Indemnification clauses in commercial contracts
Indemnification clauses appear in nearly all commercial agreements. They are an essential risk allocation tool between the parties, and as such, they are one of the most commonly and heavily negotiated provisions in a contract.
What is indemnification?
Indemnification, also referred to as indemnity, is an undertaking by one party (the indemnifying party) to compensate the other party (the indemnified party) for certain costs and expenses, typically stemming from third-party claims. Indemnification can also cover direct claims, which are claims or causes of action that one contracting party has against the other.
Why are indemnification provisions important?
Indemnification clauses allow a contracting party to:
- Customize the amount of risk it is willing to undertake in each transaction and with every counterparty
- Protect itself from damages and lawsuits that are more efficiently borne by the counterparty
For example, in a sale of goods agreement, the risk that a product injures a third party is more efficiently borne by the seller than by the buyer. The seller has more control over the goods than the buyer, whose principal obligation is to make payment. The seller is therefore in a better position to mitigate losses and liabilities related to the goods than the buyer.
Drafting and negotiating an efficient indemnification provision benefits both the indemnified and the indemnifying party. An indemnification clause may allow:
- The indemnified party to recover certain types of losses, such as attorney's fees, which are not typically recoverable under a common law cause of action.
- The indemnifying party to reduce its liability by incorporating:
- Liability cap
- Materiality qualifiers
- Liability basket
What are the components of a typical indemnification clause?
A typical indemnification clause consists of two separate and distinct obligations: an obligation to indemnify, and an obligation to defend.
Obligation to indemnify
- The obligation to indemnify requires the indemnifying party to:
- Reimburse the indemnified party for its paid costs and expenses, referred to as losses.
- Advance payment to the indemnified party for its unpaid costs and expenses, such as:
- Causes of action
Obligation to defend
For the indemnifying party, the obligation to defend consists of both:
- An obligation. The indemnifying party must:
- Reimburse paid defense costs and expenses
- Make advance payment for unpaid defense costs and expenses
- A right. The indemnifying party has the right to assume and control the defense of the third-party suit.
The obligation to defend is broader than the obligation to indemnify because it applies regardless of the merits of the third-party suit. The allegations of the lawsuit trigger the obligation to defend, not the ultimate disposition of the case.
“Hold harmless” provisions
Most indemnification provisions require the indemnifying party to "indemnify and hold harmless" the indemnified party for specified liabilities. In practice, these terms are typically paired and interpreted as a unit to mean "indemnity."
However, in some states, the phrase "hold harmless" may require the indemnifying party to advance payment for covered unpaid costs and expenses even when the defined recoverable damages are limited to losses. If the "hold harmless" obligation is omitted, the indemnifying party does not become responsible for losses until the indemnified party makes payment.
In addition, the obligation to hold harmless may release the indemnified party from any related claims or causes of action by the indemnifying party.
What are the common limitations on the indemnifying party's obligation to indemnify?
The indemnifying party's obligation to indemnify is limited to recoverable damages caused by, related to, or resulting from covered events.
Covered events are specific types of events that are listed in the indemnification clause. They can vary according to the particulars of the transaction and are subject to negotiation. The most common covered events are:
- Breach of contract
- Bodily injury or death
- Non-compliance with any laws
Recoverable damages are specific types of damages listed in the indemnification clause. These can vary and are negotiated by the parties. The principal categories of recoverable damages are:
- Losses. Losses include any covered judgments, settlements, fees, costs, and expenses. The indemnifying party becomes responsible for a loss only after the indemnified party pays.
- Liabilities. Liabilities are composed of debts and other legal obligations. The indemnifying party becomes responsible for a liability when the liability is legally imposed, but before the money is paid.
- Claims. Claims consist of damages resulting from a third-party lawsuit. The indemnifying party becomes responsible for a claim at the moment when a party, including any third party, files a lawsuit.
- Causes of action. Causes of action include damages resulting from a right to seek relief. The indemnifying party becomes responsible for a cause of action when the indemnified party's—or a third party's—right to seek relief, as the case may be, accrues.
The phrases "caused by," "related to," and "resulting from" are referred to as nexus phrases. Nexus phrases link the recoverable damages to the covered events. These phrases are typically negotiated by the parties because they either broaden or limit the obligation to indemnify.
The indemnified party typically wants to use a broad nexus phrase, such as "related to," because it expands the scope of the indemnity. The indemnifying party prefers narrower nexus phrases, such as "caused by" or "resulting from" because they narrow the scope of the indemnity.
What are the common exceptions to indemnification?
There are a number of common exceptions to indemnification. They generally relate to circumstances where the indemnified party's own actions either cause or contribute to the harm that triggers indemnification. For example, an indemnification provision may exclude indemnification for claims or losses that result from the indemnified party's:
- Negligence or gross negligence
- Improper use of the products
- Bad faith failure to comply with its obligations in the agreement
A common formulation for the negligence exception is:
"The Indemnifying Party is not obligated to indemnify the Indemnified Party for any claim arising out of the Indemnified Party's negligence or a more culpable act or omission, including recklessness or willful misconduct."
Indemnified parties with a lot of negotiating power may seek indemnification for their own negligence and insist that the exception apply only to gross negligence. While this is not against public policy, it is unusual in commercial contracts and is typically limited to certain industries such as construction.