Nearly all commercial contracts include an indemnification clause. However, the wording used in indemnity provisions often shrouds how these clauses function relative to the parties' business objectives. As a result, many business stakeholders may ignore the indemnification provision in a commercial contract because they consider it to be a purely legal issue. But, as my OGC partner Brian Heller reminds us, "There is no such thing as a 'legal only' issue in a commercial contract."
This adage is especially true as concerns indemnification clauses because they allocate important business risks between the parties. To better understand how indemnification interplays with a deal's business objectives and allocates risk requires (a) understanding what indemnification means, (b) knowing which events an indemnification provision covers and (c) appreciating how certain elements of an indemnification provision may affect its scope. This article provides an overview of these aspects alongside examples of how indemnification provisions may impact business objectives.
What does indemnification mean?
Indemnification provisions in a commercial contract allocate risk between the parties by assigning responsibility to one party for losses incurred by the other when certain events happen. Essentially, an indemnification provision obliges the indemnifying party (indemnitor) to make the indemnified party (indemnitee) whole for a loss, damage, or liability that the indemnitee has suffered.
Typically, the obligation to indemnify arises when a third-party claim is made against the indemnitee. Depending on how the indemnification clause is drafted, it also can cover regulatory fines and direct claims, meaning claims that one party has against the other. In effect, the premise of an indemnification provision is that if one party does something (or doesn't do what it was supposed to), and that act or omission gives rise to a damages claim by a third party, then the indemnitor is responsible for the indemnitee's damages in relation to the third-party claim.
Does indemnification also include the duty to defend?
Some indemnification provisions include an express duty to also "defend" the indemnitee, which means the indemnitor is responsible for defending the indemnitee once a claim is made that may result in losses, damages, or liabilities. This essentially obligates the indemnitor to "pay as you go" and cover the costs to defend the claim, subject to possible monetary limitations that other contract provisions may impose (e.g., insurance coverage limits, limitation of liability caps).
However, if the duty to defend is not specifically listed, then under most state laws, only the obligation to indemnify will apply. And, the duty to indemnify only arises once a loss, damage, or liability has been incurred or when a judgement is entered (which could be years later after all appeals have been exhausted). This is a critical distinction to consider when negotiating an indemnification provision because if there is no duty to defend, then the indemnitee (oftentimes the customer in a vendor-customer deal) could be stuck paying for losses, damages and legal costs related to a third-party claim or covering for those until a court makes a final determination about the third-party claim.
For example, let's say a retail company contracts with a SaaS vendor to use its SaaS service to help with inventory distribution. Then, a third party sues the retail company asserting that its use of the SaaS service infringes that third-party's intellectual property rights. A likely result may be that the retail company has to (a) stop using the SaaS service until the infringement matter is resolved and (b) allocate financial resources to cover for damages, as well as legal costs to defend itself, until a court enters a judgement in the case. This type of a situation can severely impede business objectives by forcing the company to find an alternative SaaS service and pay unanticipated costs to defend itself against the third-party claims. So it behooves legal counsel and business stakeholders to understand the obligations that the indemnifying party is assuming under the contract and to negotiate an the indemnification provision that protects the company in the event of a third-party claim.
What events does an indemnification provision cover?
Generally, an indemnification provision lists specific events for which the indemnitor will indemnify (and/or defend) the other party. These events may vary depending on the particulars of the commercial transaction and, usually, are the subject of negotiation. In a typical commercial contract between a vendor and customer, the indemnification may cover the following events:
- Third-party intellectual property infringement claims
- Breach of representations and warranties
- Breach of confidentially obligations
- Gross negligence or willful misconduct
- Non-compliance with applicable laws
- Breach of data privacy obligations
The events that an indemnification provision covers can directly impact the deal's business objectives, as shown in the above example about a third party claiming that a retail company's use of a SaaS service infringed their intellectual property rights. That situation not only hinders the retail company's operational inventory plan, but also imposes a financial strain.
Other important aspects of indemnification provisions.
In addition to the specific events an indemnification provision covers, several other indemnification-related elements can also impact the parties' business objectives. These include:
- a list of triggering acts (e.g., third party allegations, claims, lawsuits)
- a list of recoverable damages (e.g., losses, liabilities, damages, fines, legal fees)
- nexus phrases that link the recoverable damages to the covered events (e.g., "related to" or "directly caused by"); and
- exceptions to the indemnitor's indemnification obligations.
In a typical vendor-customer relationship, common exceptions to the vendor's indemnification obligations include the following actions by the customer: (a) using the product/service beyond the authorized scope; (b) making unauthorized modifications to the product/service; and (c) using an outdated version of the product/service, after the vendor has provided an updated version and the use of the updated version would have averted the infringement claim. Like many aspects of an indemnification provision, these exceptions are also negotiable.
How does a limitation of liability clause relate to indemnification?
While separate from the indemnification provision, a limitation of liability clause plays an important role in determining the monetary impact of the indemnitor's obligations. And, indemnification provisions should be read in tandem with the contract's limitation of liability provision to fully assess the overall business risks. Specifically, the limitation of liability provision usually (a) lists the types of damages (e.g., direct, indirect, consequential) that are covered and (b) to what extent, if any, the indemnitor's monetary liability is limited or capped. It is common for contracting parties to negotiate which types of damages apply and what the monetary liability cap will be, if any, with regard to their respective indemnification obligations.
For example, a commercial contract may impose a mutual obligation for each party to protect the other's confidential information, and a duty for each party to indemnify the other if it breaches its confidentiality obligation, with an uncapped damages amount. However, they may also decide to set a monetary liability cap with regard to different indemnification obligations (e.g.,, the cap may be set as a multiple of the fees paid under the deal). Monetary liability caps are an oft-negotiated component of commercial agreements.
What role does governing law play in relation to indemnification?
It is important to note that the duty to indemnify may arise through common law or by contract; and, if by contract, then the contract's governing law may determine whether certain aspects of an indemnification clause may be excluded or if certain liabilities may be lawfully limited. Thus, understanding how the applicable governing law interplays with indemnification and limitations of liability is imperative, as rules vary among jurisdictions.
Conclusion
Given that indemnification clauses allocate important business risks between the parties, it is wise for both legal counsel and business stakeholders to devote ample attention to these provisions. Generally, an indemnitor should be mindful of the scope of its indemnification obligations and how those interact with the limitation of liability clause. Similarly, an indemnitee should understand which risks the other party is assuming and assess whether the liability caps will adequately cover its losses in the event of an indemnification-related claim. While legal counsel can advise and make recommendations, the business stakeholders may be in the best position to assess which party is better able to control and, ultimately, to assume various business risks under the deal, like those that an indemnification provision allocates. Therefore, it is important that legal counsel and business stakeholders team up to pro-actively negotiate key elements of an indemnification provision to ensure the final deal terms support the business objectives.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.