Most business transaction agreements include some form of indemnification. Simply, contractual indemnification is a risk shifting mechanism governing which party will have liability if a problem arises under the contract. A party agreeing to provide indemnification assumes future liability and should seek to narrow the scope of the provision to reflect its obligations under the contract.
By contrast, the indemnified party will seek an indemnification provision that provides the broadest protection from future liability. Despite the fact that it can greatly influence the economic result of a transaction, the indemnification provision is generally not addressed in preliminary negotiations between business people, but is instead left to the lawyers to hammer out.
As you will see below, a few words can greatly impact the scope of the indemnification provision. This post provides a checklist and overview of some of the noteworthy provisions that in-house counsel should consider in drafting and negotiating indemnification provisions.
1. Trigger: Does the agreement clearly specify the event that triggers the indemnification right? This may include breaches of representations or warranties, covenants or other provisions in the agreement. The agreement may also provide indemnification for specific loss events (e.g., indemnification for liabilities associated with a landfill on property or pending or threatened litigation or regulatory investigations). The indemnification provision also may be triggered by a party’s negligence (simple or gross), misconduct (simple or gross) or fraud.
2. Indemnifying Party: Who is the indemnifying party? If the primary party to the contract is a company, do its principals have any individual liability and, if so, are they signatories to the agreement? If there is more than one party agreeing to provide indemnification, are their obligations proportional or joint and several? A party concerned about the credit worthiness of an indemnifying party may also request that a more financially stable party be made a party to the agreement for purposes of indemnification or guarantee the obligations of the indemnifying party.
3. Indemnified Party: Is the indemnity right limited to the party that is the signatory to the agreement or does it extend to affiliates, officers, directors and employees of the indemnified party?
4. Definition of Losses: How are losses defined for purposes of calculating indemnifiable amounts? The parties should consider whether the definition of losses will include punitive and consequential damages, fines and penalties, attorney’s fees, travel expenses and other expenses incurred in connection with a loss. 5. Survival Period: Does the agreement specify the period during which the indemnified party may assert indemnification claims? The parties may consider whether indemnification resulting from certain events (e.g. breaches of representations, warranties or covenants relating to taxes or fraud) should survive indefinitely or until the applicable statute of limitations.
6. Limitations, Baskets and Caps: The indemnifying party may seek a provision that there be a minimum dollar amount of losses suffered before the indemnification right is triggered. This threshold amount is commonly referred to as a “basket.” The basket can operate as either a true deductible such that losses are not paid until all claims exceed the basket amount or a “tipping basket” where all claims back to the first dollar are paid after the basket amount is exceeded.
The agreement may also cap the liability of the indemnifying party so that the indemnified party will not recover money after a certain amount of maximum losses. The parties also can agree to exclude certain losses from the cap or the basket.
7. Mechanics of Indemnification: The agreement also should specify the mechanics for asserting an indemnification claim and whether the indemnifying party has the right to control the defense of an action brought by a third party.
Indemnification provisions vary greatly from agreement to agreement and this post does not attempt to cover all of the various issues that are negotiated. As you can see, however, there are many ways to either narrow or broaden the scope of an indemnification provision and each directly impacts the respective liability of the parties.
Attorneys must be mindful of these issues and the importance of the indemnification provision. It also is advisable that you discuss the indemnification provision with your client and make certain they are comfortable with how it may impact their future liability.