Understanding Indemnification

Indemnification provisions are common in a variety of contracts, but often their full impact may not be understood. Knowing how indemnification works and becoming familiar with techniques for negotiating indemnification provisions are vital to any business.

The Purpose of Indemnification

All indemnification provisions seek to address two distinct purposes: (1) to modify the standard or default contractual remedies available to the parties under statute or common law and (2) to allocate risk between the parties as to specific issues of concern.

With regard to the first purpose, if the parties agree that the standard contractual remedies available to them are inadequate, they can negotiate an indemnification provision that provides for a party to seek certain additional damages, including costs and expenses.

When parties desire to allocate certain risks — essentially providing a kind of insurance — an indemnification provision can be a method for assigning risk among the parties vis a vis certain “big ticket items” such as claims for infringement, breach of confidentiality, death or personal injury, property damage, etc. With a well-crafted indemnification provision, the indemnifying party says to the indemnified party: “I will be on the hook and will pick up the tab for any losses or damages that you may incur in connection with these certain big ticket items.”

5 Key Elements of Indemnification

Indemnification provisions can range from a single sentence to several pages of carefully worded legalese, but all indemnification provisions contain five key elements:

• Who are the indemnifying party(ies)? e.g., the contracting party, a parent company, a subsidiary, or a guarantor.
• Who are the indemnified party(ies)? e.g., the contracting party, affiliates, customers, or end users.
• What is the obligation? e.g., indemnify, defend, or hold harmless.
• What types of claims are covered? e.g., damages, liabilities, losses, lost profits, judgments, settlements, taxes, fines, attorneys’ fees, costs, or expenses.
• What events are covered? e.g., breach of a representation or warranty, infringement claims, or environmental claims.

Limiting Indemnification Obligations – Techniques

Every indemnifying party would prefer to eliminate the entire indemnification provision, but that often is not practical. The type of transaction, the relative negotiating power of the parties, or a variety of other circumstances may make the inclusion of indemnification a requirement of the deal. While many clients initially take the position that any indemnification obligation is a deal breaker, there are a number of ways to limit indemnification obligations and to manage the potential exposure of the indemnifying party.

Clearly addressing the five key elements above is the fundamental approach. Precise wording will restrict who is obligated, what the obligation is, to whom the obligation is owed and the conditions of the obligation.

Beyond the five key elements, another simple technique for reducing liability can be to request mutual or reciprocal indemnification when one-way indemnification is initially suggested. By requesting that each party indemnify the other on the same terms or substantially similar terms, each party is more likely to suggest fairer terms and conditions.

Additional language can be added to restrict the claims that can be made under the indemnification provision. Adding a cap is a popular technique, setting the maximum liability of the indemnifying party. Caps are sometimes accompanied by what are known as hurdles, baskets or deductibles, which are variations of a requirement that the indemnified party first reach a specified threshold of damages before seeking indemnification. Claims may also be restricted by limiting the scope of damages, imposing reasonableness or other standards, or by allowing for set-off(s) from amounts owed to the indemnifying party.

Certain procedural limitations may also be helpful. It is not uncommon for a contract to require that the indemnified party notify the indemnifying party in a timely fashion. In some instances, the indemnification obligation may have a survival period or an expiration date. Any procedural limitation benefits the indemnifying party by (i) helping put the indemnifying party in the best possible position to address the claim and mitigate the damages, and (ii) making it more difficult for the indemnified party to make a valid claim.

In addressing possible third-party claims (where a third-party has asserted a claim against the indemnified party, who now seeks defense and/or reimbursement), an indemnifying party should require control of the defense, including the right to make decisions regarding settlement. This will help protect against the possibility of the indemnified party exacerbating the situation — a concern because the indemnified party knows the indemnifying party will be picking up the tab.

A number of other less common, but still very effective, drafting techniques can be applied to reduce the potential exposure of the indemnifying party. Multiple limitations can be employed together to virtually negate an indemnity provision.

We’re Here to Help

Navigating indemnification provisions can be intimidating, as they carry significant potential consequences to any business. Whether you are structuring the purchase or sale of a business, documenting a customer or supplier agreement, negotiating a licensing arrangement, or working on any other transaction, our attorneys are experienced in negotiating indemnification provisions and can help you understand and limit your obligations.

For more information on managing your potential exposure, contact Adam Jung at 312/840-7097 or ajung@burkelaw.com.