This is the second post in a 3-part series; click here for Part 1.
An indemnity clause is essentially an “I’ll protect your back” clause, which makes the giver of the indemnity monetarily responsible to the other party in the agreement for amounts they might owe to a third party due to a breach of contract by the indemnity giver.
Here are some simple examples:
- Product Liability
I buy a widget from you for $5 and resell it (as permitted) to an end user; the widget malfunctions and blows up in their face; the end user sues me, and I am forced to pay them $1mm. The seller of the widget has breached our contract by selling me a defective product, and is responsible for making me whole for the full amount of the third party’s loss ($1mm).
I buy software or technology from a vendor for $5, and it turns out that it infringes on a third party’s patent; the third party sues me for $1mm and I am forced to pay them $1mm back. Same thing – the vendor is responsible for covering what I owe the patent holder.
- Government Fines
I use your platform to store sensitive data for my customers; you fail to adequately secure it; my customers’ sensitive data is leaked, exposing me to $15mm in liability to my customers and government fines. The platform vendor is at fault, and therefore, must pay me $15mm.
In each of the above cases, the indemnity clause protects the non-breaching party and makes them whole by requiring the breaching party to cover the monetary losses it causes. Liability for indemnification claims should typically be unlimited because it depends on the extent of the harm caused to a third party. However, in the course of a contract negotiation, you will try to narrow or broaden the scope of liability, depending upon your position.
If you are giving the indemnity, you will try to limit its scope by:
- Narrowing the scope of your liability to the extent of your control (ability to prevent the resulting harm). For example, if the harm was caused because someone else misused or altered the widget, you should not be responsible.
- Limiting the indemnity to certain specified causes. For example, you are only liable if your widget infringed a patent or did not conform to the express specifications required in the contract.
- Restricting damages to actual out-of-pocket expenses paid to the 3rd party. For example, you will not pay the other party for their internal costs and expenses, such as the salaries of the internal personnel spending their time defending the claim.
- Excluding indirect or consequential damages. For example, you will not reimburse them for vague and speculative damages, such as lost profits (e.g., if they argue “we could’ve sold a million more units if it wasn’t defective”).
- Possibly only offering to pay after a court finally determines it was your fault.
If you are receiving the indemnity, you will seek the broadest possible coverage by:
- Seeking protection from any harm arising out of, or connected to, any part of the agreement or relationship, rather than only out of specified breaches. If you are limited to specified breaches only (which is often the case), make sure you have included all possible ways you could be harmed within the context of the deal. For example, with software and services contracts, infringement indemnities are common; and for reseller deals, product liability indemnities are typical.
- Including “pay as you go” language so that the indemnifying party must pay as expenses are incurred by you, rather than at some unspecified time in the future or after a long litigation process and final court decision.
Finally, when indemnities are going in both directions - with both parties giving and receiving (a common scenario) - you should seek to balance the scope of the indemnity provisions so that they are somewhat mutual, even if they vary in other ways depending upon the different roles of each party. If you push too hard in one direction, know that the same logic might be used against you in the other direction.
In light of the magnitude of potential third party claims, it is important for clients to take an active role in the negotiation of indemnification clauses. Take the time to consider known business risks, as well as to contemplate “what could go wrong?” within the context of the deal.
In my next post, I will discuss some basic tips for negotiating limitation on liability clauses.