Contract Time Bomb #2: The Indemnification Clause

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This is the second article in the new series entitled “Contract Time Bombs,” where I will address common contract terms that could leave your company financially and legally exposed.  I will address where they are, what they mean, and ways to help fix them.

Today, let’s explore the indemnification clause.  This clause reminds me of the optical illusion of the tree with faces.  You look at the tree and try to count how many face you can make out of the branches in the negative space, but you can only get 11 of the 12.  There’s always that blasted baby up in the corner somewhere that you only see after someone points it out to you.

The indemnification clause is similar in that, you read it, it makes sense, and nothing really looks off.  But when it is read closely, you’ll realize that, much like an optical illusion, there’s so much in the negative space of this clause that, if missed, can cost your company millions of dollars.

So what is an indemnification clause anyway?  It’s a clause that obligates a party, the indemnitor, to reimburse or compensate a second party, the indemnitee, for a loss or damages.  A lot of times the loss is due to a third party suing the indemnitee.

Indemnification clauses aren’t bad in and of themselves.  Quite honestly, in a lot of business situations, like in cases where a person or company is acting on your behalf and you can’t quite control their actions, you would be crazy not to have one in place.  This is because properly worded indemnification clauses place the risks associated with performance on the party who can best control those risks.

But here’s the deal–most indemnification clauses are just too broad, and leave a lot of room for abuse.  So let’s dive in and pick one apart, shall we?

The Anatomy

Here is a typical indemnification clause that probably resembles those contained in your own contracts:

Party A (indemnitor) agrees to indemnify and hold harmless Party B (indemnitee) and its agents of, from, and against claims, demands, damages, losses, judgments, and expenses, including, but not limited to, attorneys’ fees, arising out of, or resulting from performance of this Agreement.

Indemnify and hold harmless.”  As explained above, to “indemnify” means to take on the financial responsibility for the other party in the event something bad happens.  To “hold harmless” means that the indemnitor (remember, the one paying) will not hold the indemnitee responsible for any losses.

Party B and its agents.”  This states that not only is Party B an indemnitee, but its agents are too.  An agent is any person or company that has been given the authority to act on behalf of someone else.  Commonly used agents are subcontractors and lawyers.  Delegation is usually accomplished by a “power of attorney” or other legal contract that describes the types of actions the agent can represent you in, and other limitations.

Of, from, and against claims, demands, damages, losses, judgments, and expenses.” If the indemnitee has a claim filed against it, has to pay out any money, or sustains any loss related to the matter covered, the indemnitor is obligated.  According to this wording, the indemnitor’s obligation is triggered once a demand is made by a third party, and not just when a suit is filed.  An email stating “Hey, I think Harold Hubbitybub is coming after me, so I’m gonna need you to step in,” could very reasonably be considered a demand, especially if there is no clear definition in the contract for what communication constitutes a demand.

Including, but not limited to, attorneys’ fees.”  If the indemnitee has to hire a lawyer to deal with any claims, demands, judgments, or anything (and you can bet your bottom dollar that an attorney will be hired), the indemnitor has the obligation to pay for all of the fees associated with that.  Keep in mind that attorneys’ fees are not just limited to the hourly rate that the attorney charges.  Attorneys’ fees include expenses for travel, expert witness fees and their travel, if needed, filing fees, legal research services, and mailing fees.

Arising out of, or resulting from performance of this Agreement.” The indemnitor is on the hook for any of the claims that come about from any party’s performance as long as there is a connection to the contract.  So what happens if the indemnitee hires a subcontractor to perform a portion of the work, who then hires another subcontractor, neither of which the indemnitor knows anything about?  If something goes sideways, you probably guessed it.  According to these terms, the indemnitor is obligated to pay up.

What it Really Means

Now that we have defined what each section of the clause means, let me string it together.  When I read a clause like the common one above, this is what I see:

Party A (indemnitor) promises to Party B (indemnitee) that it will pick up the tab for any and all expenses related to any performance screw ups, failures, or omissions, by any person or company that could reasonably be connected to this contract, not matter who is at fault.

No manager or owner would ever knowingly sign up for the wording in my translation.  But when you sign up to agreements worded like the first example, that’s basically what you’re doing.  You can probably now see how unchecked indemnification clauses have the very real potential to open your company up to an endless amount of financial responsibility.

Now, let’s now look at a few easy ways to reign that baby back in.

Tip #1: Limit Who’s Covered

As I said above, an indemnification clause that places the risk of performance on the party who can best control that risk is a much better clause than one that covers any and every unfavorable scenario.  So unless you are an insurance company, if you have no control over another person or entity, or have no visibility into their affairs, you probably shouldn’t take on the risks associated with their performance.

Here’s an even better rule of thumb: protect only the party you are directly dealing with against your own actions.  Easy, right?  Here is wording that does just that:

Party A agrees to indemnify and hold harmless Party B and its agents of, from, and against claims, demands, damages, losses, judgments, and expenses, including, but not limited to, attorneys’ fees, as a result of performance of this Agreement, but only to the extent such injuries sustained were directly caused by the performance of Party A.

If you really want to get crazy with it, you could be even more specific:

Party A agrees to indemnify and hold harmless Party B and its agents of, from, and against claims, demands, damages, losses, judgments, and expenses, including, but not limited to, attorneys’ fees, as a result of performance of this Agreement, but only to the extent that such injuries sustained were directly caused by the gross negligence, recklessness, or willful misconduct of Party A while performing this Agreement.

Tip #2: Limit the Triggers

You don’t want to be responsible for any and every measly little gripe and complaint that someone brings forth.  You probably want to limit your responsibility to legitimate and significant injuries.  A good way to do this is to limit your obligation to only claims brought through the legal system via arbitration, or the courts.  This not only filters out low dollar claims, but also helps to protect against frivolous lawsuits. (If a lawsuit has no merit, you might be able to sue the other party and their attorney.)

You also probably don’t want to be responsible for another party’s attorneys’ fees.  As I mentioned above and in a previous post, legal fees can easily and quickly put you in the poor house.  I very recently reviewed a law firm’s invoice that billed one of their attorney’s at $700 an hour.  That equates to $28,000 for 40 hours worth of work.  And just as a side note, I have personally never seen any legal matter resolved in 40 hours, except for maybe speeding tickets.

The other side to that coin is that you may want to be able to hire your own attorney to deal with claims at the inception of the legal process.  Placing your company’s fate in hands of the indemnitee’s counsel who took this case for $200 and a pack of beer may not be the wisest decision.  If this is the case, including some verbiage that allows you to retain the counsel of your own choice may be a good idea.

Here’s our example that includes wording to limit the triggering events and also deals with attorneys’ fees:

Party A agrees to indemnify and hold harmless Party B and its agents of, from, and against claims and, demands, damages, losses, judgments arising from valid and binding legal proceedings, and expenses, including, but not limited to, attorneys’ fees, as a result of performance of this Agreement, but only to the extent that such injuries sustained were directly caused by the gross negligence, recklessness, or willful misconduct of Party A while performing this Agreement.  Party A may, at its own sole discretion, choose to defend any such action with counsel of its choosing.

Tip #3: Make it Mutual

If both parties are performing some aspect of the contract, then it makes sense for both parties to protect each other from their own misconduct.  This also makes for a very balanced contract.  Balanced is good because nobody wants to feel like they’re being taken advantage of, and balanced contracts hold up better in court because it shows that both sides had equal bargaining power.

Here’s some wording to help balance it all out:

Party A and Party B agree to indemnify and hold harmless each other Party A agrees to indemnify and hold harmless Party B and its agents of, from, and against claims and, demands, damages, losses, judgments arising from valid and binding legal proceedings, and expenses, including, but not limited to, attorneys’ fees, as a result of performance of this Agreement, but only to the extent that such injuries sustained were directly caused by the Indemnifying Party’s own gross negligence, recklessness, or willful misconduct while performing this Agreement.  The Indemnifying Party may, at its own sole discretion, choose to defend any such action with counsel of its choosing.

Here is a nice and clean final example:

Party A and Party B agree to indemnify and hold harmless each other of, from, and against claims and judgments arising from valid and binding legal proceedings as a result of performance of this Agreement, but only to the extent that such injuries sustained were directly caused by the Indemnifying Party’s own gross negligence, recklessness, or willful misconduct while performing this Agreement. The Indemnifying Party may, at its own sole discretion, choose to defend any such action with counsel of its choosing.

Keep these tips in mind as you review your contracts.  Remember, each state’s laws are different, so what is legal in one jurisdiction, may not be legal in another.  Always consult with an attorney if you are unsure of what the law is in your state.

Now go fix that contract!

See also Contract Time Bomb #1: The Severability Clause

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