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What is an Indemnification Clause?

Updated: May 20

As discussed in my previous Force Majeure Clause post, contract clauses that seem overwhelming and irrelevant can actually serve an important purpose. In this post, I explain what an indemnification clause is, why it's often in agreements and why it can be important to include.


The importance of an indemnification clause

An indemnification clause can protect one of the parties to the contract from damages and lawsuits (i.e., the indemnified party) if the other party (i.e,. the indemnifying party) takes actions that cause a third-party to sue the indemnified party. Such protection can include reimbursing the indemnified parts for the amounts it had to pay on account of the specified claims or paying these amounts in place of the indemnified party. Typically, in order for the indemnified party to shift the financial loss onto the indemnifying part, the indemnifying party must either:


(a) commit a significant wrongdoing, either with or without knowledge of the wrongdoing, in relation to the contract; or

(b) cause a significant breach of the contract's terms.


If either of these events occur, and a third party sues the indemnified party because of what the indemnifying party did or failed to do, then the indemnifying party must pay to defend the indemnified party and pay any of the damages and fees the third party is awarded.


How it Works

Let's consider the following example. A consultant agrees to help develop and implement software for a company. However, the consultant provides significantly outdated software, even though the consultant's contract requires the consultant provide the up-to-date and industry best software. Additionally, the consultant fails to review the software for critical errors. Because of the consultant's failures, the company suffers a data breach and its clients' data is exposed. One of the company's clients sues the company for the data breach. Without an indemnification clause, the company would likely be responsible for the damages flowing from the data breach. With a properly drafted indemnification clause in the consultant and company's contract, however, the company can shift the financial loss onto the consultant. As a result, the consultant would have to pay for the company's defense against its client's lawsuit and any damages the company suffers.

Limits on Indemnification

The indemnifying party's liability to the indemnified party may be reduced if the indemnified party's actions or inaction contributed to the problem.


Looking back to the earlier example, suppose the company requested the consultant use older software because it was cheaper. Taking such action might have caused some of the company's damages. Therefore, the consultant would not have to pay for the entirety of the company's defense and damages because part of data breach arose from the company's actions. Tailoring an Indemnification Clause

Indemnification clauses are not set in stone. Parties to an agreement can tailor an indemnification clause to fit their specific needs. For example, indemnification clauses can be structured to have both parties agree to indemnify each other for specific types of losses or only one party agreeing to indemnify the other. Where a party has more negotiation power, they may make an indemnification clause more favorable for their needs.

Conclusion

An indemnification clause is an important tool if something goes wrong. Although it might look unnecessary, parties should include an indemnification clause in their agreements and ensure it is well drafted for their specific circumstances. A party should also review the indemnification clause carefully to see whether it covers potential lawsuits that could occur or is too one sided.


If you have any questions, please don't hesitate to contact me.

The information provided on my blog is not legal advice and should not be relied on as legal advice. Anyone reviewing this post should use it as only a first step in understanding how an indemnification clause works. You should consider consulting with a lawyer when drafting a contract.



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