Nearly every commercial contract will have an indemnification provision. Indemnity is a contractual obligation of one party to compensate the loss suffered by the other party due to an act or omission. It is no secret that indemnification provision in a contract can be difficult to read for an ordinary person. I have seen many occasions where this clause is often treated as “boilerplate” and do not receive the necessary attention. As contracts are not made for good times, failure to pay attention to indemnification provisions can lead to unpleasant surprises down the road. Often parties find themselves facing more liability than they thought bargained for when they signed the agreement. A reasonable amount of forethought can address some of the more common defects seen in indemnification provisions.
Let us try with a simple example clause:
“Party A shall indemnify Party B against all loss or penalties arising out of any third-party claims arising out of the negligent acts or omissions or willful misconduct of Party A in the performance of its obligations under this Agreement.”
In the above example, scope of indemnity provisions limited to third party claims, and this is the generally accepted practice. However, if the parties so intend, such provisions may also encompass direct claims between the two parties. An indemnification provision for direct claims typically covers damages relating to other party’s breach of the agreement.
Many indemnification clauses address this problem by including language specifying that the indemnity covers losses “to the extent” caused by or resulting from the actions of the indemnifying party. This is certainly helpful, but a more explicit statement of the intent of the parties can avoid any doubt on the issue.
What is “indemnification for direct claims”?
Here is a simple example of indemnification for direct claims for your understanding:
“Party A shall indemnify Party B from and against any loss or penalties sustained by any person or entity arising out of the negligent acts, omissions or willful misconduct of Party A in the performance of its obligations under this Agreement.”
In the above clause, direct claims between the parties become subject to indemnification. In commercial contracts establishing an ongoing relationship between the parties, such a clause is not helpful nor advisable. Commercial contract indemnification provisions typically do not cover direct claims. The risk is that a party can almost always be sued for the direct loss under contract or tort theory. The inclusion of this language means that in addition to covering claims by third parties, Party B can bring an indemnification claim for direct damages from breach of the agreement.
Generally, between two parties to a commercial contract, there are no indemnity obligations. The idea behind such a proposition is the apportionment of risks amongst the parties entering into a business relationship. In theory, Party B doesn’t need an indemnification for direct losses because they have an option of raising a claim for the breach of contract and damages. An indemnification clause must be only intended to cover claims against a party that result from the other party’s negligence, infringement, etc, and never to cover the direct losses. If the indemnification covers Party B’s direct losses, it’s basically Party A paying Party B’s costs to sue them! This is not commercially reasonable.
Also, the use of this approach provides duplicative coverage for events of default, as most commercial contracts will contain detailed provisions on defaults and remedies, and these provisions presumably should control any loss suffered by Party B due to Party A’s default. The end result may be the same, but it is possible that Party B is more likely to bring an indemnity claim (which could be made without having to allege that Party A is in default) than sue for breach. Having duplicative remedial schemes is not the most prudent approach; and it can lead to unintended consequences if the indemnity provisions turn out to have a different and broader scope than the other breach and remedy provisions in the contract.
I have seen some of my colleagues trying to balance this kind of scenarios of direct indemnification with a Limitation of Liability covering such direct claims. Also, some lawyers used to keep exclusions for claims arising out of any deliverables developed as per the specifications of the other party.
Generally, in Merger and Acquisition (M&A) transactions, indemnities typically include coverage for direct claims on behalf of the buyer and are only effective following closing. M&A indemnities effectively provide for a purchase price adjustment if the seller turns out to have breached its warranties or commitments.
The indemnifying party can also benefit from indemnification coverage of direct claims, but only if the indemnification successfully limits the indemnified party’s remedies. For example, the indemnifying party benefits from an indemnification for direct claims if it also includes a sole remedy provision that limits the indemnified party’s remedies to indemnification. However, if the indemnification covers direct claims based on breach of the agreement, the indemnifying party should ensure that any limitation of liability on damages for breach of the agreement also applies to these indemnification-related direct damages.
What is the benefit derived by the party insisting for indemnification for direct claims? Indemnification for direct claims can give the indemnified party remedies that are greater than or additional to those provided under other contract provisions or the law. For example, indemnified parties can typically recover attorneys’ fees under indemnification, while the law otherwise generally prohibits without an express agreement.
It may be difficult at times; but we should invest some time in the indemnity provisions of contracts to ensure that they function as intended and consistently with the other provisions of the agreement. Indemnities are a common talking point during contractual negotiations, and a common cause of disputes. If the issues are not properly negotiated, or the indemnity clause is poorly drafted, the consequences can be serious regardless of whether you are the party giving or receiving the indemnity.