- 8 min read
- Nia Balbo
Introduction
For every contract you execute, there’s going to be some risk involved — but that doesn’t mean you can’t do everything in your power to minimize that risk.
Indemnification clauses play a huge role in assigning legal liability in the event of a contract breach and reducing risk across commercial agreements.
In this blog, we’ll discuss indemnification clauses, why they’re necessary, and how to draft them to best protect your enterprise.
What is an Indemnification Clause?
An indemnification clause is an agreement between two parties in which one party (the indemnifying party) promises to compensate the other (the indemnified party) if they cause the other party a loss or damage.
Enforcing the clause typically requires the indemnifying party to cover the costs associated with the loss so the indemnified party doesn’t experience additional financial harm.
Why Do I Need an Indemnification Clause?
The core purpose of an indemnification clause is to mitigate risk as much as possible for parties entering into business arrangements. You reap several benefits by including these clauses in your commercial contracts.
1. Risk Transfer
When one party takes on significantly more risk than the other, indemnification clauses offer the chance to shift that risk to another party. This lessens the amount of risk the indemnified party may assume and gives them a sense of security, knowing they won’t be as responsible in the event of loss.
2. Liability Limitations
You can use indemnification clauses to restrict the liability of a party within a contract. Doing so limits the amount of financial exposure that a party takes on, lessening their chances of experiencing higher losses or damages.
3. Term Clarification
Indemnification clauses allow you and your counterparty to explicitly define the terms and conditions that will apply if one of you should experience a loss. Establishing clear terms up front makes for much less confusion and an easier time enforcing the clause, if necessary.
4. Financial Protection
Indemnification clauses ensure your counterparty financially compensates you if their actions (or inaction) force you to experience a loss. Especially if your revenue hinges on the counterparty fulfilling contract obligations, you won’t be left high and dry if they drop the ball.
5. Contracting Assurance
Since an indemnification clause defines your terms early on, you have less overall contract risk to worry about. That means you can focus your attention on more strategic tasks.
Choosing the right indemnification clause ensures you reap every benefit of protecting your enterprise.
Are There Different Types of Indemnification Clauses?
There are several types of indemnification clauses, each one providing a different set of conditions and protections.
Bare Indemnity
Bare indemnity clauses provide complete, no-limit protection against liability or loss. You should approach this type of clause with caution since the risk you assume could be significantly high.
Limited Indemnity
As the name implies, limited indemnity clauses limit the indemnifying party’s legal liability. The indemnifying would only be liable to cover damage caused by their own delinquency.
Third-Party Indemnity
Under this type of clause, the indemnified party can claim losses resulting from the actions of a non-contracted party.
Mutual Indemnity
In this case, both parties agree to compensate each other for damages incurred due to a mutual breach of contract.
Whichever indemnification clause you choose, you must draft it carefully to ensure it’s fully enforceable.
What Terms Do Indemnification Clauses Include?
Any clause is only as good as the components and language used to craft it. A well-drafted indemnification clause will include the:
- Indemnification Event — What situation will trigger the indemnification obligation?
- Indemnifying Party — Which party will be responsible for paying compensation?
- Indemnified Party — Which party will receive compensation?
- Scope of Indemnification — What types of losses does the indemnification cover?
- Time Limitations for Indemnification — How long will the compensating party have to cover damages?
- Amount of Indemnification — What is the highest amount the indemnifying party will be responsible for paying?
- Subrogation — To what extent can the indemnifying party pursue compensation from a third party?
- Exclusions — Will there be any exceptions to enforcing the clause?
With so much riding on how these clauses are drafted and managed, you’ll want to ensure you’re following a few best practices.
Tips for Drafting Indemnification Clauses
How you draft indemnification clauses and the specific terms you use within them will vary based on your enterprise and the contract’s overall goals. Still, some baseline tips apply across the board.
1. Be Careful How You Use Language
The language you use (or don’t use) can result in your counterparties or a court interpreting the clause with a broader or narrower lens. Choose your position and language carefully to best support your risk reduction strategy.
2. Be Mindful of Your Jurisdiction
Certain jurisdictions interpret indemnification clauses differently. Take this into consideration as you draft and review contract language.
3. Consider How Indemnity Clauses Affect Other Clauses
Contract clauses rarely exist in a vacuum. As you draft an indemnity clause, consider how that language relates to other terms in the rest of your agreement.
Here are key interactions to keep in mind:
- Limitation of Liability – Indemnity clauses often overlap with limitation of liability clauses, which cap the amount one party has to pay the other for certain breaches or liabilities. For example, if the indemnity clause provides broad coverage for certain risks, but the limitation of liability clause imposes a strict monetary cap, the effectiveness of the indemnity could be substantially restricted.
- Insurance Provisions – Contracts can include requirements for one or both parties to maintain specific types of insurance. The scope of indemnity might depend on the coverage and limits of the required insurance policies. For instance, a party might only be required to indemnify for losses that exceed the coverage provided by insurance. This interplay should be explicitly clarified to avoid gaps in expected coverage or overlapping coverages that could complicate claims.
- Breach and Remedies – If an indemnity clause covers specific actions or inactions, it might implicitly permit certain behaviors that you’d otherwise consider breaches under different contract sections. It’s important to define clearly how indemnification interacts with the rights to terminate the contract or seek other remedies for breach.
- Warranties – A breach of warranty might trigger indemnification under certain conditions. Discrepancies between what is warranted and what is indemnified can lead to disputes and unmet expectations.
- Dispute Resolution – The procedures outlined for resolving disputes within a contract need to account for the processes involved in claiming indemnity. The dispute resolution clause should specify whether indemnity claims require mediation or arbitration first, how claims are to be documented and verified, and the timelines for such processes.
4. Leverage Tools to Improve Contract Authoring
As your business changes over time, so will the way you draft clauses. Leverage AI contract lifecycle management tools to build an approved template library to automate contract drafting for clauses that you frequently use.
5. Track Contract Terms Post-Signature
If you should experience a loss, you’ll want to know how you are protected as soon as possible. Closely monitor these clauses after execution to address problems quickly.
Redefine Contracting and Protect Your Enterprise
Manually trying to author and manage every clause in your contract portfolio is nearly impossible. You’ll only leave yourself open to increased legal liability and the associated consequences.
With Sirion’s AI-native CLM platform, you can transform how you create, store, and optimize your agreements for a unified contracting experience.
Centralize your contracts. Standardize your processes. Keep every obligation on your radar. See the AI live.
Additional Resources
What Happens if You Break an NDA?
What is Contract Administration? Definition and Key Aspects
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