Small business owners often enter contracts without being fully aware of their ramifications. This is inevitable since the average entrepreneur is not fully equipped to decipher the nitty gritty of legal jargon. Unfortunately, this lack of understanding can often lead to unpleasant consequences. This article seeks to explain a much-misunderstood concept: indemnification.
What is Indemnification?
Simply put, indemnification means compensation for loss. Under contract law, an indemnification clause aims to shift liability for the loss of one party onto the other party (the indemnifying party). It's helpful to think about indemnification in term of a protection that protects one party against loss by transferring liability in event of any damage sustained. Indemnification clauses, sometimes referred to as "hold harmless" provisions, can be either one way (where only one party provides the indemnity) or mutual (where both parties agree to compensate the other for expenses arising out of their breach)
WHY ARE INDEMNIFICATION CLAUSES IMPORTANT?
Indemnification provisions allows parties to tailor the amount of risk they are willing to undertake, which in turns helps to protect them from unnecessary litigation. An effectively drafted indemnification agreement provides benefits to both parties.
Indemnification Clauses and Small Businesses
Small business owners consider adding indemnification clauses to their standard contract to mitigate claims based on losses caused by third parties. For example, if bad craftsmanship causes injury to one of your customers, an indemnity clause would protect you from the lawsuit that would follow. Liability instead will be incurred by the construction company.
Indemnification clauses for smaller businesses are often fiercely negotiated and highly litigated. Indemnification for smaller businesses entails evaluating a multitude of factors such as: 1) determining the financial limits, 2) determining time limits, and 3) determining how risky a business is. The riskier the business, the greater the necessity and likelihood of an indemnification clause. For example, indemnification clauses are extensively used in contracts potentially involving a breach of intellectual property law due to the significant liability an intellectual property lawsuit might bring. In all cases, indemnity clauses must be encapsulated in a written contract to be deemed valid. Indemnity clauses will outline how claims are to be made and paid out.
The Components of an Indemnification Clause
Typically, an indemnification clause has two separate and distinct obligations: 1) an obligation to indemnify, and 2) an obligation to defend.
The obligation to indemnify entails incurring the losses of the indemnified party, i.e., its paid cost and expenses. The obligation to defend is inclusive of both an obligation and a right for the indemnifying party. The obligation aspect stems from having to reimburse defense costs paid upfront. They have the right to control the third-party defense.
The Scope and Workings of an Indemnification Clause
The scope of an indemnification clause depends on how narrow or broad the wording is. Some narrowly worded clauses limit the extent of liability to the extent it arises out of breach of the contract. More widely worded provisions may impose liability for loss arising in any way out of or related to the contract. Since a breach will make you liable to cover damages and legal fees, it is important to assess your ability to manage the defense of any third-party claims. It is best to avoid clauses require you to bear the indemnified party's legal fees as a reimbursable expense, since courts do not allow the recovery of these fees unless the contract specifically provides for it. Every single word of the indemnification clause can be significant and should be vetted thoroughly by a lawyer.
For instance, it is better to agree to defend against "all reasonable claims" as opposed to "all claims." Likewise, it is advisable to cap the amount of liability that can be owed to a mutually agreed upon maximum.
Are Indemnification Provisions Enforceable?
Yes. However, in certain cases, courts will refuse to recognize these provisions. This happens in the case of "broad form" or "no fault" indemnities in which one party is deemed liable regardless of any fault on their part, as it is against public policy. Certain states also disallow punitive damages. Moreover, damages for unforeseeable and improbable outcomes are not recoverable either unless it can be proven that the party in breach had knowledge of the circumstances in question.
Efforts must be made to make the indemnity clause as clear as possible-explicitly stating examples of indemnifiable acts would be ideal, since most ambiguities are resolved in favor of the indemnifying party.
Things To Watch Out for in an Indemnification Clause
- Proportionality: It is wise to accept potential liability only in proportion to your fault. If the indemnity provision is such that your obligation is not limited to claims stemming from your own negligence or fault, you are accepting risks that are not within your control.
- Uninsurable Indemnity: Property damage and bodily harm are usually covered by commercial insurance policies. Any liability that extends beyond these may not be insurable, and you may be stuck paying for them out of pocket.
- Defense Obligations: As an extension to the point above, if the indemnity provision you agreed to is broader than your insurance coverage, be extra careful about the use of the term "defend" in that provision. This can force you to incur legal costs relating to a claim even before fault is established.
A well-balanced indemnifying clause should be broad enough to cover both parties' concerns but narrow enough not have its equitability and enforceability questions. Contact The South Texas Business Lawyers to ensure that your provisions are airtight!
Disclaimer: This article is made available for educational purposes only, to give you general information and a general understanding of the law, not to provide specific legal advice. By using this article, you understand and acknowledge that no attorney-client relationship is formed between you and The South Texas Business Lawyers, nor should any such relationship be implied. This article should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.
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