Contract Tip: Understand Your Indemnification Clause
Updated: January 27, 2020
What is an Indemnification Clause? Essentially, an Indemnification Clause is a risk-shifting agreement. One party agrees to accept certain risks and financial consequences that may occur in the future from injury, breach of contract, or other legal claims.
You may have seen such a clause buried in the fine print of a contract but skimmed over it because the word didn’t mean anything to you. Indemnification clauses often contain the language “X agrees to indemnify, defend, and hold harmless Y from . . . “. Though seemingly boilerplate legal jargon, these are powerful clauses that should not be carelessly skimmed over.
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.
Why include indemnification clauses in your contract?
Why use an indemnification clause in your contract? Because all contracts involve risk. When two parties enter into a contract, they are agreeing how to apportion the risk. For example, if ABC leases an office to MNO, the parties face the risks of natural disaster, accidental damage, personal injury, intentional misconduct, and more. The landlord does not want the financial risk of damage caused by the tenant and the tenant’s customers. The tenant does not want the financial risks caused by the landlord’s subcontractors (for example, the snow removal company smashes into your store front window). A fair and reasonable indemnification clause can alleviate many of these concerns.
When negotiating the lease a knowledgeable attorney will explain to her client the ramifications of the indemnification clause and draft a clause specifically addressing the risks of greatest concern to the parties. Too often, larger business force unfair indemnficiation clauses on smaller businesses. They attempt to remove all risks, even risks that may be outside of your control, such as someone else’s lost profits or third-party actions.
What are the benefits of an indemnification clause?
What are the benefits of an indemnification clause? The benefits are (1) knowing now what to expect in the event of litigation or a claim for damages, and (2) satisfactorily apportioning risk to your benefit, (3) reducing your future expenses. At the very least, an indemnification clause should place you in a better position than if you omitted the clause from the contract.
What should a thoughtful, carefully written indemnification clause address? While it is always context specific, there are general guidelines and a great clause will identify:
- The parties protected (often not just the parties to the contract, but extended to others, such as customers or boards of directors),
- The types of damages, claims, and legal actions that will invoke the indemnification responsibilities of the party accepting the risk (the indemnitor),
- The process for notifying the indemnitor of an actual or potential claim,
- 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 indmenification expenses are capped or subject to a minimum threshold, and
- Whether a party must obtain the consent of the other party to settle the matter.
Traps for the unwary
Unfortunately too many attorneys act as scriveners (a fancy word for copying text) and do not use their critical thinking skills. These is especially apparent in many indemnification clauses. A poorly drafted clause leads to poor results for the client. Some traps include:
- Overly broad clauses that hold you liable for more than you believed you would be. For example, an overly broad clause may hold your business liable for third-party acts, attorneys fees, consequential damages, or even the other party’s negligence if you do not carefully draft your clause.
- Overly narrow clauses that do not provide sufficient redress in the event your business faces economic loss. Like the overly broad clause, an overly narrow clause could fail to provide the remedies you expected, such as damages due to acts of third parties and the recovery of attorneys’ fees and consequential damages.
- There are times when it is strategic to allow the indemnification clause be the exclusive remedy and there are times when you would prefer the availability of all legal remedies. Understand whether and how an indemnification clause limits your future ability to recover damages.
- Indemnification clauses can cap the amount of damages you may recover. Likewise, they can include thresholds in which you cannot recover until you incur a certain threshold of damage. There are also baskets, offsets, and other combinations to limit one party’s liability and limit the other party’s recovery. If not carefully drafted, you may not recover the amount you anticipated.
Indemnification clauses are much more than mere boilerplate. They are, when thoughtfully and carefully written, are a valuable part of your contract. Although your attorney has a duty to understand these clauses and carefully draft and negotiate them, educating yourself and understanding your agreement is a smart move that can result in strategic decisions later during the term of your agreement.