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What You Need To Know About Indemnification Clauses – Part 1

One of the most overlooked provisions in almost any contract is the indemnification clause. While most people pay a great deal of attention to the core business terms of a contract like the price and payment terms, by the time they reach the end of the contract, they have often already mentally checked out, and skip or skim over legal provisions such as the indemnification clause and limitations on liability, dismissing them as mere “boilerplate.” But make no mistake – when things go wrong, the indemnification clause may be one of the most important provisions in the entire contract, with ramifications that may impact your potential liability for years, even after the term of the contract has expired.   As a result, indemnification provisions are often heavily negotiated, and heavily litigated as well.  This is the first part in a series of articles that will explore certain aspects of indemnification provisions and their significance in contract and lease negotiations.

It isn’t surprising that so many people, including some lawyers, are reluctant to dig deeply into indemnification clauses.  The language is often complex and difficult to understand.  In plain English, to “indemnify” someone means that one party agrees to compensate the other party for losses that the other party may suffer when things that go wrong, especially for losses caused by injuries to a third party.  Another way to look at it is that the indemnification clause allocates and shifts potential risk in a contract from one party to another.  Consider, for example, who would be liable for damages in each of the following examples:

  • You own a restaurant that purchases a tainted food product from a vendor which is then incorporated into dishes that the restaurant offers to customers on its regular menu. A number of customers are hospitalized after consuming dishes made with the tainted ingredient, resulting in a class action lawsuit against the restaurant.
  • You sit on the board of directors of your condominium association. One of the residents sues the condominium and its management company for injuries sustained by the resident after tripping on a large crack in the condominium’s sidewalk.  Despite having receiving repeated notices that the sidewalk was in poor condition, the management company failed to repair the crack.
  • Your company leases warehouse space that the company uses to store inventory and make deliveries to customers. A driver for a third-party delivery service picking up a shipment from the warehouse is injured after the steps leading to the loading dock collapse under him.
  • You are a software developer. In the process of developing a new application for a client, you inadvertently incorporate certain pieces of code created by another person who then sues both you and your client for copyright infringement.

In each of these scenarios, the restaurant, the condominium, the tenant company and the software developer could each be liable for damages as a result of the damages suffered by third parties.  Whether each of them is entitled to reimbursement for their losses from the vendor, the management company, the landlord, or the client, and the magnitude of their own liability for the other party’s damages all depends on the terms of the indemnification provision in the contract between the parties.

Given the magnitude of potential claims by third parties, it is important to carefully consider what could go wrong in a contract and to actively negotiate indemnification clauses.  Regardless of whether you are the party giving an indemnity or the party being indemnified, there are a number of important points to address.  First, you need to consider the scope of the indemnification.  If you are giving the indemnification, you will want to make sure that the scope of the indemnification is as narrowly tailored as possible in order to limit your obligation to indemnify the other party to certain specific and well-defined risks.  On the other hand, if you are the party being indemnified, you want this language to be as broad as it can be to protect you from as many risks as possible.  To achieve the correct balance between these competing interests, the parties need to carefully consider factors such as the risks involved, which party has greater control of the risk, and the economics of the contract.  Some contracts only require a one-way indemnification in which one party indemnifies the other only from claims by third parties.  Other contracts may contain a mutual indemnification provision, in which each party agrees to indemnify the other against losses caused by the indemnifying party or by a breach of the agreement by the indemnifying party.  You should also consider whether you could be responsible for providing the other party with a legal defense, as well as being responsible for their direct losses.

The indemnification obligations under a contract go hand in hand with the insurance that each party to a contract needs to carry.  When negotiating an indemnification provision, a review of your business’ insurance policies is critical. If you are required to indemnify the other party under a contract, does your business have sufficient insurance in place to cover these potential costs? Do you need to add other types of insurance to cover this obligation?  Before signing on the dotted line, it is important to confirm that your business is adequately insured so that it can avoid incurring liabilities that could financially destroy the business.

Another consideration is that most indemnification provisions “survive” the term of the contact, meaning that the obligation of one or both of the parties to indemnify the other continues even after the contract expires or is terminated.  It is very important to understand how long the indemnification obligation will continue, and to limit it to an appropriate period of time.