The Indemnification Clause, Beyond Just Boilerplate

The Indemnification Clause, Beyond Just Boilerplate, by Rebecca Gray, for Contract NerdsWith multiple layers of uncertainty on both sides of most commercial deals, the indemnification clause is often hotly contested during contract negotiations.

As contract negotiators, we want to protect our clients. So we dive into the fray seeking ironclad clauses that shift away as much risk as possible. Sometimes it’s about fairness: “We shouldn’t have to defend ourselves against lawsuits prompted by your negligence.” Often, though, bargaining power plays an outsized role in negotiating indemnification clauses.

Much of the danger falls to the party that needs the deal most. But there are real risks to Goliath from overreaching as well.

Indemnification clauses are meaty, expert-level boilerplate. There are no one-size-fits-all answers here. But read on for a few pointers all Contract Nerds—whether representing David, Goliath, or your average Joe—should keep in mind when working with indemnification clauses.

It Isn’t a Win If You Can’t Cash the Check.

You might have all the power in this particular deal, but requiring the other side to sign an indemnification check they can’t cover is not going to help your bottom line. Think bank fees, or in this instance, spiraling litigation costs, as you fight to tap resources that just aren’t there.

Before you flex your contracting leverage, look into the actual mechanics behind the clause you are drafting. Talk to your own people, and don’t be afraid to ask detailed questions of the other side as well. What are the biggest risks associated with this deal? Apart from who should pay for a particular bad outcome, there are the not-insignificant questions “who can?” and “who actually will?”

Are there deep pockets, in the form of insurance, a generous operating margin, or a wealthy parent company that can be tapped to cover the risk in question? If yes, be sure to connect the dots between your indemnification clause and the ultimate payor. For instance, if the insurance policy you’d hoped to rely on expressly disclaims “liabilities assumed by contract,” you’ll want to know this up front, and adjust contingency plans accordingly. Conversely, if you’ll be adding an indemnitee as an additional insured on your insurance policy, you’ll want to consider whether terms of the contract itself—in particular, any caps or other limitations on the scope or extent of liability—should be incorporated into the same policy.

Our job as contract negotiators isn’t winning concessions at the drafting table. Our job is reducing uncertainty and real-world risk. If there are no resources to back up the indemnification clause you negotiate, you may only “win” yourself a lawsuit and a place in line with other bankruptcy creditors.

Know the Status Quo.

Pay attention to the governing law of the contract, and make sure you know what outcomes are likely both with and without the language under discussion. How will your contractual terms be read in the context of state laws or codes regarding indemnification?

For example, sellers are often asked to sign one-sided clauses indemnifying the buyer (and possibly the buyer’s affiliates, customers, etc.) against third-party claims “arising from or related to” the purchase and use of seller’s widgets. As contract negotiator for the seller, you might expect a high-five for fending off such an indemnification clause. But under the Uniform Commercial Code (UCC) as adopted throughout most of the United States, silence is not necessarily your friend. Absent an express agreement to the contrary, the default rule requires a merchant seller to indemnify the buyer against third-party claims “by way of infringement or the like.” UCC Section 2-312(c). And a general liability disclaimer that does not specifically disclaim this warranty against third-party infringement is not enough to change the status quo in most states.

Similarly, narrowing the language from “indemnify and defend” down to “indemnify” won’t necessarily get you out of paying defense costs. In California, for instance, Civil Code § 2778 states that “unless a contrary intention appears,” the default indemnification “embraces the costs of defense,” and “[t]he person indemnifying is bound…to defend actions or proceedings…in respect to the matters embraced by the indemnity.”

Know Your Alternatives.

Just as it’s important to understand the likely legal result without the indemnification language under discussion, it’s also worthwhile to think through practical alternatives for addressing relevant risks. If you can mitigate or cabin a particular risk by other means, you may prefer to use your negotiating capital on other provisions.

Can you draft a contractual workaround, such as a remedies clause requiring a non-infringing substitute if it turns out that a particular deliverable infringes on a third party’s intellectual property rights? How effective would this workaround be, given your anticipated use of the deliverable?

Could you quarantine outsized risks by running the transaction through a subsidiary? This strategy is particularly useful in acquisitions, services contracts that involve creating a workforce in a new or highly regulated jurisdiction, or any other deal that presents specific risks that can be isolated operationally, geographically, or otherwise.

Should you simply kick the can down the road? Where the balance of contracting power and the likely balance of fault is roughly equal between the parties, it may not make sense to waste time arguing over indemnification at the contract stage. The liability in question may well be worth fighting over, but is it worth fighting over now? I’ve seen parties recognize that they (or more likely, their insurance companies) are simply going to have to duke it out later in the event of an unlikely but potentially catastrophic third-party claim.

Understand the Whole Battle.

Last but definitely not least, before you sign off on that “perfect” indemnification clause, be sure to think through both 1) its relationship to the other clauses in your contract, and 2) the procedures that will govern its operation in real life. Agreement on indemnification, standing alone, is a recipe for legal battles at every fork in the indemnification process. Take time on the front end to clarify both how claims for indemnification should proceed, and how the scope of indemnification itself will impact—or be impacted by—the rest of the contract.

For instance, be sure to consider the relationship between your indemnification clause and your limitation of liability clause. Either one could eviscerate the other if you aren’t careful. Do you want your contractual cap on liability to apply to indemnification obligations? There is no right or wrong here, but the answer should be clear enough to reduce uncertainty—and therefore legal spend—in the event that indemnity is called in.

Should your indemnification clause cover damages that are specifically excluded elsewhere in the contract, such as incidental or consequential damages? Again, the choice could go either way, but think it through and avoid ambiguity or contradictions in the final contract. If you include a broad waiver of consequential damages, but you want the scope of indemnification to include consequential damages, you should include an explicit carve-out to make that clear.

Eliminating ambiguity and contradiction with respect to other contract terms is only half the “process” battle, though. You also need to consider the rules that will govern claims for indemnification. Save headaches and needless expense on both sides by setting forth, in the indemnification clause itself, (a) how and when indemnification claims must be presented, (b) who will control the defense, and under what circumstances, (c) who will have settlement authority, the conditions that will govern that authority, etc.

And remember that forcing through an indemnification clause the other side can neither insure nor pay for does not actually shift the risk in question, it simply increases the uncertainty—and therefore the cost—associated with that particular risk.

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Check out the earlier articles in this Beyond Just Boilerplate series, on mandatory arbitration clauses and why we call it boilerplate. And stay tuned for our next installment in late October.

© 2021 The Entrepreneur’s Lawyer®

 

Author:
Rebecca serves as outsourced in-house counsel to businesses and entrepreneurs, working to develop legal strategies that create opportunities for growth while protecting and increasing value. She founded The Entrepreneur’s Lawyer® to create a home for the resources and guides she wished she had readily available as a newly minted #startupGC.

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