The Unknown Superpowers of the Indemnification Clause
Deep in the boilerplate of your contracts lurks a clause called the “indemnification clause”. What is this clause and is it important?
Simply stated, the indemnification clause is an agreement to shift financial risk from one party to another. It defines who will bear the burden of an unknown, future financial liability arises. Think of it as a private insurance policy between you and the other party.
Since you want to minimize your risk, the indemnification clause is very important to read, understand, and negotiate. A properly, thoughtfully drafted indemnification clause is a powerful tool in your contract. It can also be a trap when carelessly drafted. Read further to learn why.
Indemnification Clauses 101.
Indemnification clauses often contain the language “X agrees to indemnify, defend, and hold harmless Y from . . . to the extent they arise from . . . except for . . .”.
What comes after the . . . are very powerful phrases that may significantly benefit or burden you in the future.
- One Way Indemnification: this protects only one party in the contract. One-way clauses are used when there is a significant risk of claims by a third-party (one not a party to the contract).
- Mutual Indemnification: this protects both parties by using identical language. Sometimes this leads to nonsensical or undesirable results, so be careful.
- Extend the statute of limitations. The law requires you to sue within so many years of the event causing you damage. This is the statute of limitations. You can use an indemnification clause to extend the period in which you can sue (or be sued).
- Eliminate the duty to mitigate. Ordinarily, you have a duty to mitigate, which is a fancy way of saying you must take reasonable steps to limit the damages you suffer. With indemnification, you can modify or remove the duty to mitigate.
- Cover losses beyond what the law permits. Traditional contract law does not cover all losses, such as events not reasonably contemplated by the parties. Indemnification clauses can require one party to cover damages stemming from far-fetched or unlikely events.
- Allow you to recover attorneys’ fees. The American legal system generally does not permit the injured party to recover attorneys’ fees. Unfortunately, it is often too expensive to sue the other party. With an indemnification clause, you can recover attorneys’ fees incurred when an indemnifiable event occurs. This makes it worth the time and effort to claim what is rightfully your. It is also an incentive for the other party to pay rather than litigate.
Include these terms in your indemnification clause:
- The parties protected (often not just the parties to the contract, but others, such as customers or boards of directors).
- The types events that give rise to the right of indemnification.
- The process for notifying the other party when you believe you should be indemnified.
- Which party will take on the responsibility for defending the claim.
- Which party is financially responsible for damages, awards, attorney fees, fines, and other expenses.
- Whether indemnification expenses are capped or subject to a minimum threshold.
- Whether a party must obtain the consent of the other party to settle the matter.
13 Traps for the Unwary.
Unfortunately, too many attorneys act as scriveners (a fancy word for “copying text”) instead of thinking about what they are writing. This is especially apparent in many indemnification clauses.
A poorly drafted clause leads to poor results for the client. Don’t let this happen to you. Look for these possible traps:
- Overly broad clauses: These clauses hold you responsible for more than you believed you would be.
- Overly narrow clauses: These clauses do not provide sufficient compensation in the event your business faces economic loss.
- Exclusive remedy. When an event occurs, this clause benefits the injured party. Consider the likelihood of an event occurring and the possible cost to you to decide whether or not you want indemnity to be the exclusive remedy.
- Hidden indemnity clauses: Some indemnity clauses hide in other clauses, such as mandatory arbitration clauses, limitation of warranties, or intellectual property infringement clauses. Watch for them.
- Loss of Control: Some indemnity clauses require you not only to foot the bill for litigation but to allow the other party to choose their law firm and litigation strategy. You are simply the bank. The other party will have no incentive to stick to a budget.
- The “Judgment Proof” party. An indemnification clause is worthless if the other party no longer exists, cannot be found, or has no assets to indemnify you.
- Insurance doesn’t cover everything. Too many businesses have been burned by assuming that “insurance will cover it”. Review your insurance coverage.
- Attorney incompetence. Many attorneys do not understand these clauses and simply cut and paste from a document they previously used. Use an attorney who specializes in contract drafting.
- “Reasonable” versus “all”. There’s a huge difference between indemnifying against “reasonable” and “all” losses. “All” means what it says – even highly unlikely losses only found in bad movie scripts.
- Caps. Caps can be good or bad, depending on the situation. For losses that are likely or expensive, the injured party will not want a cap on recovery while the party footing the bill will want a cap.
- Insurance-first provisions. Some indemnification clauses do not take effect unless the damage exceeds what insurance covers.
- Waiving comparative negligence. If you are 65% responsible for the damage and the other party is 35% responsible, do you really want to be on the hook for all of the damage? Of course not. Unfortunately, if you are not careful, your indemnity clause might require you to reimburse the other party for damage when they were partially responsible.
- Consequential or indirect damages. These are damages indirectly related to the event that caused the loss. For example: loss of profits, loss of business opportunity, loss of goodwill, and loss of business reputation.
9 Practical Tips.
- What possible losses may occur during (or as a result of) your contract?
- How much these possible losses might cost?
- Who should be responsible for losses caused by third parties (i.e. employees, customers, contractors, cyber-hackers, and thieves)?
- Who is in the best position to prevent the loss?
- Who has the strongest bargaining position?
- Will you be willing to spend the time and money to sue the other party to collect your rightful reimbursement?
- Will the other party have the financial resources to reimburse you for indemnified losses?
- What trade-offs in other contract provisions are you willing to accept in return for stronger indemnification provisions?
- How much risk is too much? When are you willing to walk away from the contract negotiations?
So Why Use Indemnification Clauses?
Now that I’ve scared you, why use an indemnification clause in your contract in the first place? Because all contracts involve risk and this is one way to shift your risk to someone else. Less risk means less money you will spend in the future (theoretically, anyway).
Since indemnification clauses shift risk, it is important that you carefully negotiate the terms.
In most contracts, one party has the upper hand. It is not uncommon for that party to impose substantial risk on the subordinate party – including those outside of the subordinate party’s control. Knowing this, it is important to assess the probability of risk and the economic cost if the risk arises. Be prepared to walk away if the risk exceeds your risk tolerance.
Indemnification clauses are much more than mere boilerplate. They are, when thoughtfully and carefully written, are a valuable part of your contract. You can strategically use indemnification clauses to limit your future risk and as a negotiating chip for other contract provisions.
Here are Concerto Law, we continually keep up-to-date with contract boilerplate provisions so we can help you strategically use them in your contract and protect you from stealthy indemnification clauses.
Call Christine Kuntz at Concerto Law to write, review, or negotiate your next contract.