What is an indemnification clause in a contract?
What is the purpose and scope of an indemnification provision?
What should you look out for when you are negotiating an indemnity?
In this article, we will break down the notion of indemnification clause so you know all there is to know about it.
We will first define the indemnification provision, look at its purpose, provide you with specific and concrete examples of the scope of the indemnification obligation, compare it with a hold harmless provisions and more.
We bet there are things you did not know about indemnification clauses!
Are you ready?
Let’s get started…
What is an indemnification clause?
An indemnification clause or an indemnification provision is a contractual clause used to shift costs, expenses and liability from one party to the other.
When parties include an indemnity clause in their contract, they will stipulate the circumstances where one party is required to assume the costs and expenses for the other.
We call this the “triggers”.
Very often, an indemnification provision used to limit a party’s exposure to third party claims.
In other words, the parties to the contract will promise one another that if due to their actions or omissions, a third party files a lawsuit against them, they will cover the costs and expenses.
An indemnification clause can be mutual (or bilateral) where the parties reciprocally indemnify one another for certain liabilities or it can be unilateral (one-sided) where one party only indemnifies the other.
What is the purpose of an indemnity in a contract?
The purpose of an indemnity in a contract is to protect one party, the indemnified party, against losses caused by the other party, the indemnifying party.
The indemnification clauses are usually heavily negotiated in commercial contracts as the parties’ objective is to shift responsibility and risk to the other as much as possible.
Negotiating an indemnification provision can be highly relevant in cases where the risk that a party breaches the contract or fails to adequately perform its obligation is high.
For example, if you purchase accounting software to help you comply with certain legal obligations and prepare your financial statements, you’d expect that the software provider indemnify you for damages if the use of the software directly resulted in a regulatory fine or penalty.
Generally, the objective of the indemnification provision is to protect a contractual party from the fault or breach of the other party’s contractual obligations.
Scope of an indemnification clause
It’s important to properly scope the indemnification clause in a contract so it is clear when the indemnity provision is triggered and what type of costs or expenses are to be assumed.
An indemnification provision should minimally have the following elements scoped:
- What events trigger the indemnification obligation?
- What type of claim will be indemnified?
- Indemnification against first-party or third-party claims?
- What costs will the indemnifying party assume?
- Who should be indemnified?
- Should you consider specific exclusions?
Let’s look at each of these factors.
What events trigger the indemnification obligation?
The first thing to look for is the event giving rise to the indemnification obligation.
Generally, the indemnification clause will get triggered due to a party’s breach of a contract, acts of negligence or other nonperformance of contractual obligations.
It’s important to be clear about the events.
The goal here is for the indemnifying party to have a clear and reasonable understanding of what events may give rise to indemnification obligations.
If the events giving rise to indemnity are too broad, the allocation of risk will be significant.
For example, you can say that you’ll indemnify the other party for acts of “willful misconduct”:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and due to Party A’s acts of willful misconduct in any way relating to or arising out of this Agreement
You can also say “any acts”:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and due to Party A’s acts or omission in any way relating to or arising out of this Agreement
As you can see, agreeing to “acts or omissions” may potentially trigger the indemnification provision is more often than for acts of willful misconduct.
What type of claim will be indemnified?
The second factor to consider is what type of claims giving rise to an indemnification clause.
You need to carefully analyze the indemnification language used in the clause to ensure the type of claims make sense.
For example, the indemnity clause can be drafted by saying that a party will indemnify the other for any claims or demands:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and due to Party A’s acts of willful misconduct in any way relating to or arising out of this Agreement
Another clause can be scoped to only judicial proceedings:
Party A shall indemnify and hold Party B harmless from any and all judicial proceedings, suits, actions and judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and due to a Party A’s acts of willful misconduct in any way relating to or arising out of this Agreement
Depending on the wording, an indemnification clause can also be triggered if someone “threatens” a contractual party with a lawsuit or any type of claim:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments, allegations or threats of a claim, suit or demand and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and due to Party A’s acts of willful misconduct in any way relating to or arising out of this Agreement
Indemnification against first-party or third-party claims?
The third factor to keep an eye out for is whether the indemnification provision is worded to include first-party claims or third-party claims.
When we say “first-party”, we are referring to claims filed by the other contracting party.
For example, Party A breaches the contract, Party B files a lawsuit against Party A and demands that Party A indemnify it for the costs and expenses of the lawsuit.
A first-party obligation can be worded as follows:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) of whatsoever kind, nature and origin and in any way relating to or arising out of this Agreement
A third-party claim is when a third-party, unknown to the contractual parties at the moment of the signing of the contract, files a claim or suit against Party A or Party B.
In this case, the indemnification obligation will be triggered only if a third-party sues or threatens to sue a party to the contract due to the actions or omissions of a contracting party.
For example, Party A breaches the contract in such a way that government sues Party B for violating certain laws and regulations, Party B will use the indemnification clause to demand that Party A assume the legal expenses incurred.
The indemnification language to protect against third-party claims can look like this:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and in any way relating to or arising out of this Agreement
What costs will the indemnifying party assume?
The fourth factor is to understand what costs will be assumed by the indemnifying party.
It all comes down to how much risk a party is willing to assume.
For example, the indemnification clause can be worded as follows:
Party A shall indemnify and hold Party B harmless from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) of whatsoever kind and whatsoever nature imposed on, asserted against or incurred by any of the Indemnified Party in any way relating to or arising out of this Agreement
In this example, the scope of the indemnification clause is quite broad.
The indemnifying party will assume any and all costs, expenses and disbursements of whatsoever kind imposed or incurred by the other party.
Who should be indemnified?
In your assessment of the indemnification clause, you’ll need to determine who is being indemnified.
Are you looking to indemnify only the other contracting party or are you agreeing to indemnify others as well?
For example, an indemnification clause can be worded where Party A will indemnify Party B only:
Party A shall indemnify and hold Party B harmless, from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and in any way relating to or arising out of this Agreement
In this case, Party B is the only party that is entitled to indemnification rights.
The indemnification clause can also say:
Party A shall indemnify and hold Party B harmless, including its employees, successors, assigns, affiliates, agents, representatives or any other entity under its effective control, from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and in any way relating to or arising out of this Agreement
In this case, the scope of who can be entitled to indemnification is much wider as you will cover the costs and expenses of Party B along with its employees, representatives and affiliates etc.
Should you consider specific exclusions?
It’s useful to consider potential carveouts or exceptions to the trigger of the indemnification provision.
For example, it may not be fair for a party to be obligated to indemnify the other party when the party claiming indemnification caused the event of liability.
For example, if Party A agreed to indemnify Party B for “any and all damages and lawsuits” and Party B’s negligence results in a third-party claim against it, it would not be fair for Party A to assume that.
As such, the indemnification clause should exclude events where a party had a contributory role.
In some other cases, an indemnification exclusion can be for events of liability below a certain threshold.
For example, the parties can agree that they will not indemnify for claims or damages below $100,000.
This will potentially eliminate many small claims but can be costly to defend nonetheless.
An indemnification clause can also be limited in time.
For example, the indemnification provision will be in effect during the term of the agreement or for one year.
Indemnification clause vs hold harmless clause?
Many consider an indemnification clause and a hold harmless clause to mean the same thing.
In fact, they use the terminology interchangeably.
However, it is important not to confuse an indemnification clause with a hold harmless clause.
They are related but are different.
An indemnification clause is a contractual clause aimed at obliging a party from assuming costs and expenses incurred by another party.
As the name implies, “to indemnify” means to compensate a person from damages, loss, injury or harm.
On the other hand, a hold harmless clause is a contractual provision where one party agrees to hold the other “harmless” from an unavoidable risk resulting from a specific event.
For example, if a person asks a service provider to render service in a hazardous place, the service provider will demand a hold harmless clause to ensure it is free from any exposed risk when going to the client’s premises.
Another example is a company offering parachuting services.
The parachuting company will demand a hold harmless clause from its client wanting to go parachuting.
Essentially, the company is saying that this activity is risky and you cannot sue me if something were to happen to you.
The parachuting company is asking its clients to hold it harmless from the unavoidable risks of parachuting.
Indemnification contract
Although an indemnification clause is found in a much larger contract, parties can agree to indemnifications obligations in a standalone contract.
For example, many corporate executives will enter into a standalone indemnification contract with their employers.
In other words, they are saying that my job as a corporate executive will expose me to potential risks of claims, demands and lawsuits.
As such, if the executive is pursued by a client, shareholder, government, competitor or anyone, they can have the assurance that the company will assume the costs and expenses.
Is an indemnification provision enforceable?
In the United States, the courts will generally enforce an indemnification clause.
However, there are exceptions to this rule.
If the indemnification provision in reasonable and protects a contractual party from the fault of the other, the clause should be enforced by the court.
However, if the indemnification provision is drafted in such a way that any event can result in a party having to assume the risks and costs of the other even without committing a fault, that can be harder for the courts to digest.
The courts will also consider the proximity of the damages claimed with the fault of the breaching party.
If there is not proximity or it’s improbable that the event giving rise to the liability was caused by the other contractual party, the courts may not enforce the indemnification provision.
Indemnification clause sample
Here is a sample indemnification provision:
The Parties agree to indemnify, defend and hold one another harmless, including their employees, successors, assigns, affiliates, agents, representatives or any other entity under its effective control, from any and all liabilities, damages, penalties, claims, demands, actions, suits, judgments and any and all costs, expenses or disbursements (including reasonable attorneys’ fees and expenses) resulting from a third-party claim and in any way relating to or arising out of this Agreement due to a party’s acts of gross negligence or willful misconduct.
This clause is a mutual indemnification clause, scoped to third-party claims, for any and all damages and liabilities resulting from acts of gross negligence or willful misconduct.
Frequently asked questions
Why do you need an indemnity clause?
An indemnification clause is pretty much a standard clause in many business transactions.
Parties with equal negotiating power will generally agree to scope the indemnification clause in such a way that they both assume a fair and equal share of risk.
Quite often, the parties will agree to indemnify the other for acts of gross negligence or willful misconduct.
It’s not mandatory to have an indemnity clause in a contract but the use of it is pretty widespread.
What do you look for in an indemnification clause?
The purpose of an indemnification clause is to pass risk and liability to another party.
What should you look for in an indemnification clause and how to limit the risk?
You should consider the following in your assessment:
- What events trigger the indemnification obligation?
- What type of claim will be indemnified?
- Indemnification against first-party or third-party claims?
- What costs will the indemnifying party assume?
- Who should be indemnified?
- Should you consider specific exclusions?
By scoping the indemnification obligations too broadly, you may be exposed to more risk than you had an appetite for.
What if there is no indemnification clause?
An indemnification clause is not mandatory for a contract to be valid.
If there is no indemnification clause, then the parties will not be entitled to any contractual indemnification.
This does not mean that a party may not be held liable towards another party in a court of law, it just means that contractually a party cannot claim compensation for specific damages or expenses.
Should I sign an indemnification clause?
In business, an indemnification provision is considered a standard clause of a contract.
It can be difficult to refuse to sign an indemnification clause and expect to close all your deals with all your clients, partners, vendors and suppliers.
Many expect to see an indemnification of some sort in their contract.
What’s important is that you understand the anatomy of an indemnification provision so you can properly scope it to your risk tolerance.
If you are not sure whether you should sign an indemnification clause, you should consult with an attorney for guidance as every contract should be assessed on a case-by-case basis.
What is a mutual indemnification clause?
A mutual indemnification clause is when the contracting parties mutually and reciprocally agree to indemnify one another.
A mutual indemnification (or bilateral indemnification) clause is in contrast to a unilateral indemnification clause (or one-way indemnification).
For example, a mutual indemnification clause will say:
“the parties agree to indemnify, defend and hold one another harmless…”
On the other hand, a unilateral indemnification clause will say:
“Party A agrees to indemnify and hold Party B harmless against…”
How common is an indemnification clause?
An indemnification clause is quite common and practically standard in nearly all business transactions.
You’ll find indemnification language in large and complex contracts and even in smaller contracts.
You may not know it but you may be agreeing to indemnification provisions whenever you hit the “I agree” button on terms and conditions presented to you online!
