Understanding the Indemnification Clause in Contracts: A Comprehensive Guide

Risks are inherent in any transaction – but what happens when loss is actually suffered? Who bears the loss? Inserting an indemnification clause into your contract is important to prepare for these circumstances as it can transfer risk between the contracting parties to obligate one party to compensate for losses/damages suffered by the other. Here is your guide to everything you need to know about indemnification clauses. 

What is an indemnification clause? 

An indemnity provides that an individual agrees to compensate another person if they suffer a loss. It is a provision that allocates risks of the business activities that the parties may be subject to and attributes responsibilities for these risks and their liabilities.

Why are indemnification clauses important? 

Indemnification clauses are important because of how versatile they are. They allow parties to determine and allocate the risks depending on what they are willing to undertake in their commercial transactions.

Indemnification clauses can serve as a form of protection from lawsuits actions by guaranteeing that the Indemnitor will bear the legal consequences.

An example would be where you sell your business to another business owner. It would be common in this scenario for the buyer to ask the seller to indemnify for losses arising out of the employee’s lawsuits within 12 months.

Without the indemnification clause, the new business owner would suffer losses before taking over the business.

What are the essential elements of an indemnification clause?

An obligation to indemnify

This may include the obligation to pay for any losses or any pre-paid expenses incurred by the counterparty. It might also involve advance payments to the counterparty for unpaid costs and expenses for any losses, liabilities, claims or causes of action.

The Indemnitor

This refers to the person who undertakes the obligation to indemnify. Normally, the Indemnitor will be a party to the underlying transaction or agreement. Before agreeing to the indemnity, one should consider whether they have sufficient financial resources to cover the potential losses incurred by the counterparty to the contract. If they do not have adequate financial resources to do so, he or they may ask for a third party to be a guarantor to cover the indemnity obligation.

This is common practice for loan arrangements or when students sign a new lease. After assessing the party's financial status, the bank or the landlord will request a guarantor before agreeing to sign a lease with the student. The third-party undertaking an indemnification obligation, or a guarantee will then sign on a separate document.

The Indemnitee

This refers to the person who receives the benefits after indemnification. The indemnitee must be well defined, as this can affect the coverage of damages. Typically, the definition will include all its employees, members, partners, agents, assigned party, successors, or any other party related to the indemnitee in the business transaction.

What is the scope of coverage? 

This depends on the requirements of the transaction itself. Generally, there are two considerations in defining the scope of coverage: the subject matter (covered damage) and the standard of care.

The subject matter (covered damage)

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”... 

• a specific place

• a business transaction

• a group of people

• breach of this agreement or contractor

Standard of care

This would delineate 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 wilful 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 covers all 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. The 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

Going back to the example of a student lease, in those circumstances, an indemnification clause could specify that a student is liable for all the damages relating to the premises during occupancy except for any negligence from the landlord. This would mean that 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, say, a weather storm hits, and the landlord knowingly fails to repair the ceiling.

This is also commonly used when a patient signs an agreement for medical treatment. Doctors would not be liable for the patients' damages unless they have been proven to be negligent in providing that medical treatment. What is considered negligent depends on the industry's nature and the services provided.

Gross Negligence

This sets a higher bar than mere negligence as it requires the assessment of the fault element. The Indemnitor will only be obligated to indemnify if he or she had the intention to cause harm. A sample clause would look something like the following:

“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 negligence, willful misconduct, or culpable act or omission.”

Are there any other limitations? 

Cap

It is common to limit the damages which the party takes the risk or obligation to indemnify, otherwise, the Indemnitor may be undertaking an obligation or risk that could be unlimited. Many events that could cause damages are unforeseeable, making it essential to protect the business from over-indemnifying. When negotiating a contract, it is vital that you arrange for an amount reflecting the appropriate risk that your business should be undertaking.

Period

Different contracts require varying periods of indemnification. For some contracts, the indemnification period may end when the contract expires. However, many contracts contain an indemnification obligation that lasts beyond the contract itself. This is termed a “survival period”, as a party may sometimes only claim damages after the contracting period.

Indemnification vs Insurance: What's the difference? 

It might seem like indemnification clauses are effectively the same as insurance. This is not true, as insurance is a policy. It transfers risk from one party in exchange for a payment. An indemnity clause on the other hand allocates risks within a contractual relationship by changing the rights of the parties, specifying which party would be responsible for certain adverse consequences arising out of the transaction. If you have agreed to a particular indemnification clause, you can consult your insurance company to transfer that risk by paying the insurance company.

How can I protect my company? 

It is essential to pay attention 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 that you may want to consider including in your indemnification clause:

Non-compliance or illegal activities

Some contracts may explicitly state that any illegal activities are 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 for illegal activities. Although an indemnification clause may not necessarily be enforceable when a party seeks to recover damages that are a consequence of their illegal act, it is still useful to explicitly state it in the indemnification clause. This is certainly the case with criminal offences, as 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 for losses that are 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 the 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.

Summary 

• Indemnification clauses are important provisions for allocating risks arising out of a contract. Identification clauses are different from insurances. Insurance transfers the risk in exchange for payment.

• The wording of the indemnification clause generally differs on two levels: subject matter (covered damages) and the standard of care (level of fault)

• As a result, it is useful to lay out foreseeable events that would cause damages in the indemnification clause.

Please note that this is a general summary of the position under common law and does not constitute legal advice. As the laws of each jurisdiction may be different, you may wish to consult your lawyer.