Demystifying Indemnification Clauses in Contracts

If you own a business, you’ve signed many contracts.  If you’re being honest, you’ll acknowledge that you’ve signed many without reading them or taking the time to truly understand the implications for some of the provisions.  Maybe you assume the provisions are non-negotiable.  Perhaps you’ve never had a problem previously so you don’t care what the contract says.  When things go perfectly, then you’re right – many of the contractual provisions are irrelevant.  The truth is that contracts are signed for when things go wrong or when something happens that calls for an extra level of guidance.  We all know that things sometimes do not go according to plan; stuff happens.  If everything went perfectly all the time, nobody would ever sign contracts. 

Contracts are essential to delineate the responsibilities and obligations of parties entering into a business arrangement. One crucial provision found in many contracts is the indemnification clause. Understanding the implications of an indemnification clause is vital to safeguarding your interests and limiting potential liabilities.

What is an Indemnification Clause?

An indemnification clause is a contractual provision in which one party agrees to compensate or reimburse the other party for specific losses, damages, liabilities, or expenses resulting from the contract or certain defined events. Essentially, it shifts the risk of certain potential losses from one party to another.

Here’s a sample indemnification clause:

Your business agrees to protect, defend, [hold harmless,] and indemnify (collectively “Indemnify” and “Indemnification”) ABC Company, its subsidiaries, and its and their respective successors, assigns, directors, officers, employees, agents, stockholders and affiliates (collectively, “Indemnified Parties”) from and against all claims, demands, actions, suits, damages, liabilities, losses, settlements, judgments, costs, and expenses of or by a third party, including but not limited to reasonable attorneys’ fees and costs (collectively, “Claims”), actually or allegedly, directly or indirectly, arising out of or related to (1) any breach of any representation or warranty of your business contained in this Agreement; (2) any breach or violation of any covenant or other obligation or duty of Company under this Agreement or under applicable law; (3) any third party Claims which arise out of, relate to or result from any act or omission of your business;  in each case whether or not caused in whole or in part by the negligence of ABC Company, or any other Indemnified Party, and whether or not the relevant Claim has merit.

When Indemnification Provisions Are Used?

 

Indemnification clauses are used in a wide variety of contracts. They are used to guarantee products and to support professional service agreements. Common uses of indemnification clauses include:

• Construction contracts so that the owner is not blamed for injuries arising from accidents on a project site or relating to the work completed by the contractor

• Master service agreements so that the vendor is not responsible for claims relating to the work performed by your business

• Partnership agreements so that a partner is not responsible for the personal actions of the other partner

• Insurance contracts that protect an insured in case of their liability

• Commercial leases so that the landlord is not responsible for claims arising for things happening in the leased premises

Why Should You be Concerned About Agreeing to an Indemnification Clause?

Agreeing to an indemnification clause without fully comprehending its scope and implications can expose you to significant financial risks and legal consequences. If not carefully drafted and negotiated, an indemnification clause could result in unforeseen liabilities and costs, potentially jeopardizing your financial stability and legal rights.  When you agree to indemnify, you’re agreeing to:

Defend the other business:

The obligation to defend may make you responsible for reimbursing attorney fees and other defense costs if the company you are indemnifying is sued while the lawsuit is going on.  You may be required to pay even before the outcome of the lawsuit is determined.  The duty to defend applies even if the third-party’s claim has no merit or the third party loses the case.

Cover damages assessed against the other business:

The indemnification clause should also specify the damages that the indemnified party can recover. For example, the damages might cover:

• Losses – Losses may include court judgments, settlements, attorney fees, legal expenses, and associated costs.

• Liabilities – Liabilities include debts and other legal obligations.

Cover the other business for their own fault:

Some indemnification clauses require you to cover expenses and losses even if the other business is totally or partially at fault. 

3 Ways to Limit Your Liability in a Contract with an Indemnification Clause:

1. Limit the Scope of Your Liability:

You should not agree to unlimited indemnification.  When presented with an indemnification clause, ensure that the language is precise, unambiguous, and limited in scope. Limiting the scope includes limiting the identify of the parties (persons) to whom you owe a duty.  You should avoid any language that says you’re indemnifying a company and all of its “affiliates, subsidiaries”, etc.  You should avoid indemnifying a business for their own negligence.  Clearly define the types of losses or liabilities that are subject to indemnification to avoid broad and open-ended obligations.

2. Limit the Dollar Value of Your Liability:

Consider including a limitation of liability provision in the contract to cap the amount that you can be held responsible for under the indemnification clause. Perhaps it is a multiple of the amount you’ve been paid pursuant to the contract.  You may also want to include a “floor” of expenses that below which, your duty to indemnify does not kick in. By setting a specific monetary limit or defining a cap on indemnification obligations, you can control and mitigate potential financial risks.

3. Delete any Duty to Defend:

The duty to defend is generally broader than the duty to indemnify because the duty to defend is triggered by allegations alone. A duty to defend may be owed with respect to a claim in which no damages are ultimately awarded. So even though a claim may be completely frivolous, if you agreed to defend the other contracting party against the claim, you might be obligated to hire an attorney to defend the other company at the your expense.  In many instances the expenses of defending a lawsuit, which typically include attorneys’ fees, expert witness fees, deposition expenses, and court costs, far exceed the actual amount in controversy. If both you and the other company are named as defendants in the lawsuit, you might be required to pay for two lawyers, one to defend it, and one to defend the other company.  This is a huge potential expense that you want to avoid.

Understanding the nature of indemnification clauses and taking proactive steps to limit your liability can help protect your interests and mitigate potential risks in contractual agreements. Prioritize clarity, specificity, and fairness in negotiating and drafting indemnification clauses to safeguard your rights and financial well-being.  The experienced small business attorneys at Fiffik Law Group can review your contracts and help limit the risks you take one through indemnification clauses.