Indiana Business Law Blog
Three of our recent articles addressed allocating risk with business contracts. In this one, we expand on our earlier articles by focusing on techniques experienced business attorneys use to write better indemnification clauses.
Use Defined Terms to Improve Readability
Let’s start with the following clause setting out the basic indemnification rights and duties in a contract for the sale and purchase of equipment. It consists of one sentence, long and difficult to follow, but typical as indemnification clauses go.
Seller shall indemnify and defend Buyer, Buyer’s Affiliates, and their respective shareholders, members, directors, managers, officers, employees, and other agents
(i) from all lawsuits, claims, causes of action, government or administrative actions, or other legal proceedings; and
(ii) for all losses, damages of any nature (including consequential, incidental, statutory, and punitive damages), costs and expenses (including reasonable attorneys’ fees, legal expenses, and court costs), fines, or penalties,to the extent they are related to or arise from any defect in the Equipment, including any defect (latent or otherwise), in design, material, or manufacturing.
Who indemnifies whom for what?
In a previous article, we suggested keeping that business owners keep that question in mind when analyzing indemnification clauses . There is a similar question for defense obligations, but the answers are almost always the same for both indemnification and defense.
One way to improve our hypothetical indemnification clause is to use defined terms to answer that question. The defined terms can appear in a section of the contract with other defined terms, but if they are not used anywhere else, placing them in the indemnification itself will make the indemnification clause easier to read.
Here is a way to revise the above contract language using four defined terms.
11.01 Seller shall indemnify and defend the Indemnitees for all Losses and from all Claims to the extent the Losses or Claims are related to or arise from any Defect in the Equipment.
11.02 As used in this Section 11:
(a) “Indemnitees” means Buyer, Buyer’s Affiliates, and their respective shareholders, members, directors, managers, officers, employees, and other agents.
(b) “Claims” means all lawsuits, claims, causes of action, government or administrative actions, or other legal proceedings.
(c) “Losses” means all losses, damages of any nature (including consequential, incidental, statutory, and punitive damages), costs and expenses (including reasonable attorneys’ fees, legal expenses, and court costs), fines, or penalties.
(d) “Defect” includes all defects, latent or otherwise, including defects in design, material, or manufacturing.
The revised clause is easier to read and understand because the defined terms make it easier to answer the question, “Who indemnifies whom for what?”
- “Who” is Seller. No new defined term was needed because Seller is the only indemnitor. Sometimes another person, such as the indemnitor’s owners, may assume an indemnification obligation to assure the other party that someone will have the financial wherewithal to keep the indemnitor’s promise. In that case, the other person should be added as a party to the contract for the limited purpose of the indemnification section, and “Seller” should be replaced as the subject of Section 11.01 by a fifth defined term, “Indemnitors,” that includes both Seller and the other person making the promise.
- “Whom” is the Indemnitees.
- “What” is Losses related to or arising Defects.
Some other observations about definitions
These tips apply to all defined terms, not only those affecting indemnification clauses.
- Use defined words that are consistent with their usual definition, enabling the reader to get the general idea without referring to the definitions.
- Shorter contracts are not always better or easier to understand. Despite being longer, the revised clause is easier to read than the original because the operative language itself is simpler and more direct.
Consider persons other than the parties who may incur losses that should be indemnified.
Indemnification clauses can go beyond protecting the immediate contracting parties, extending rights to anyone. Persons most often included are parties related to a party to the contract. In our example, those persons, defined as Indemnitees, are the Buyer’s affiliates and the officers, employees, agents, or subcontractors of either the Buyer or its affiliates.
First-Party versus Third-Party Indemnification
In an earlier article on indemnification clauses, we mentioned the distinction between first-party losses and third-party losses. First-party losses are those incurred directly by a party to the contract. In our example above, the Buyer of the Equipment above may lose sales and profit if the Equipment breaks down. Third-party losses are amounts a party is obligated to pay a third party. For example, our hypothetical Buyer may be owe damages to another person for injury caused by an Equipment malfunction.
It is seldom disputed whether indemnification clauses cover third-party losses. That is the traditional reason for indemnification clauses, and it is indisputable under the language of most business contracts that the parties intend to include third-party losses within the indemnification and defense obligations. On the other hand, there may be a question whether a contract includes indemnification for first-person losses. (Defense obligations are irrelevant for first-person losses.)
To answer that question, the court will attempt to discern the intent of the parties, beginning (and likely ending) with the language of the contract. In the ideal situation, the business contract will address the question expressly, for example by incorporating language into the definition of Losses in our revised example clause.
(c) “Losses” means all losses, damages of any nature (including consequential, incidental, statutory, and punitive damages), costs and expenses (including reasonable attorneys’ fees, legal expenses, and court costs), fines, or penalties, including lost profits or other losses incurred directly by a Buyer Indemnitee and amounts a Buyer Indemnitee may owe a third person.
Attorneys’ Fees for Enforcement
Disputes over indemnification obligations can lead to significant legal expenses for enforcement. In most cases, a party who must sue the other to enforce an indemnification clause will expect to be reimbursed not only for litigation expenses related to the underlying claim but also for litigation expenses incurred in compelling the other party to honor its indemnification and defense obligations. A colloquial term for litigation expenses incurred in enforcing indemnification and defense obligations is “fees on fees.”
What if the contract is silent? Indiana case law is complicated and even seemingly contradictory. Our view is that a party can recover attorneys’ fees and other expenses in enforcing indemnification rights if fees and litigation expenses are included in the underlying indemnification. However, the best practice is to expressly include them. For example, fees on fees can be expressly incorporated into the definition of Losses in our revised example clause.
(c) “Losses” means all losses, damages of any nature, costs, expenses, fines, or penalties (including, without limitation, reasonable attorneys’ fees, legal expenses, court costs, and cost of appellate proceedings), including lost profits or other losses incurred directly by a Buyer Indemnitee and amounts a Buyer Indemnitee may owe a third person and including reasonable attorneys’ fees, legal expenses, and court costs incurred by a B uyer Indemnitee in enforcing a right under this Section 11.
Another, even more direct, way to accomplish the same result is to include a sentence such as:
In the event of a dispute arising from the enforcement of this indemnification provision, the Indemnitor shall reimburse the Buyer Indemnitee for all reasonable attorneys’ fees, court costs, and related expenses incurred in enforcing rights under this Agreement.
Should Indemnification Be the Exclusive Remedy?
When drafting indemnification provisions, parties must decide whether indemnification should serve as the exclusive remedy for claims under the contract. x Making indemnification exclusive can simplify risk allocation by precluding other potential remedies, such as direct breach of contract or tort claims. However, exclusivity may limit the indemnitee’s ability to pursue claims beyond the scope of indemnification. Indemnification should never be the sole remedy unless it includes first-party losses.
This sentence makes our example indemnification clause the sole remedy.
Rights under this Section 11 are the Parties’ sole remedies for any Claims and Losses related to or arising from this Agreement or the performance of their obligations hereunder.
This one makes it the nonexclusive remedy:
Notwithstanding anything to the contrary in this Section 11, the Parties retain all other rights and remedies they may have under law or equity for Claims or Losses related to or arising from this Agreement or the performance of their obligations hereunder.
Baskets and Caps: Limiting Liability
Indemnification clauses often include mechanisms to limit the indemnitor’s liability, such as “baskets” and “caps.” These tools provide a structured way to manage exposure while fostering fair allocation of risks.
A “basket” is a threshold amount that must be reached before indemnification obligations are triggered. For example, if the contract includes a $10,000 basket, the indemnitor is only liable for claims exceeding that amount. Baskets ensure the indemnitor is not burdened with small, routine claims.
A “cap” is the maximum amount the indemnitor is liable to pay under the indemnification provision. Caps protect the indemnitor from unlimited exposure and make liabilities more predictable.
An indemnification contract can include baskets, or caps, or both. This clause includes both:
No person may assert a right of indemnification under this section unless that person’s Losses exceed, or are reasonably expected to exceed, $5000 in the aggregate. The indemnification and defense obligations of each Party under this Section 11 are limited to $100,000 in the aggregate.
Variations on the theme are almost endless, all to be considered in the judgment of an experienced business lawyer.
Conclusion
Indemnification clauses are a cornerstone of risk management in business contracts. They deserve careful drafting and close attention from both the business lawyer and the business owner.
A well-drafted indemnification clause can prevent disputes, streamline enforcement, and protect your business. For legal guidance on drafting or reviewing indemnification provisions, please contact our business attorneys who understand the specifics details of Indiana law.