The primary purpose of the indemnification clause is to shift risk from one party to another. Though often an unappreciated clause, the financial consequences of a poorly drafted clause can be devastating to your client. Learn how to draft a clause that will protect your client from unexpected, future financial expenditures.
Identify and Define the Risks
When drafting or reviewing the indemnification clause, begin by identifying the risks specific to your client and the transaction. Risk commonly enumerated in indemnity clauses include: personal injury, property damage, negligence, theft, misappropriation of funds, fraud, breach of warranty, intellectual property infringement, and third party actions or claims. This is not an exhaustive list.
While it is helpful to examine similar contracts – and you can find many examples in the Law Insider database – do not wed yourself to that language. Be open to new ideas and a custom solution.
Next, decide whether certain risks should be specifically excluded from the clause or limited in scope. Keep in mind, the probability or the severity of damage may be sufficiently great that certain risks are better addressed in a separate clause. Therefore, you often see indemnification provisions embedded in confidentiality clauses, environmental hazard clauses, and intellectual property warranties.
In theory, an indemnity clause shifts the risk to the party who is in the best position to prevent or mitigate the risk. In reality, however, the negotiating power, likelihood of occurrence, and the probability of recovery from the Indemnitor all influence how the parties apportion risk.
Consider also risks associated with third parties? While neither party to the contract can control the action of a third party, often one has more authority or responsibility for the third party. For example, in construction contracts, the general contractor arguably has more authority over the actions of the subcontractors than the property owner does. In a commercial lease, the tenant generally has more control over the actions of its business invitees than the landlord.
Broad, Limited, or Intermediate Scope. In its broadest form, the Indemnitor assumes an unqualified obligation to indemnify the other party from all liabilities arising from the contract, regardless of fault – even the indemnitee’s own negligence.
In the most limited form, the indemnity clause is essentially a comparative negligence clause. Here, the Indemnitor assumes liability only for its own actions or negligence.
Between these extremes, lay a gradient of possibilities. A quick search through the Law Insider database reveals clauses ranging from very expansive (indemnification from all liabilities except those due to the other party’s fault or negligence) to very narrow (indemnification only for specified actions or events).
When drafting or reviewing the scope of the indemnity clause, consider the following:
- Does one party indemnify the other against all claims or only reasonable claims?
- Concerning negligence claims, is it proportional to fault or is it joint-and-several?
- Is the Indemnitor liable for the actions of third parties?
- May the indemnitee recover consequential damages, punitive damages, or loss of profit?
- Must claims for indemnity be brought within a certain period?
- Are damages capped?
- Does insurance coverage offset the Indemnitor’s liability?
- Do damages include governmental or contractual penalties incurred by the indemnitee?
- Are the risks within the Indemnitor’s control?
The goal is to carefully draft a clause that protects your client’s business and future financial exposure. While it is tempting to use the broad form in all instances, it can lead to absurd results, especially when the provision is mutual. In addition, a broad form may damage negotiations between the parties. Lastly, most states will not enforce indemnification against the indemnitee’s own negligence. Review the pertinent governing law drafting or reviewing a broad form indemnity clause.
Defending the Claim. What happens when the right to indemnity arises? There are various iterations on managing the process. At its most basic, the indemnification clause should describe how to notify the Indemnitor of the claim, which party will manage the defense, and whether the indemnitee has any veto power over the settlement.
Here are some common questions to consider when drafting the clause:
- What are the notice requirements in order to obtain indemnification? Will the Indemnitor receive notice before the time period for responding to a Complaint expires?
- Who will control the litigation?
- Is Indemnitor consent necessary to settle the claim?
- Is indemnity limited to losses not covered by insurance?
- Is indemnification the exclusive remedy or does the party reserve all other rights available under the law?
There is no one-size-fits-all mechanism for defending the claim. Decide what is practical, reasonable, and in the best interest of your client. Though we cannot predict the future, experience combined with careful drafting can eliminate many of the problems so often exposed during indemnity clause litigation.
Precise and Intentional Drafting.
With precise, intentional drafting you can avoid ambiguities, impractical notice requirements, and unfavorable defense provisions.
Too often, the indemnification clause is a run-on sentence worthy of a Virginia Woolf novel. Instead, construct the indemnification clause in a language your client can understand. For example, avoid the run-on sentences and instead use an outline paragraphing technique. Define terms in a separate paragraph rather than using strings of synonyms. Tailor the clause to the particular circumstances of the transaction instead of blindly borrowing from another agreement.
To conclude, the next time you draft or review an indemnification clause, cast more than a cursory glance. This important clause is more than mere boilerplate. Take advantage of the risk-shifting powers of indemnification to limit future risk to your client.