No Glossing Over Indemnification Provisions

When was the last time you seriously reviewed an indemnification provision in a contract? We recently had clients who were leasing a commercial building. Among other language, the lease agreement’s indemnification provision provided that our clients would be responsible for any damage that would occur on the leased property, even if our clients were not responsible for causing the damage. We wrestled with what to do—our clients did not want to be liable for any damage they did not cause. In the end, we were able to negotiate an agreement that our clients would only indemnify the landlord for damages caused by our clients. In addition, we had our clients’ insurance company review and agree to pay out on any claims relating to the indemnification provision.

Unfortunately, not all indemnification negotiations are that easy. Instead, as attorneys, we need to take time to understand the risks, duties, and strategies that are involved in drafting and reviewing indemnification provisions. This article highlights some of those risks, duties, and strategies attorneys need to be aware of when negotiating and drafting an indemnification provision.

Purpose of Indemnification

Indemnification stems from “the concept that a party should be held responsible for his own wrongs, and if another is compelled to pay damages caused by the wrongdoer, that party is entitled to recover from the wrongdoer.”[i] Indemnification is at once both a risk-shifting mechanism and a deterrent to injurious behavior on the part of the indemnifying party that could otherwise harm the indemnified party.[ii]

The obligation to indemnify can arise from an explicit contractual provision or from an implied duty based on the relationship between parties. Numerous types of agreements, including purchase agreements, business entity formation documents, construction agreements, and use agreements, have explicit contractual indemnification provisions. A contractual indemnification provision can be advantageous for both parties. For the indemnifying party, it can spell out and limit the indemnifying party’s potential liability. For the indemnified party, it may be ideal because it can provide for recovery of fees and costs associated with enforcing the indemnification.

As for common law indemnification in Idaho, “[i]t is well established that under the common law, a person who without fault on his part is compelled to pay damages occasioned by the negligence of another is entitled to indemnity.”[iii] However, there are potential problems for both parties in depending on common law indemnification. By relying on common law indemnification, the indemnifying party runs the risk that it might be obligated to provide broad indemnification for a wide range of situations.

Conversely, by relying on common law indemnity, the indemnified party risks the possibility that the indemnifying party may not be financially able to indemnify by the time of indemnification, as well as the possibility that the common law indemnification obligation may not cover all of the situations for which the indemnified party wishes to be covered. This innate uncertainty in common law indemnity for both parties can be resolved through carefully drafting a contractual indemnification provision.

Indemnification Triggers

As a preliminary matter to drafting and agreeing to an indemnification provision, both parties must understand what events will trigger indemnification. Indemnification triggers may include misrepresentation, whether negligent or contractual, such as breach of warranty; breach of contract or damages arising from work performed under a contract; tax related losses; and infringement of intellectual property. Depending on the parties’ specific contractual relationship, both parties will want to carefully consider what events elicit a claim for indemnification.

Drafting Indemnity Clauses

Because of the potential pitfalls associated with indemnity clauses for both parties, careful drafting is crucial to avoid unnecessary problems and conflict. A typical indemnity clause covers numerous topics, including the scope of indemnification, the duty to “hold harmless,” exculpation, defense costs, the duty to defend, procedures, exclusions, and the right of subrogation. With such a vast array of topics to be addressed, clarity in drafting is essential to ensure that both parties have similar understanding of potential indemnification.

Buried within these topics is the inherent conflict of interest between the parties: the indemnified party wants broad coverage for as many potential liabilities as possible, while the indemnifying party wants to limit its obligation to indemnify the other party. The parties’ attorneys can address these competing interests through careful drafting.

Drafting Concerns for the Indemnifying Party

The indemnifying party has particular concern in drafting a narrow indemnification clause to limit its potential future obligation. To address this concern, counsel should carefully define what situations require indemnification, as well as the scope and extent of the party’s obligation to indemnify.

Articulating the scope of its obligation to indemnify is always a major concern. Indemnification provisions often include language requiring the indemnifying party to “indemnify and hold harmless” the indemnified party.

Some courts may look to this phrase as merely redundant, for “[w]hen a person promises to hold another harmless, he does not promise to prevent harm from occurring. That would be an impossible promise to keep.”[iv] This line of reasoning instead finds that by agreeing to “hold harmless,” the indemnifying party “promise[s] in the traditional and accepted parlance of the commercial world … to make things right if harm [does] occur,”[v] or essentially, indemnification.

However, other courts, including the Idaho Supreme Court, have looked at indemnification provisions with “hold harmless” language as indicating the indemnifying party is also obligated to indemnify for loss caused by its negligence: “[T]he indemnification provision contains the ‘hold harmless’ language which, although not talismanic, is nonetheless indicative of a specific intent to encompass indemnification for the indemnitee’s negligence.”[vi] Carefully consider inclusion of “hold harmless” language in an indemnification provision to safeguard against additional and unwanted future obligations.

Another related concern is to determine exactly what expenses the indemnifying party must cover. A contractual indemnification provision provides for the indemnifying party to compensate the indemnified party for “loss.” Consequently, an indemnifying party interested in limiting its potential exposure should define exactly what constitutes a loss under the agreement. Always draft the obligation to limit losses to general damages while excluding punitive and consequential damages under the indemnification provision.

Next, establish whether the indemnification provision provides for indemnification of first-party and third-party claims. A first-party indemnification claim is a claim by the indemnified party for a loss suffered directly. A third-party indemnification claim is a claim by the indemnified party for a loss resulting from a claim by a third party. If both first-party and third-party indemnification scenarios are to be addressed, do so in separate clauses of the indemnification provision. By failing to separate these claims, an indemnifying party could unintentionally expand its obligation to indemnify against third-party claims.

Address how the indemnified party is to provide notice of an indemnification claim. The provision should define at what point the time period for providing notice begins to run, whether it begins when the triggering event occurs or when the indemnified party discovers the triggering event. Include the deadline for notice of an indemnification claim, whether it is immediately following knowledge of the triggering event, with reasonable promptness after discovering the triggering event, or within some other defined timeframe. Also limit the length of time when an indemnified party can formally bring a claim for indemnification. Make sure the time period is not longer than any applicable statutes of limitations.

Finally, check with the indemnifying party’s insurance provider to make sure its potential obligations to indemnify are covered under its commercial general liability policy. Broad blanket coverage for indemnification obligations is often available under these policies, but may result in higher premiums. However, for the indemnifying party, higher premiums may be worth the peace of mind in knowing it has coverage for potential indemnification obligations.

Drafting Concerns for the Indemnified Party

Given the nature and underlying conflict of their positions, an indemnified party has different objectives and concerns regarding indemnification than those of the indemnifying party. It looks to shift risk to the indemnifying party, and therefore wants an all-inclusive indemnification obligation. Because of this inherent conflict, many of the concerns facing the indemnifying party are also of concern to the indemnified party, but framed differently—while the indemnifying party will wish to limit its obligation, the indemnified party will seek to increase its coverage.

While the indemnified party may not feel the same impetus to narrowly draft terms defining the scope and range of indemnification, it should take special care in drafting an indemnification provision to avoid unfavorable strict judicial construction. In Idaho, courts strictly construe indemnification provisions against the indemnified party, particularly in cases where it drafted the provision.[vii] This is due to the “hazardous” and “extraordinary” character of the indemnification relationship.[viii] With this warning in mind, an indemnified party must ensure that in its desire for broad indemnification, the provision is still drafted in a way that provides precise direction to any future courts interpreting the provision.

During the drafting process, define the indemnifying party’s duty to defend the indemnified party against third-party claims to address the indemnified party’s potential vulnerabilities in turning over its defense to the indemnifying party. The indemnified party must decide if it wants the indemnifying party to be the sole defender of any third-party claims against it, or if the defense approach will be collaborative. Also articulate at what point in the litigation the indemnified party will take over its own defense.

This is an especially important consideration because of the very real possibilities of the indemnifying party lacking the finances to conduct a strong defense, a breakdown in cooperation between the parties regarding handling of the defense, and unsatisfactory counsel hired by the indemnifying party. The indemnified party may determine that it will take over its defense against third-party claims if there is a “reasonable possibility” or “reasonable basis” that any of the above concerns impede the indemnifying party’s defense.

Finally, address the indemnifying party’s ability to bind the indemnified party to a settlement agreement. Because of the parties’ conflicting interests, the indemnified party will want to limit the indemnifying party’s ability to agree to a settlement without the indemnified party’s consent. Include language prohibiting the indemnifying party from entering into a settlement agreement unless the indemnified party is fully indemnified for all losses, the indemnified party receives an unconditional release for all related claims, the indemnified party does not admit wrongdoing, and there are no material effects for the indemnified party beyond the relief granted by the settlement agreement. By inserting this or similar language into a duty to defend clause, the indemnified party can protect itself from otherwise being bound to an undesirable settlement agreement.

Special Indemnification Considerations

Beyond the individual concerns of the parties, additional considerations face both parties to an indemnification agreement. One important issue is drafting reciprocity indemnification clauses. The parties may wish to include language in which each agrees to indemnify the other. For basic reciprocal indemnification provisions, one paragraph may be sufficient to address the mutual indemnification obligations. If, however, the triggering events requiring indemnification are markedly different for each party, the better approach is to draft two separate clauses, one in which the first party is the indemnifying party and the other in which the second party is the indemnifying party. Breaking a reciprocal indemnification provision into two separate clauses permits the parties to be more specific as to what triggers each party’s indemnification obligation.

Another special consideration is how to handle indemnification for known loss. This concern can arise in real estate transactions when land contaminants are discovered as the parties are drafting the sales agreement.[ix] If the parties wish to proceed with the sale, they may choose to address the indemnifying party’s obligation by adjusting the purchase price to reflect the estimated cost in cleaning up contamination. Another approach is for the indemnifying party to agree to cover any additional cleanup costs beyond an initial agreed-upon amount. Finally, the parties may agree to require the indemnifying party to purchase insurance to cover any contamination costs. Regardless of which approach is taken, both parties will want to incorporate the drafting tips discussed above to ensure their competing interests are protected.

Conclusion

Because of underlying competing interests, indemnification can be a potential minefield for both parties to an indemnification agreement. Address possible questions regarding the scope of the indemnification provision while drafting, rather than when future conflicts arise. By carefully drafting a clear-cut and precise indemnification provision, counsel for both parties can ensure the parties are better protected against the uncertainties inherent in indemnification.

Jarin O. Hammer joined Beard St. Clair Gaffney Thomson PA in 1997. His practice focuses on business, tax, and real estate. Jarin received his juris doctorate from the University of Idaho and his LL.M. in taxation from the University of Florida. He advises business owners on a wide array of legal issues including the formation of entities, taxation of business transactions, contract negotiations, land use and planning issues, and mergers and acquisitions.