreted against the person who included them.
- It is important not to forget that the Australian Consumer Law can effect limitations and exclusions, to make them void or unenforceable.