You are entering a new business partnership or signing a service agreement. Everything seems fine until something goes wrong. Maybe a client sues for a mistake or an unexpected problem arises. Who's responsible for the costs? This is where indemnification clauses factor in.

In 2017, the well-known ride-sharing company, Uber, found itself embroiled in a lawsuit that highlighted the importance of indemnification clauses. The case revolved around Uber's use of a background check service provided by Hirease LLC. When a passenger sued Uber after being assaulted by a driver, Uber sought indemnification from Hirease, arguing that the background check provider should cover the legal costs and damages because their service failed to identify the driver’s criminal history.

That’s why you need to ensure you know the ins and outs of indemnification clauses and this blog post aims to educate you on just that.

What is an indemnity/indemnification clause?

An indemnity or indemnification clause is a part of a contract where one party agrees to compensate the other for any harm, loss, or liability that arises out of the contract. It's like a promise to take responsibility if something goes wrong.

Indemnification means protecting someone from financial loss or legal penalties. When you agree to indemnify someone, you agree to cover their costs if they face claims or damages related to the contract.

If someone said you can only work on one section of a contract, I would always pick the section dealing with indemnification, limitation of liability and warranty.  Or, as I call them, the “Big Three.”

~Sterling Miller, CEO and Senior Counsel for Hilgers Graben PLLC
Ten Things: I Know It’s Only Boilerplate

Key components of an indemnification clause

Here are the essential elements to include for a well-drafted indemnity clause:

1. Identification of parties involved

Clearly identify the indemnifying party (the one providing indemnity) and the indemnified party (the one receiving it). This clarity helps avoid confusion and ensures both parties understand their roles and responsibilities.

Tip: Use explicit names or titles of the parties involved to avoid ambiguity. For example, "Company A" and "Company B" should be consistently used throughout the clause.

2. Scope of indemnity

Define what types of losses or damages are covered. This includes legal fees, damages, and other costs. Be specific about what is covered to prevent disputes. The scope should be comprehensive yet clear, specifying all scenarios where indemnity will apply.

Tip: Clearly state the types of claims covered, such as third-party claims, direct damages, indirect damages, and associated legal costs. Avoid vague language to minimize misunderstandings.

3. Duration of the indemnity

Specify how long the indemnity will last. This can be tied to the term of the agreement or extend beyond it. Ensure the duration aligns with the nature of the contract and the potential risks involved. It's important to define whether the indemnity survives the termination of the contract and for how long.

Tip: Clearly mention whether the indemnity survives the termination of the contract and for how long. For instance, "This indemnity shall survive the termination of this agreement for a period of three years."

4. Financial limits on indemnity

Set a cap on the amount the indemnitor can be required to pay. This limit helps manage risk and ensures that the Indemnitor is not exposed to unlimited liability. The financial limit should be reasonable and reflect the potential scope of losses.

Tip: Define a specific monetary cap or a formula based on the contract's value.

5. Procedures for making a claim

Outline the steps the indemnitee must follow to make a claim under the indemnity. This includes how and when to notify the indemnitor of a claim and any required documentation. Clear procedures help prevent delays and ensure that claims are handled efficiently.

Tip: Specify the notification period, required documentation, and the process for handling claims.

6. Exclusions

Detail any exceptions to the indemnification obligation. These might include specific types of damages or circumstances not covered by the clause. Clearly outlining exclusions helps manage expectations and reduces potential conflicts.

7. Defense and control of claims

Specify whether the indemnifying party has the right to control the defense of the claim or if both parties will collaborate. This includes who will bear the costs of defense and under what conditions.

Also read: 5 Most Negotiated Terms and Clauses in a Contract

Types of indemnity clauses

After understanding the key components, you need to know the different types of indemnity clauses. Each type serves a unique purpose and offers varying levels of protection depending on the contract and associated risks.

#1 Mutual indemnity clauses

Mutual indemnity clauses require both parties to indemnify each other. This means each party agrees to compensate the other for certain losses or damages that arise from breaches or specific actions. This type of clause is often used when both parties have equal bargaining power and similar levels of risk.

• Both parties provide and receive indemnity
• Common in agreements where responsibilities and risks are shared equally

#2 Unilateral indemnity clauses

Unilateral indemnity clauses require only one party to indemnify the other. Typically, this means one party (often the one with less bargaining power) agrees to compensate the other for losses or damages. This type of clause is often seen in contracts where there is a clear difference in power or risk between the parties.

• Only one party provides indemnity
• Common in contracts where one party is at greater risk or has more power

#3 Comparative and contributory negligence clauses

Comparative and contributory negligence clauses address situations where both parties may be partially at fault. These clauses outline how liability will be shared based on the degree of fault of each party. Comparative negligence allows for damages to be apportioned based on each party's level of fault, while contributory negligence may limit or bar recovery if one party is found to be partially at fault.

• Allocate liability based on the degree of fault
• Comparative negligence allows for shared liability
• Contributory negligence may limit or prevent recovery if one party is partially at fault

Also read: How to Review Indemnity Agreements: A Comprehensive Guide

Benefits of an indemnity clause for in-house legal teams

#1 Keeps your company safe from financial loss

• Covers specific losses: If something goes wrong and your company faces losses or damages, an indemnity clause ensures another party will cover those costs. This can include legal fees, damages, or other unexpected expenses
• Financial safety net: With these clauses in place, you avoid significant financial setbacks, keeping your company's finances stable and secure

#2 Helps you manage risks better

• Spot and address risks early: Indemnity clauses help you identify potential risks right from the start and assign responsibility for them. This way, you can tackle issues before they become major problems
• Clear responsibilities: These clauses spell out who is responsible for what, reducing confusion and preventing disputes over liability.

#3 Ensures legal compliance

• Meets legal standards: Well-crafted indemnity clauses make sure your contracts comply with relevant laws and regulations. This means fewer legal headaches down the road
• Stay current: Regularly reviewing and updating these clauses keeps your contracts aligned with the latest legal standards and best practices

#4 Gives you a leg up in negotiations

• Stronger negotiation position: Clear indemnity clauses put you in a better position during contract negotiations. They set a straightforward framework for discussing liabilities and responsibilities, making it easier to negotiate favorable terms
• Fair risk allocation: By clearly outlining who takes on what risks, you can ensure fair terms for your company

#5 Makes dispute resolution easier

• Simplifies the process: If a dispute arises, having an indemnity clause makes resolving it simpler. The clause outlines the process and responsibilities, saving you time and resources
• Reduces litigation: Clear indemnity provisions can help avoid litigation by providing a clear path for resolving issues, cutting down on legal costs and time spent on disputes

Also read: How to create an effective contract clause library

Limitations of the indemnity clause

Indemnity clauses are great, but they have their limits. Knowing these can help you use them more effectively in your contracts. Let’s break it down:

Scope of coverage

• Not all-inclusive: Indemnity clauses don't cover everything. They usually focus on specific liabilities, so some risks might still fall on your company
• Exclusions: These clauses often exclude certain things, like gross negligence or willful misconduct. This limits how much protection you actually get

Legal enforceability

• Varies by location: Depending on where you are, the enforceability of indemnity clauses can differ. Some places might not enforce certain provisions, which can weaken the clause
• Public policy issues: Courts might not enforce clauses that go against public policy, like those trying to cover gross negligence or illegal actions

Financial stability of the other party

• Insolvency risk: If the party providing indemnity goes bankrupt or isn't financially stable, your company might still have to cover the costs
• Insurance limits: Even if the other party has insurance, it might not be enough to fully cover the loss, especially if damages exceed policy limits

Complexity and clarity

• Ambiguous language: If the clause is not clearly written, it can lead to misunderstandings and disputes. Precise language is crucial for enforcement
• Complicated negotiations: Creating a balanced indemnity clause can lead to lengthy negotiations, delaying contract finalization

Potential for increased costs

• Higher premiums: Heavy reliance on indemnity clauses might lead to higher insurance premiums for the indemnifying party, which can increase overall costs
• Litigation expenses: Enforcing an indemnity clause can be costly, with legal fees and court costs, especially if there's a dispute

Exceptions to the indemnity clause

While indemnity clauses offer significant protection, there are typically several exceptions where the indemnifying party is not obligated to compensate the indemnified party. You need to know these exceptions to draft balanced and fair indemnity agreements.

#1 Gross negligence or willful misconduct

Indemnity clauses often exclude coverage for losses resulting from the gross negligence or willful misconduct of the indemnified party. This ensures that parties are not protected from their own severe or intentional wrongdoing.

#2 Unlawful acts

Any actions that are illegal or violate the law are typically excluded from indemnification. This prevents the indemnifying party from being liable for acts that are against public policy or illegal.

#3 Breach of contract by indemnified party

Losses or damages resulting from the indemnified party’s own breach of the contract are usually not covered by the indemnity clause. This ensures accountability and encourages parties to fulfill their contractual obligations.

Example: In a vendor agreement, Walmart was not indemnified for losses resulting from its own breach of the contract terms. When Walmart failed to adhere to agreed delivery schedules, causing financial loss to the vendor, the indemnity clause did not apply. This scenario emphasized the importance of fulfilling contractual obligations to benefit from indemnity protection

Also read: How to Handle and Resolve Breach of Contracts

#4 Indirect or consequential damages

Many indemnity clauses exclude coverage for indirect or consequential damages, such as loss of profits, loss of business, or reputational harm. These types of damages can be difficult to quantify and are often considered too remote to be indemnified.

#5 Claims not promptly reported

Indemnity clauses often require that claims be reported within a specific time frame. If the indemnified party fails to report the claim promptly, the indemnifying party may not be obligated to cover the losses. This helps ensure timely notice and adequate opportunity for the indemnifying party to respond to claims.

#6 Third-party claims not covered

Some indemnity clauses specifically exclude third-party claims, limiting indemnification to direct claims between the contracting parties. This is particularly relevant in contracts where third-party risks are considered separate or need to be addressed through other means.

Example: In an agreement between Pfizer and a distributor, the indemnity clause specifically excluded third-party claims. When a third-party customer sued the distributor for product defects, Pfizer was not liable for indemnification. This clear exclusion of third-party claims helped delineate the responsibilities and liabilities between the involved parties.

Common misconceptions about indemnity clauses

Indemnity clauses are often misunderstood, leading to several misconceptions about their scope and application. Clarifying these myths is crucial for ensuring these clauses are effectively utilized. Here are some common misconceptions and examples:

#1 Indemnity clauses cover all types of damages

Misconception: Many believe that indemnity clauses provide blanket coverage for all possible damages.

Reality: Indemnity clauses typically cover specific types of damages and may exclude indirect or consequential damages. It’s essential to define the scope of coverage clearly within the clause.

Example: A software development contract might exclude coverage for indirect damages such as loss of profits, even though direct damages like repair costs might be covered.

#2 Indemnity clauses automatically protect against all third-party claims

Misconception: Some assume that indemnity clauses always protect against third-party claims. 

Reality: Not all indemnity clauses cover third-party claims. The clause must explicitly state whether third-party claims are included.

Example: In a distribution agreement, the manufacturer might include an indemnity clause that excludes third-party claims to avoid liabilities from consumer lawsuits.

#3 Indemnity clauses are the same as insurance

Misconception: Indemnity clauses are often mistaken for insurance policies.

Reality: While indemnity clauses and insurance policies both manage risk, they are not the same. Indemnity clauses are contractual agreements between parties, whereas insurance involves a third-party insurer.

Example: A construction contract might include an indemnity clause, but the contractor also needs separate liability insurance to cover broader risks not included in the indemnity clause.

#4 Indemnity clauses negate the need for other risk management strategies

Misconception: Some believe that an indemnity clause is sufficient on its own.

Reality: Indemnity clauses are part of a broader risk management strategy and should not be relied upon exclusively.

Example: A business might use indemnity clauses in contracts but also employ robust compliance measures and risk assessments to mitigate potential liabilities.

#5 Indemnity clauses are always enforceable as written

Misconception: Parties often think that indemnity clauses are enforceable exactly as written.

Reality: Courts may interpret or even invalidate indemnity clauses if they are deemed unreasonable or against public policy.

Example: A clause that attempts to indemnify a party for its own gross negligence might be struck down by a court.

How VerifAI can help with indemnification clauses

Indemnification clauses are vital for managing risk in contracts, but drafting and reviewing them can be complex. SpotDraft’s VerifAI simplifies and enhances this process in several ways:

1. Suggestions and redlines: VerifAI ensures clear and precise language, reducing ambiguity that could lead to disputes. It suggests improvements for clearer, more effective clauses
2. Comprehensive risk management: The tool analyzes the scope of indemnity to ensure appropriate coverage and explicitly defines exclusions, like gross negligence
3. Automated compliance checks: VerifAI checks clauses against current legal standards and regulations or your company-specific guidelines, ensuring they are enforceable and up-to-date
4. Efficiency in review: By automating the review process, VerifAI saves time and quickly identifies potential issues, making negotiations smoother

Also read: How to Review Vendor/Supplier Contracts: A Comprehensive Guide

On your way to drafting indemnification clauses

Indemnification clauses are crucial for mitigating risk in contracts, but their complexity can be daunting. VerifAI simplifies this process, ensuring precision in drafting, comprehensive risk management, automated compliance checks, efficient reviews, and financial security. VerifAI transforms the way indemnification clauses are handled, making them clearer, more effective, and compliant with current legal standards.

Ready to streamline your contract management and enhance your indemnification clauses? Check out VerifAI today!