What’s in a word? Indemnity, exclusion and limitation clauses in the commercial context

Commercial Directions

Indemnity, exclusion and limitation clauses play a crucial role in commercial dealings. A number of recent decisions in the NSW Supreme Court and Court of Appeal have highlighted the importance of care and precision when drafting such clauses into agreements. The failure to ensure that those clauses are correctly drafted may have a large impact on your business if such clauses are sought to be relied upon at a later time.

Types of clauses

Indemnity, exclusion and limitation clauses each play a specific role in balancing and managing the risks associated with commercial agreements. Each is not mutually exclusive and it is common for all three clauses to be adopted in commercial agreements.

  • An indemnity clause is a means by which one party agrees to indemnify the other for any losses suffered in the case of some event. An indemnity clause provides the ability to shift the financial risk associated with some conduct to another party. As such, the benefitting party may avoid bearing the financial costs of some event despite being liable. The utility of an indemnity clause is dependant upon the guaranteeing party’s ability to pay.  A party may be entitled to an indemnity under a contract, however, that indemnity will have little effect where the other party does not have adequate funds with which to indemnify the benefitting party.  Therefore, it is essential you understand the financial capacity of the party providing the indemnity
  • Exclusion clauses seek to completely remove a party’s liability for certain types of conduct or events. Exclusion clauses can vary widely in the range of their effect. Some clauses may seek to avoid liability for any happening, whilst others may be narrowly drafted so as to remove liability for only specific events. The advantage of exclusion clauses rests in their ability to completely remove liability which would otherwise rest with the benefitting party. As such, they are not subject to the same weakness as indemnity clauses given their effectiveness is not dependent upon the financial position of the indemnifying party
  • Limitation clauses differ from exclusion clauses as they seek to limit, rather than completely remove, a party’s potential liability. Limitation clauses may limit either the amount of money payable upon the happening of a certain event, the time period for which a party may be liable, or a combination of the two. Limitation clauses allow the party relying on them to calculate their potential liability to a certain amount, or to rule off their books once the liability time period has been reached. This has clear commercial advantages, most notably in relation to the cost of insurance.

Necessity of precision and clarity

Despite the commercial advantages associated with indemnity, exclusion and limitation clauses, they may result in large financial losses if not correctly drafted. A number of issues must be considered when determining whether an indemnity, exclusion or limitation clause is appropriate for the commercial agreement. Matters of paramount concern include the proper identification of the class of liability to be indemnified, excluded or limited, and the relevant limit on monetary liability.

Courts have consistently expounded the rule that the terms of a contract are to be interpreted by reference to the words’ natural and ordinary meeting. A number of decisions have highlighted the extensive difference the inclusion or exclusion of a single word can have on the interpretation of an entire exclusion clause:

  • In Erect Safe Scaffolding (Australia) Pty Limited v Sutton [2008] NSWCA 114 it was held that an indemnity clause requiring a subcontractor to indemnify the head contractor against all damage incurred by the head contractor ‘arising out of the performance of’ the scaffolding works was found to be too narrowly worded to cover negligence
  • In BI (Contracting) Pty Ltd v AW Baulderstone Holdings Pty Ltd [2007] NSWCA 173 it was held that an indemnity clause which stated that a subcontractor ‘shall indemnify the builder against all liability relating to the subcontract works’ was sufficiently wide to cover negligence
  • In Owners SP 62930 v Kell & Rigby [2009] NSWSC 1342 it was held that a limitation clause which limited liability ‘whether under the law of contract, tort or otherwise’ was sufficiently wide to limit liability for a claim under statute.

The abovementioned cases demonstrate the importance of precision and clarity when drafting such clauses into commercial agreements. Poorly drafted clauses may contain ambiguities. Where an ambiguity is found in an indemnity, exclusion or limitation clause, the contra proferentum rule of interpretation states that the clause should be read in the way least favourable to the benefitting party. Thus, it is essential to avoid ambiguities to ensure that the clause is capable of only one interpretation.

Conclusion

Indemnity, exclusion and limitation clauses continue to play a crucial role in balancing and managing the commercial risks associated with binding agreements. In order to ensure those clauses have the desired effect, it is essential that the clauses are drafted carefully and precisely. Recent cases have highlighted that something as simple as the absence of a word can result in a huge shift in liability, potentially resulting in massive financial losses.


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