Suppose you are a repairing company where you have sent your employees to repair an air conditioner at another company. However, during the repair, your employee suffered an injury due to the other company's environment. In this situation, who pays for the compensation for the injury of your employee? If there is an indemnification clause in your contract, your client may be obligated to indemnify the injuries suffered by your employee.
Indemnification clauses can be commonly found in many contracts, especially commercial agreements, but what do they do? Which type of indemnification clause is the most suitable for your business? Here is a guide to everything that you need to know about indemnification clauses in your contract.
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In essence, an indemnity provides that a person agrees to compensate another person if they suffer a loss. It is a provision that allocates risks of the business activities that the parties are involved in and attributes responsibilities for these risks and their subsequent liabilities.
The utility of indemnification clauses is versatile. It allows parties to determine and allocate the risks they are willing to undertake in their commercial transactions.
Most of the indemnification clauses serve as protection from lawsuits for actions and that Indemnitor will bear all legal consequences.
For example, if you are selling your business to another business owner. It is pretty common for the buyer to ask the seller to indemnify for losses arising out of the employee’s lawsuits within 12 months.
It is reasonable protection as the seller would not want to be part of any technically not his or her fault lawsuits. Without the indemnification clause, the new business owner would have already suffered losses before taking over the business.
An obligation to indemnify - may include the obligation to pay for any losses or any pre-paid expenses incurred by the counterparty. Or make any advance payment to the counterparty for its unpaid costs and expenses for any losses, liabilities, claims or causes of actions.
The Indemnitor - The person who takes on the obligation to indemnify. Normally, the Indemnitor will be a party to the underlying transaction or agreement. Before agreeing to be an indemnity, one should consider whether they have sufficient financial resources to cover the potential losses incurred by the counterparty to the contract. If the Indemnitor does not have adequate financial resources to do so, he or she may ask for a third party to be a guarantor to cover the indemnity obligation.
This is a common practice in a loan arrangement or when a student is signing on a new lease. After assessing the party's financial status, the bank or the landlord may request a guarantor before agreeing to sign a lease with the student. The third party undertaking an indemnification obligation or a guarantee will usually sign on a separate document.
The Indemnitee – This is the person who will be receiving the benefits as a result of indemnification. The definition of the indemnitee must be well defined, as it could affect the coverage of damages. Typically, the definition will include all of its employees, members, partners, agents, assigned party, successors, or any other party related to the indemnitee in that business transaction.
This may depend on the needs of the transaction itself. Generally, there are two main consideration in defining the scope of coverage: the subject matter (Covered damage) and the standard of care.
The subject matter (Covered matter) – An indemnification provision would specify the scope of coverage. The following are illustrative examples of covered matters in an indemnification provision:
All damages “arise out of” or “relate to” or “in connection with” ….
Standard of care – delimits the degree of caution and prudence expected from an individual. If the standard of care specified in the indemnification is high (e.g. requirement for willful misconduct or negligence), then not all breaches to the agreement would require the Indemnitor to indemnify the indemnitee.
Typically, there are three levels of standard of care:
No requirement for the standard of care - This will cover any damages arising out of the subject matter defined by the indemnification clause. The person seeking damages would not need to prove that there is any fault on the part of the contract-breaching party. A typical example would be a tenancy. A tenant would be obligated to indemnify the landlord for all damages in connection with the premises during their time of occupancy, regardless of the cause, including the landlord's negligence.
Negligence – If we continue on the example of a student lease, the indemnification clause could specify that a student is liable for all of the damages relating to the premises during their time of occupancy except for any negligence on the part of the landlord. For example, the landlord would be expected to repair the house before taking on new tenants, such as repairing the ceiling. The tenant would not be liable to indemnify the landlord when a weather storm hits and the landlord knowingly failed to repair the ceiling.
This is also frequently used when a patient signs an agreement for receiving medical treatment. Doctors would not be liable for the patients' damages unless they have been proven to be negligent in providing that medical treatment. Hence, what is considered negligent would vary depending on the industry's nature and the services provided.
Gross Negligence – This sets a higher bar than a mere requirement for negligence. This requires the assessment of a fault element. The Indemnitor will only be obligated to indemnify if he or she had the intention to cause harm.
A sample clause:
“The indemnifying party is not obligated to indemnify the Indemnified Party for any claim arising out of or in connection with the Indemnified Party’s own negligence, willful misconduct, or culpable act or omission.”
Cap: It is common to limit the number of damages that party is taking the risk or obligation to indemnify. Otherwise, the Indemnitor may be undertaking an obligation or risk that could potentially be unlimited. Many events that could cause damages are unforeseeable hence it is essential to protect the business from over-indemnifying. Hence, when you are negotiating a contract, it is vital to arrange for an amount reflecting the appropriate risk that your business should be undertaking.
Period: Different contracts require different periods of indemnification. For some contracts, the indemnification period may end simultaneously as the expiry date of the contract. However, many contracts contain an indemnification obligation that lasts beyond the underlying contract itself. These are typically called “survival periods”, as a party may sometimes only claim damages after the contracting period.
It seems like indemnification clauses are effectively doing the same job as insurance. However, are they the same thing? No. Not exactly. Insurance is a policy. It effectively transfers risk from one party. In exchange, there is a charge for payment to transfer that particular risk. The insured party who has paid the money would not need to pay. At the same time, an indemnity clause is simply the process of allocating risks within a contractual relationship, specifying which party would be responsible for unfortunate events arising out of the transaction. Hence, if you have agreed to a particular indemnification clause, you may consult the insurance company to transfer that risk by paying the insurance company.
It is essential to pay extra caution to the contractual language used in the identification clause. You may wish to include illustrative examples that the indemnification clause would cover explicitly. This is useful in limiting your exposure or making sure that the indemnification clause covers the risk you are concerned with. The following are illustrative examples in which you may want to consider including in your indemnification clause:
Non-compliance or illegal activities – Some contracts may explicitly state that any illegal activities would be considered a breach of contract. Hence the Indemnitor would be liable to indemnify for the damages arising out of that illegal activity.
On the other hand, you may also exclude the right of indemnification based on illegal activities. Although an indemnification clause may not necessarily be enforceable when a party seeks to recover damages that are a consequence of their own illegal act, it is still useful to explicitly state it in the indemnification clause. This is the case with criminal offences. You cannot transfer criminal liability through an indemnification clause. An indemnity against criminal liability is generally unenforceable. However, where indemnification seeks to transfer the risk of a criminal charge of strict liability and the party has committed the offence innocently, the indemnification clause might be enforceable.
Exclude future losses or profits - You may wish to limit damages of losses that may be too remote. Exclusion of the business's future losses or profits is frequently used when the indemnification clause operates on a “survival period”.
“Hold harmless” clauses – these clauses require the Indemnitor to make an advance payment for covered damages, even though these payment and costs have not been made. Without a “hold harmless” provision, the indemnifying party will only become responsible after the indemnified party (indemnitee) pays for the covered damages.
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