The Essential Contract Review Checklist - Part 5: Indemnification - Shielding Against Risks and Costs
In Part 5 of this series - a comprehensive checklist for reviewing contracts - we dive into the nuances of indemnification, which serves as a powerful risk allocation mechanism in commercial contracts. Indemnification represents a contractual commitment by one party to safeguard the other from loss or liability or costs stemming from specified claims, breaches, or other predetermined events or conditions.
By specifying the circumstances under which one party must indemnify or “make whole” another for incurred losses or costs, indemnification clauses can significantly impact the overall risk profile of a transaction, potentially shifting substantial financial burdens from one party to another. Given their importance, a thorough understanding of the elements of indemnification clauses is essential for effective contract review and negotiation. In this article, I will deconstruct the elements of indemnification to provide a comprehensive understanding of their structure, functionality, and implications for risk management in contractual relationships. However, the elements discussed here are only indicative, as each scenario will ultimately depend on factors such as the specific nature of the agreement, the parties’ business needs, the transaction details, associated risks, the industry, regulatory landscape, and the governing jurisdiction, as well as other factors.
1. Who is Indemnifying?
This part of the indemnification clause specifies which party is responsible for covering the losses or liabilities or costs. In many cases, the party providing a service or product (the vendor) is the one indemnifying the other party (the customer). For example, in a cloud service agreement, the service provider (vendor) may indemnify the client (customer) against any claims and costs resulting from data breaches caused by the vendor’s negligence in safeguarding the client's sensitive information.
However, in some cases, the customer may also have indemnification obligations (e.g., in case of customer-caused harm or infringement). For instance, in a software licensing agreement, if the customer modifies the software and subsequently infringes on a third party's intellectual property rights, the customer may be obligated to indemnify the vendor against any resulting claims or damages.
2. Who is being Indemnified?
The indemnified party, or indemnitee, is the beneficiary of the indemnification provision, receiving protection against specified losses, damages or costs. Often, the customer is the party being indemnified, but other related entities, such as affiliates, officers, directors, employees, and agents, may also be included.
Indemnitor’s Perspective: The indemnitor should carefully assess who is being indemnified. Including too many parties (e.g., affiliates, subcontractors or employees) may significantly expand the indemnitor’s liability. The indemnitor may consider limiting the scope to the primary contracting party (indemnitee) and its officers or employees directly involved in the business relationship.
Indemnitee’s Perspective: The indemnitee may often want to include a broader set of related entities (e.g., affiliates, subsidiaries, officers, directors, employees, and sometimes even clients or customers) under the indemnity to ensure comprehensive protection across the entire corporate structure and downstream entities.
The potential ripple effects of the contract should be taken into consideration. If the indemnitee's affiliates or end-users could be impacted by the indemnitor's products or services, they may be included in the indemnification coverage, depending on the situation, parties’ bargaining power, and how much risk the indemnitor is able to take on.
3. “Defend”, “Indemnify”, and “Hold Harmless”
The terms “defend”, “indemnify”, and “hold harmless” each carry distinct legal obligations in an indemnity clause, and understanding their differences is crucial when negotiating such provisions.
A. The obligation to “defend” could require the indemnifying party to manage and finance the legal defense of the indemnified party when a covered claim arises, often beginning as soon as a claim is asserted. This includes hiring attorneys, covering legal fees, and ensuring that the indemnitee is protected from the outset, regardless of whether liability has been determined.
Indemnitor’s and Indemnitee’s Perspectives: The indemnifying party or indemnitor may seek to include the right to “defend” as its obligation, particularly when its intellectual property is at stake. Since the indemnitor bears the financial risk ultimately, they are strongly incentivized to manage the defense efficiently and vigorously, instead of letting the indemnitee handle the defense and face the possibility of higher damages. Therefore, rather than avoiding the defense obligation, it may be prudent to ensure that the indemnitor maintains control over the defense strategy and critical case decisions, such as settlements and appeals. If a defense obligation is included, the procedures for notifying the indemnitor of claims and the extent of the indemnitee's involvement or cooperation in the defense process, should be clearly specified.
B. To “indemnify” refers to the obligation to compensate another party for losses, liabilities, or costs that arise from specified circumstances, typically following the establishment of liability or the occurrence of a loss. The timing of indemnification may differ based on the terminology used in the indemnification clause. Generally, the term “damages” indicates compensation is required after a final resolution is reached, while “liabilities” may necessitate payment as soon as a legal obligation is recognized, even if the total financial impact has yet to be fully assessed. This distinction underscores the importance of clearly defining the terms within the indemnification clause to effectively manage potential risks and ensure appropriate financial protections for all parties involved.
C. “Hold harmless” is a promise that protects the indemnitee from any subsequent fallout or additional consequences resulting from a covered claim.
Indemnitee’s Perspective: While often used interchangeably with “indemnify”, in some jurisdictions like California, “hold harmless” adds an additional layer of protection by ensuring that the indemnitee is not financially burdened by any subsequent or additional costs resulting from covered claims. While “indemnify” may give you the active right to seek indemnification, “hold harmless” may give you the defensive right to be protected from any covered claims and costs made against you.
Indemnitor’s Perspective: Sometimes, indemnifying parties may consider removing “hold harmless” as it could expand the scope of their indemnity obligations in some jurisdictions.
The interpretation and application of these terms can vary significantly across jurisdictions. For instance, the implied duty to defend as part of an indemnity obligation exists in some States (U.S.) unless expressly negated. Given these nuances and potential legal implications, it's crucial to carefully consider the scope and obligations associated with each of these terms.
The obligation to “defend” could require the indemnifying party to manage and finance the legal defense of the indemnified party when a covered claim arises, often beginning as soon as a claim is asserted.
4. What Damages are covered?
This section details the types of damages that are subject to indemnification. These may include direct damages, such as the costs of replacing or repairing a defective product, as well as indirect and consequential damages, such as lost profits.
Indemnitor’s Perspective: Indemnitors may typically seek to limit covered damages to direct damages only, excluding indirect, consequential, or punitive damages. They may also push for overall caps on their indemnification liability.
Indemnitee’s Perspective: Indemnitees often advocate for broad coverage, including direct, indirect, and consequential damages. They may push for including “any liability whatsoever”. This could mean the indemnitor would cover all potential financial exposure, including third-party claims, settlements, and judgments. In high-risk scenarios, such as intellectual property infringement or data breaches, indemnitees may seek uncapped indemnification.
The types of damages covered in the indemnification provision and carve-outs for specific high-risk scenarios where broader or uncapped indemnification may be appropriate, should be carefully considered and defined.
5. Are Direct and Third-Party Claims covered?
Indemnification provisions may encompass damages or costs from two distinct categories of claims - direct and third-party. Direct claims arise between the contracting parties themselves, while third-party claims involve external entities seeking recourse against the indemnified party.
For direct claims, indemnification applies to damages or costs incurred by the indemnified party due to the indemnifying party's acts, omissions, or breaches of contract. In contrast, third-party claims involve claims made by an external party against the indemnified party. Indemnification is most commonly used to address these third-party claims, such as in cases of intellectual property infringement or data breach allegations brought by third parties.
In many instances, parties limit indemnification to cover only third-party claims and address liability for direct damages (e.g. contractual breaches) elsewhere in the contract. Additionally, parties should consider the interplay between indemnification and limitation of liability clauses, particularly when direct claims are included under indemnification (more on this when analyzing Limitation of Liability in this series - The Essential Contract Review Checklist). Failure to adequately address these distinctions may lead to increased liability exposure or potential disputes.
6. What is the Connection between the Damages and the Triggering Events?
The indemnification clause should clarify the causal relationship between the event triggering the indemnification and the damages or costs incurred. Typically, the indemnity is tied to damages “arising out of” or “relating to” specific events.
Indemnitor’s Perspective: Indemnifying parties often prefer narrower nexus phrases such as “directly caused by” or “to the extent caused by”, which limit the indemnitor’s obligations to circumstances with a clear, direct causal link to the event in question, thereby potentially reducing exposure to unrelated or incidental claims.
Indemnitee’s Perspective: Conversely, indemnified parties may seek broader language like “in any way arising from or related to”, or “in connection with”, which extends the indemnification obligation to a wider range of scenarios. This may provide better protection for the indemnified party, ensuring that even indirectly related damages or costs are covered.
7. What types of Triggering Events are covered?
The indemnification clause should clearly define the underlying events or circumstances that trigger the indemnification obligation. Indemnifying parties/indemnitors typically aim to limit indemnifiable events to specific, narrowly defined scenarios directly related to their contractual duties or performance obligations, whereas indemnified parties/indemnitees often push for broad coverage, including general breach of contract and negligence, as well as specific high-risk areas relevant to the transaction.
Breach of Contract: Indemnifying parties may typically try to exclude breach of contract from indemnification. This is because they wish to avoid exposure to both indemnity and damages for breach of contract. On the other hand, indemnified parties may insist that if a breach of contract by the indemnifying party results in a third party claim, then that should be covered.
Infringement: Indemnifying parties may prefer the scope of infringement claims to be as narrow as possible. For instance, they may restrict it so as to cover claims with respect to only U.S. patents as of the effective date of the agreement. Indemnified parties, on the other hand, may typically wish to broaden the scope to any intellectual property or other proprietary right of any third party.
Negligence: Indemnifying parties may wish to limit negligence to its own actions and exclude its affiliates’ and employees’ actions from the scope of negligence claims. They may also limit negligence to “in the performance of the obligations under the contract”. Conversely, indemnified parties typically prefer the negligence of affiliates and employees to be also included, as well as any negligence of the indemnifying party that results in a claim against the indemnified party.
Ultimately, the covered triggering events should be tailored to the specific risks of the transaction. Parties usually consider including a mix of general categories (e.g., breach of representations and warranties) and specific scenarios (e.g., data breaches).
For optimum protection, the indemnification clause should clarify the causal relationship between the event triggering the indemnification and the damages or costs incurred. Typically, the indemnity is tied to damages “arising out of” or “relating to” specific events.
8. Are there any Exclusions?
Exclusions in indemnification clauses limit the indemnitor's obligations in certain circumstances. Examples include damages or claims resulting from the indemnitee’s own negligence, third-party claims arising from the indemnitee’s modifications to the product, force majeure events, or circumstances beyond the indemnitor’s control.
Modifications: Indemnifying parties typically prefer to exclude claims arising as a result of product modifications, while indemnified parties try to put a qualification that if the modifications were necessary to use the product as contemplated, then that should be covered.
Combinations: Similar to modifications, indemnifying parties usually prefer excluding claims resulting from combined use with other products not supplied by the indemnifying party. On the other hand, indemnified parties prefer no exclusion or a limitation that if the product was designed for combined use with other products, and used as intended, then that should be covered.
Failure to Comply with Instructions: Indemnifying parties may try to exclude claims arising from failure to comply with the product instructions or guidance. On the other hand, indemnified parties may try to limit such failure to comply with instructions to those specifically included in the user manual that came with the product. Additionally, they may prefer to include liability if it was a direct result of following the instructions.
9. What is the Indemnification Process?
The indemnification clause should outline the process for invoking and fulfilling the indemnification obligation.
Indemnitor’s Perspective: Indemnifying parties often seek detailed procedural requirements, including prompt notice of claims, control over the defense and settlement process, and the right to approve any settlements. They may also want to address failure to notify or delay in notifying.
Indemnitee’s Perspective: Indemnified parties may wish to include provisions allowing them to participate in the defense of claims and requiring their consent before any settlement is made, so as to have the ability to defend their reputation and financial interests, if applicable. If they are required to cooperate in the defense, they may wish to do so at the indemnifying party’s expense. Additionally, they may also want to address situations in case the indemnifying party does not step up to defend the claim.
10. Are there Additional Indemnification Provisions?
It may be helpful to keep in mind that indemnification obligations may not be confined solely to the designated "Indemnification" section. Additional indemnification provisions can be strategically or inadvertently incorporated into various other clauses throughout the agreement. These dispersed indemnities warrant careful scrutiny during contract review and negotiation.
The presence of such additional indemnification provisions can have significant implications, particularly with respect to liability caps. For instance, if the parties have agreed to a monetary limit on indemnification within the primary indemnification clause, it is crucial to note that this cap may not extend to indemnification obligations embedded elsewhere in the contract. Consequently, these additional indemnities may effectively render the overall indemnification liability to be uncapped, potentially exposing parties to unforeseen and unlimited financial risk.
11. Is the Indemnification Mutual?
Sometimes, contracts include mutual indemnification provisions, where both parties agree to indemnify each other. However, if these mutual indemnification provisions cover events where only one party is primarily responsible, the indemnification may not be truly mutual. For example, in a mutual indemnification clause, if a breach of representations and warranties is included, but only one party (e.g., the seller) is primarily making those representations, then the mutual indemnification would largely benefit the other party. In such cases, the clause might appear mutual, but in reality, it places more responsibility on one side.
Parties occasionally incorporate mutual indemnification clauses with the intent of allocating reciprocal risk. However, the practical effect of such provisions may not be as mutual as intended, particularly when the indemnification covers scenarios where the parties have asymmetric or unequal obligations.
By carefully structuring the indemnification clause, one can create a clear framework for risk allocation and financial responsibility for specific events, ensuring each party understands its obligations in the event of claims or liabilities. A well-crafted indemnification provision manages risks effectively and strengthens trust, paving the way for a successful and mutually beneficial business relationship.
I love anything to do with contracts, be it drafting, reviewing, or negotiating! In the next article of this series, we will examine the nuances of Limitation of Liability - Understanding the Boundaries of Risk Exposure.
THE INFORMATION PROVIDED IN THIS ARTICLE DOES NOT, AND IS NOT INTENDED TO, CONSTITUTE LEGAL ADVICE; AND IT IS NOT PROVIDED WITH ANY GUARANTEE, WARRANTY, OR REPRESENTATION; INSTEAD, ALL INFORMATION AND CONTENT IN THIS ARTICLE ARE FOR GENERAL INFORMATIONAL PURPOSES ONLY.
