Good contracts keep businesses on track. They help manage expectations and allocate responsibilities. But what happens if something goes terribly wrong and one party’s actions lead to financial losses, a third-party claim or a lawsuit?
An indemnification clause can help answer that question. Indemnification clauses are contract provisions that require one party to compensate or protect the other against specific losses.
How indemnification works
Because the language can shift a lot of financial risk from one party to the other, it has to be carefully negotiated and written. In general, when there is an indemnification clause, the party providing indemnification (the indemnitor) could be legally obligated to pay the other party (the indemnitee) for losses related to:
- Legal fees and/or defense costs
- Settlements or judgments
- Property damage
- Personal injury claims
- Regulatory fines or penalties
- Claims for infringement of intellectual property
Essentially, any loss suffered by the indemnitee due to the indemnitor’s actions (or inaction) can potentially be subject to reimbursement requirements.
For example, imagine that a retailer hires a contractor to install shelving in its store – but they do it improperly. One of the shelves falls, injuring a customer. The injured customer sues the retailer. If the retailer has a properly drafted indemnification clause, the contractor may be required to cover the retailer’s defense costs and any settlement or judgment ultimately paid.
Indemnification clauses vary considerably. Some apply only to third-party claims, such as lawsuits filed by customers, employees or vendors. Others may cover direct losses between the contracting parties. A clause might apply to negligence, misconduct, a contractual breach or a violation of the law.
It’s important to remember that a broadly written indemnification clause can leave your business exposed to risks that you cannot properly anticipate or insure against. In some cases, you could be asked to indemnify the other party for their negligence. Insurance will not cover every contractual obligation, particularly when a business agrees to accept liability beyond what the law would otherwise require.
It’s always wisest to have your contracts drafted and reviewed by an experienced legal professional.