Indemnification Clauses Explained

In this article, we’ll answer common questions regarding indemnification clauses in contracts, including “What is an indemnification clause?” and “How do I write a secure indemnification clause?” Indemnification clauses can appear confusing or intimidating and are often overlooked, as they contain unfamiliar legal jargon; continue reading to learn how to effectively navigate these clauses.

What is an Indemnification Clause?

An indemnification clause is a common element of contracts, used to formally transfer the risk of potential liability from one party to another. Legally defined as, “to make reimbursement to one of a loss already incurred by him,” an indemnity clause states that one party agrees to “indemnify the other party,” or absorb the losses caused by the other party.

When you agree to indemnify someone, you are stating that if you or your agents do certain specified things that result in the other party experiencing monetary loss, damages, or a lawsuit from a third party, you agree to defend the other party and pay for all costs of the lawsuit including any damages they are required to pay as a result of the suit.  You are also agreeing to pay the other party back for any out-of-pocket costs resulting from your wrongdoing.  

Essentially, the indemnifying party is acting as an insurer, because the giver of the indemnity is monetarily responsible to the other party in the agreement for things that may go wrong.

What are the Different Types of Indemnity Clauses?‍‍

Some of the most common types of indemnification clauses are:

• Bare Indemnities: Party A indemnifies Party B for all liabilities or losses incurred in connection with specified events or circumstances, but without setting out any specific limitations. These indemnities do not clearly state whether or not they indemnify losses arising out of Party B’s acts and/or omissions, so they may be interpreted to have the effect of a reverse indemnity.‍
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• Reverse or Reflexive Indemnities: Party A indemnifies Party B against losses incurred as a result of Party B’s own acts and/or omissions (usually due to Party B’s own negligence).‍
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• Proportionate or Limited Indemnities: These indemnities are the opposite of Reverse Indemnities. Party A indemnifies Party B against all losses, except for those incurred as a result of Party B’s own acts and/or omissions.‍
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• Third Party Indemnities: Party A indemnifies Party B against liabilities to or claims by Party C.‍
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• Financing Indemnities: Party A indemnifies Party B against losses incurred if Party C fails to honor the financial obligation (i.e. the primary obligation) to Party B (usually coupled with a guarantee).‍
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• Party/Party Indemnities: Each party to a contract indemnifies the other(s) for losses occasioned by the indemnifier’s breach of the contract.

When Are Indemnification Clauses Useful in Business Contracts?

Example A: Imagine that you are a business owner, and you hire a contractor to complete a few renovation projects. During construction, the contractor injures the local UPS driver and damages his vehicle. The UPS driver, a third party in this scenario, would likely sue both the contractor and your business, because the incident happened on your property. Let’s assume the case goes to trial, your company is found not liable, and the contractor is found to be 100% responsible. At this point, you will have spent a lot of money defending yourself in the lawsuit. Depending on the indemnity clause you and the contractor agreed on, your company might be entitled to reimbursement from the contractor of all the money you put toward defending yourself in the lawsuit. If you had agreed to shift all liability costs to yourself in the contract, you would not be able to receive reimbursement, even though you had nothing to do with the incident. If you had indemnified the contractor, you would be responsible for all of his costs, on top of your own.

Example B: Imagine that you are a manufacturer of a technical gadget, and a distribution company sells your product for you. One day, your gadget malfunctions and explodes, injuring one of your customers. The injured customer then sues the distributor, because they sold your product to the customer. The distributor is then required to pay the customer a specified amount of money. If you provided indemnity for your distributor in the indemnity clause of your contract, the distributor would be able to turn around and request reimbursement from your company to replace the cost of paying to a third party. You might also be responsible for the distributor's court costs and legal fees along the way, depending on the fine print.

As you can see from these examples, indemnifying another party can become costly in a matter of seconds, especially if the clause is broadly worded and covers all claims, regardless of their merit.

What are Some Tips for Indemnifying Another Party?

If you’re considering indemnifying another party in a contract, consider the following:

• Carefully read the entire drafted indemnity clause prior to signing, and be sure to understand and analyze each piece. For example, there’s a big difference between “defending against reasonable claims” and “defending against all claims.” While they sound similar, one could save you millions of dollars over another.
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• Limit the scope of the indemnity clause by limiting the warranty. Phrase the warranty to clearly state indemnity only over the factors you truly wish to be responsible for and can somewhat control. Consider including indemnities for breach of contract and negligence in addition to the existing common law rights.
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• Set a firm cap on the amount you will pay the other party in the event of indemnification. If the other party wants a broader warranty or higher liability cap, negotiate a higher price in exchange.
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• Purchase professional indemnity insurance, which covers legal costs and damages associated with a breach in professional duty.
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• Consult a lawyer or have a lawyer review the indemnity clause prior to signing.

Can I get out of a Contract with an Unfair Indemnity Clause?

Even if an indemnification clause doesn’t seem fair, most courts will enforce it. The court system usually says that the parties to the contract are free to allocate the risks whichever way they agree on. If both parties agree, the court will validate the current indemnity clause, even if one party seems to hold more risk than the other.

As the giver of the indemnity (also referred to as the indemnitor), how can I avoid agreeing to protect the wrong parties and risks?

• Narrow the scope of your liability to the extent of your control. For example, clarify and separate any risks you do not have the ability to prevent.
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• Limit the indemnity to only protect specific scenarios. For example, if a patent was infringed upon, you will no longer provide indemnity.
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• Restricting damages to out-of-pocket expenses paid to third parties. For example, you will not pay for the other party’s internal costs and expenses, like salaries or utility bills.
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• Eliminate indirect or consequential damages. For example, speculative loss in potential sales, had the actions not occurred.
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• Offer to pay expenses only after a court officially determines the situation as your fault.
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• Consider imposing an express obligation to mitigate loss.
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• Limit the amount of time during which claims can be brought under the indemnity clause. For example, within the last 5 years from the completion of work.
  

As the receiver of the indemnity (also referred to as the indemnitee), how can I seek the broadest possible coverage?

• Ask for protection from any harm arising out of or connected to any part of the agreement or relationship, rather than only out of specified breaches.
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• Think about the most common or likely ways you could possibly be harmed, and seek protection for those instances. Some scenarios may be obvious, but be sure to do your research and think outside of your regular scope of work, especially events involving third parties that you cannot control.
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• When seeking protection, use “pay as you go” language, meaning the indemnifying party has to immediately reimburse the other, rather than waiting an unspecified amount of time after an extensive litigation process.

When indemnities are going both ways for all parties (both parties are giving an indemnity for some things and receiving indemnity for others in the same agreement), it’s important to balance the risks and rewards evenly.

What are Some Common Pitfalls of Indemnification Clauses?

Never try to cover third parties and circumstances beyond the ordinary breach circumstances actionable under common law. There is no need for you to guarantee indemnity for the other party where common law would demand the same action. By protecting these one-off scenarios, circumstances may branch into unintended onerous obligations where common law cannot otherwise impose.

Be as clear as possible when drafting an indemnity clause. Any ambiguity in the contract presents a risk that the indemnity cannot cover losses that the receiving party is counting on. Ambiguity is also risky for the indemnifier, as they may be required to indemnify losses that were never considered or agreed upon. When it comes to commercial negotiations, document the entire scope of the negotiated indemnity and identify exact coverage.

Another aspect of the indemnification clause to keep in mind is the duration of liability. Define exactly how many years the indemnity can be enforced before becoming invalid. The limitation period in relation to an indemnity clause starts from the date of which the indemnifier refuses to honor the indemnity. The indemnified party would then have a specified number of years from that date to bring legal proceedings and enforce the indemnity. In most instances, parties granting indemnity do not realize the extended period of time in which they are covering risk as part of their indemnity obligations