Indemnification: What is it?

Indemnification means one party agrees to pay losses incurred by another to a third party.

For example, if you were a business owner selling Widget XYZ as an original design to a retailer, and your contract with the retailer contains an indemnity clause, you, rather than the retailer, would be responsible to pay the retailer’s legal costs and expenses if the retailer is sued by a third party who claims Widget XYZ is a copy of their product.

In most cases, the requirement to indemnify must be contained in a written contract between the parties.  However, in some states parties may be required to pay for the losses of another in certain limited circumstances.

Why Is an Indemnity Clause Important?

Indemnity protects your business from liability and lawsuits. When you hire a firm to remodel your place of business, for example, the contract should protect you from liability. If shoddy workmanship causes a customer or visitor to be injured, you should be able to seek indemnity from the contractor so that he (and not you) will be responsible to pay for the person’s injury.

On the other hand, there are good reasons to limit indemnity clauses only to circumstances you can control.  For example, say you own a design studio and are hired to create an original work for a client.  After you turn the work over to the client, he makes changes to the design so that a large portion of it copies the design of a well-known brand.  If that brand sues your client, you would want to be sure any indemnification clause was limited so that it excludes any changes made after you turn over the work so you don’t have to pay in this situation.

Reasons to Consider Not Indemnifying:

  • There are too many factors that are out of your control.

  • The proposed indemnity clause is so broad that it would require your company to pay for the acts of the client or contractor.

  • The other party has protection from money damages from another source, such as workers compensation.

Reasons to Consider Indemnifying:

  • Without the clause, the contract may put one or both parties at a higher risk of liability.

  • Providing reasonable protection from risk is essential to clinching the deal.

  • The indemnity clause is industry standard and a part of your standard contract.

Example: Your Contract Contains a Well-Drafted Indemnity Clause

You provide tutoring services.  Your contract contains a clause that requires the student to indemnify you and hold you harmless if the student fails to improve his or her grades in school.

An 18 year old high school senior retains your services. Her ability to graduate from an expensive private school depends on her passing math. You assure her that you can help, but that you cannot guarantee she will pass. She signs your standard contract containing the clause mentioned above.

She fails the class. Her parents threaten to sue you for damages in the amount of the next year’s tuition. Because your contract contains an indemnification provision, if the parents were to sue you, the student would be responsible to pay for your losses in court.  If it did not, you might be responsible to repay the parents.

With Indemnity

Positives:

  • Indemnity assures a party protection from financial liability stemming from the acts of its client or contractor

  • Indemnity increases the level of trust in a relationship because one party is willing to cover the other party’s losses

Negatives:

  • Indemnity clauses are sometimes difficult to negotiate

  • For a client, insisting on an indemnity clause can lead to increased costs of services due to the increased risk of the contract

Without Indemnity

Positives:

  • The contract is easier to understand as it contains less legal jargon

  • Potential risks remain unspoken, which can make sealing the deal easier

Negatives:

  • The potential risks remain unspoken so if something does happen, the correct party may not be the one paying for it

  • Lawsuits are more likely to occur and, when they occur, are often more costly

Common Mistakes:

People often make the mistake of being too detailed in an indemnity clause.  Indemnity provisions don’t have to be overly complicated, but they should be specific enough to be understood by the parties.  Often, just the threat of having to pay another person’s legal fees is enough to force a client or contractor to correct his behavior.  

Indemnity does not absolve the parties of their normal responsibilities. Do not make the mistake of assuming the other party knows that. Your contract should state that gross negligence or misconduct voids indemnity.

If you are unfamiliar with your state’s laws that relate to the subject of the contract, you should talk to a lawyer to make sure that you know what you’re getting into.  For example, most states say that a person cannot sue her employer if she is injured on the job if the employer provides the required workmens compensation insurance.  However, New York law allows an employee to sue the owner of the property that is not her employer, and also allows that employer to seek indemnification from that lawsuit from the employer.  So essentially the employer might end up paying twice (once for the workers compensation coverage and again for the property owner’s payout to the injured employee).

Frequently Asked Questions

  • Why can’t I just use a standard contract?

    With any contract, it’s important to completely understand all the provisions so you know what you are agreeing to.  It’s best to have an attorney familiar with your business draw up a contract for you and then ensure you understand it so that it is a tool that works for you, if you should ever need it.

  • What if the indemnity clause scares off my client or contractor?/

    You should be able to explain that the indemnity clause is there to protect the parties from the risk of working with a client or customer.  It’s nothing more than a promise by the client or contractor to pay for losses he or she causes.

Next Steps:

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