It’s common to see indemnification clauses in many different kinds of contracts, but especially in commercial contracts. These clauses are a critical part of a contract that can serve to assign risk appropriately between the parties that are being included in an agreement. That is why it’s so important to not only include them but to make sure that the clauses are stated correctly.
What Is Indemnification?
Indemnification is compensation for loss or damages. An indemnification clause in a commercial contract is a statement about which party will be liable for loss or damages that may occur during the course of the agreement.
Indemnification clauses give indemnified parties the ability to pursue compensation for any cost or expense that may occur from any third-party claims or even some direct claims in certain situations. For example, should a legal dispute arise, an indemnified party could recapture the cost of using an attorney from the indemnifying party. The indemnified party is also usually held harmless or protected from future losses or claims.
When you’re creating a clause with the goal of indemnification, both parties can adjust the amount of risk they’re willing to assume and, in this way, protect themselves from lawsuits or damages that may be more appropriately charged to the party on the other side of the agreement. Indemnifying parties might be able to minimize any losses that occur by making use of the following:
- Liability cap: A clause that limits the total amount of damages the indemnified party can pursue the indemnifying party for recovery.
- Materiality qualifiers: Phrase modifications to parts of a contract that cause a higher threshold to be instituted and met in order for the other party to take action on a claim.
- Liability basket: A tool that limits an indemnifying party’s obligations to pay another party for small losses or claims below a specific threshold.
What Are the Components of an Indemnification Clause?
Standard indemnification clauses are based on two distinct and separate obligations: the obligation to indemnify and the obligation to defend.
The part of the clause that deals with the obligation to indemnify is where the roles of the participating parties in the agreement are outlined. This is where it’s stated which party will be performing an activity and which party will “hold harmless” or provide compensation if any losses or damages should occur.
The part of the clause dealing with the obligation to defend focuses on the right of the indemnifying party that is covering any losses to investigate and defend against the claim. This gives indemnifying parties the opportunity to ensure that the claim is valid before making any compensatory payment. This section of the clause can also provide indemnifying parties an opportunity to assume the defense of any third-party lawsuits should they desire to.
What Should Be the Scope of Indemnification for a Company?
Since indemnification is an obligation of one party to be responsible for any losses the other party might suffer if certain events occur, it’s important to have a clear framework of indemnification that can limit the type of claims that can be made.
One way to limit the scope of indemnification is by ensuring it only applies to third-party claims. This means that if the indemnified party is pursued for damages by someone who isn’t a party to the agreement, the indemnifying party would be responsible for compensating the indemnified party for any payments they may have to make or fees they may incur in the course of legal proceedings.
Another option is to limit indemnification to personal injury, property damage, or death resulting from the indemnifying party’s negligence.
A third option to limit the scope could be to make indemnification for “breach of contract,” “breach of warranty,” or “all acts and omissions” off limits.
In addition, it’s a good practice to limit indemnification obligations to insurance amounts. This helps to diminish the risk and can assist the indemnifying party in meeting the compensatory requirements.
Although it’s frequently one of the last items to be dealt with when a commercial contract is being negotiated, indemnification clauses are critical to ensure that each party’s financial obligations in the wake of losses or damages are clear.
Broad indemnification clauses can be the source of potentially significant financial consequences for the indemnifying party, so it’s very important to limit the scope appropriately. For the indemnified party, the priority is making sure that they are “held harmless” and that the most relevant items are included in the indemnification clause to ensure that they’re covered should an incident occur.
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