It is no secret that indemnification provisions in contracts can be difficult to read; the goal of many appears to be sleep or confusion.  One unfortunate result of the opacity is that these provisions are often treated as “boilerplate” and do not receive the attention they deserve.  Failure to pay proper attention to indemnification provisions can lead to painful surprises down the road.  On the other hand, a modest amount of forethought can address some of the more common defects seen in indemnification provisions.

At the outset, I note that the focus here is on commercial contracts, as opposed to M&A transactions.  In M&A transactions, indemnities typically include coverage for direct claims on behalf of the buyer and are only effective following closing.  M&A indemnities effectively provide for a purchase price adjustment if the seller turns out to have breached its representations, warranties or covenants.  In commercial contracts, indemnities serve a different role -- more in line with the traditional concept of indemnification that most lawyers are taught in their contracts class in law school.  Namely, if Party A and Party B enter into a contract, the indemnities typically (but as we shall see, not always) provide that if Party A causes harm to a third party, Party A agrees to hold Party B harmless from any claims that third parties might bring. There are various permutations of this basic concept, leading to serious consequences if the provision is not properly structured.

Set forth below is a sample indemnification clause that seems comprehensive and coherent, but which contains some subtle infirmities.

Party A agrees to indemnify, defend and hold harmless Party B and its officers, directors, employees, agents, affiliates, parent, subsidiaries, permitted successors and assigns from and against any and all claims, counterclaims, suits, demands, actions, causes of action, damages, penalties, injuries, setoffs, liens, attachments, judgments, debts, costs, expenses (including without limitation attorneys' fees and expenses) or other liabilities of every character whatsoever (collectively, "Liabilities") for property damage, bodily injury, sickness, and/or disease, including death, or for economic or environmental injury or damages sustained by any person or entity arising out of: (1) the negligent acts, omissions, negligence or willful misconduct of Party A in the performance of its obligations pursuant to this Agreement; (2) any misrepresentation made by Party A in this Agreement; (3) any breach of this Agreement by Party A; or (4) the failure of Party A to comply with, and any liabilities arising under, any Applicable Law.  For the sake of clarity, the Parties agree that consequential damages suffered by a third party which are an element of loss subject to indemnification hereunder shall be considered direct damages hereunder.

Inadvertent Waivers of Comparative Negligence Regime.

Most parties to a contract likely expect that if they are going to be held liable for wrongdoing, they will only be held liable for their “share” of the problem.  Indemnification language is often imprecise about this, with the result that claims are possible for coverage of all damages even when both the claiming party and the indemnifying party share responsibility for the problem. Our example above contemplates various triggers for indemnification liability but does not expressly state anywhere that Party A is only to be held liable on the basis of fault.  As a result, it is possible that Party A might be 60% responsible for the harm and yet have to pay for 100% of the losses.  Note that, even if the triggering event is negligence, and no breach of contract has occurred, this language would still arguably hold Party A 100% liable when it is 60% at fault, unless there is a reciprocal provision under which Party A can make an indemnification claim against Party B.  Many indemnification clauses address this problem by including language specifying that the indemnity covers losses “to the extent” caused by or resulting from the actions of the indemnifying party.  This is certainly helpful, but a more explicit statement of the intent of the parties can avoid any doubt on the issue.  Here is an example:

If both Party B and Party A are negligent or otherwise at fault or strictly liable without fault, then the obligations of indemnification under this Section shall continue, but Party A shall indemnify Party B only for the percentage of responsibility for the damage or injuries attributable to Party A.

Coverage of Direct Claims.

One area that often creeps into the indemnity language is where direct claims between the parties become subject to indemnification.  As noted above, this is a common approach in M&A transactions for post-closing claims, but in the context of commercial contracts establishing an ongoing relationship between the parties, it arguably is not helpful. In our example above, the problematic language is the phrase "sustained by any person or entity." The inclusion of this language means that in addition to covering claims by third parties, Party B can bring an indemnification claim for direct damages from breach of the agreement. The use of this approach provides duplicative coverage for events of default, as most any commercial contract (including the one from which this excerpt was taken) will contain detailed provisions on defaults and remedies, and these provisions presumably should control when the issue is damages suffered by Party B due to Party A’s default.  It is possible that the end result is the same in any case, but it is also possible that Party B is more likely to bring an indemnity claim (which could be made without having to allege that Party A is in default) than sue for breach.  A fatal flaw?  No, but having duplicative remedial schemes is not the most coherent approach; and it can lead to unintended consequences if the indemnity provisions turn out to have a different scope than the other breach and remedy provisions in the contract.

Backdoor to Coverage of Consequential Damages.

Most commercial contracts include broad waivers of consequential damage claims. That said, one of the more common “carve outs” to these waivers involves indemnification, and our example above includes such typical language for such a carve out. The point being made by this language is actually a good one -- namely that if Party A does something wrong, and a third party (lets refer to them as Party C) sues Party B as a result, Party B should not be responsible for the resulting claim. After all, Party B had nothing to do with the situation so why should Party B bear any responsibility? This is a quite valid viewpoint for Party B to hold, but it presupposes that Party B was not in a position to influence the outcome of Party C’s claim against Party B.  For example, if Party C’s claim for consequential damages is based upon breach of contract, as opposed to tort, then it would appear that Party B was in a position to negotiate a waiver of consequential damages with Party C.  In such a circumstance, it can be argued that Party B should be responsible for the consequential damage element of Party C’s claim, given that consequential damages are routinely waived by contracting parties (and Party A would presumably not expect an opposite result).  Set forth below is sample language that accomplishes such a result.

The term “Liabilities” as used in this Section (i) shall not include consequential, incidental, indirect, punitive or special damages of any kind that are payable to third party customers or service providers of Party B, and (ii) shall not include any supply replacement costs, cover damages or similar liabilities that are payable to a party’s customer(s) because of such Party B’s failure to deliver its products or services to its customers.

Note that clause (ii) in the foregoing language is actually addressing the coverage of direct claims problem discussed above -- namely that direct claims by Party B that are really seeking coverage for “cost of cover” or similar damages suffered by Party B’s third party customers are not subject to indemnification at all.  Whether there is coverage under the defaults and remedies section for such claims is another matter, but presumably should also be addressed directly (and it may be that, depending on the nature of the relationship between Party A and Party B, such damages would, or would not, be recoverable).

Employee Coverage Beyond Workers’ Comp Limits.

Workers’ compensation statutes provide insurance coverage for employees who are injured on the job, in exchange for mandatory relinquishment of the employee’s right to sue his or her employer for negligence. But what happens when, for example, an employee of Party A is injured on the job at Party B’s facility, in a circumstance where Party A was 75% at fault and Party B was 25% at fault?  Let’s say the employee is entitled to a workers’ compensation payout of $100,000, but also successfully sues Party B for negligence and wins an award of $1,000,000.   One might expect (and rightfully so) that Party A should be responsible for $750,000 of this amount.  In order to make it absolutely clear, however, that any immunity Party A might have between itself and its own employee is not effective as regards the indemnification claim by Party B, some additional language in the indemnity clause is helpful. Here is an example:

Each of the Parties hereby specifically and expressly agrees that with respect to any and all claims against an indemnified person by any representative of an indemnifying party, any indemnification available hereunder shall not be limited by reason of any immunity to which such indemnifying party may be entitled under any workers compensation and/or industrial insurance acts, disability benefit acts, or other employee benefits acts and any limitation on the amount or type of damages, compensation, or benefits payable by or for the indemnifying party to such representative with respect to any such claim. For the sake of clarity, the indemnifying party’s waiver of immunity by the provisions of this section extends only to indemnification claims against the indemnifying party by or on behalf of the indemnified person under or pursuant to this agreement, and does not apply to any claims made by the indemnifying party’s representatives directly against the indemnifying party.

In the example given above, the foregoing language would preserve Party A’s rights to limit coverage as between itself and its own employee to the workers’ compensation recovery amount of $100,000, but would nonetheless require Party A to bear its fair share of the ultimate recovery won by Party A’s employee.

Putting it all together, set forth below is a revised sample of our indemnification clause, highlighting the changes made in order to avoid the various problems discussed in this article.

Party A agrees to indemnify, defend and hold harmless Party B and its officers, directors, employees, agents, affiliates, parent, subsidiaries, permitted successors and assigns from and against any and all claims, counterclaims, suits, demands, actions, causes of action, damages, penalties, injuries, setoffs, liens, attachments, judgments, debts, costs, expenses (including without limitation attorneys' fees and expenses) or other liabilities of every character whatsoever (collectively, "Liabilities") for property damage, bodily injury, sickness, and/or disease, including death, or for economic or environmental injury or damages sustained by third parties, to the extent arising out of: (1) the negligent acts, omissions, negligence or willful misconduct of Party A in the performance of its obligations pursuant to this Agreement; (2) any misrepresentation made by Party A in this Agreement; (3) any breach of this Agreement by Party A; or (4) the failure of Party A to comply with, and any liabilities arising under, any Applicable Law.  If both Party B and Party A are negligent or otherwise at fault or strictly liable without fault, then the obligations of indemnification under this Section shall continue, but Party A shall indemnify Party B only for the percentage of responsibility for the damage or injuries attributable to Party A. For the sake of clarity, the Parties agree that consequential damages suffered by a third party which are an element of loss subject to indemnification hereunder shall be considered direct damages hereunder; provided, however, that the term “Liabilities” as used in this Section (i) shall not include consequential, incidental, indirect, punitive or special damages of any kind that are payable to third party customers or service providers of Party B, and (ii) shall not include any supply replacement costs, cover damages or similar liabilities that are payable to a party’s customer(s) because of such Party B’s failure to deliver its products or services to its customers.

Each of the Parties hereby specifically and expressly agrees that with respect to any and all claims against an indemnified person by any representative of an indemnifying party, any indemnification available hereunder shall not be limited by reason of any immunity to which such indemnifying party may be entitled under any workers compensation and/or industrial insurance acts, disability benefit acts, or other employee benefits acts and any limitation on the amount or type of damages, compensation, or benefits payable by or for the indemnifying party to such representative with respect to any such claim.  For the sake of clarity, the indemnifying party’s waiver of immunity by the provisions of this section extends only to indemnification claims against the indemnifying party by or on behalf of the indemnified person under or pursuant to this agreement, and does not apply to any claims made by the indemnifying party’s representatives directly against the indemnifying party.

The foregoing examples highlight some of the pitfalls that await contracting parties who are less than careful when it comes to indemnification language. Although it may be difficult at times, careful lawyers should invest some time in the indemnity provisions of their contracts to ensure that they function as intended and consistently with the other provisions of the agreement.