*AI was used as a collaborative tool to help draft this article, though it was substantially drafted and revised by the author.
Key Takeaways:
- A concise and effective indemnification clause must clearly define who is providing and receiving protection, the specific scope and types of claims covered, and the procedural details for how the indemnity is invoked and managed.
- Indemnity isn’t a “one-size-fits-all” solution; it should be tailored to the specific industry and the actual risk profile of the business relationship.
- Contracts should be readable and understood by the business teams they serve.
One of my favorite mentors used to explain the concept of indemnity to her business clients by using an analogy about a pair of shoes. It went like this.
A lawsuit is filed and someone is going to court. Who is going to step into the pair of shoes that walks into court that day? The person who steps into the shoes is the indemnifying party. An indemnity clause is a negotiation around which party wears the shoes, how much the shoes cost, and how they will get to court.
Over the course of my legal career, I have seen a wide range of indemnification clauses that varied from short and sweet to meandering and complex. Ultimately, the most effective clauses are concise, straightforward, and address three questions: Who, What, and How?
Address the Who, What, and How
An indemnity clause sets clear expectations about the chain of events that are triggered by a third-party lawsuit. Indemnification clauses can be daunting because they address hypothetical, conceptual issues – but they are also grounded in procedural details. At its heart, every indemnity clause is built on three pillars: Who, What, and How. If your clause is missing one of these pillars, it will not be an effective guardrail to help the parties navigate future disputes.
The Who
The “Who” is usually the easiest piece to identify, yet it’s where a lot of over-drafting happens.
The indemnification clause must be clear about who is providing the indemnity (the indemnitor or indemnifying party) and who is being protected (the indemnitee or indemnified party). While it’s tempting to include “affiliates, directors, officers, employees, etc.” in the list of protected parties, keep the clause focused on who actually faces the risk of having the third-party lawsuit brought against them.
In the alternative, if you are providing the indemnity, your goal is to ensure the list of indemnitees isn’t overly broad. In many contracts, indemnification obligations will be mutual. That means your goal in drafting will be to ensure the clause is fair and balanced in either scenario; especially for the contracting party you’re representing. In some contractual relationships you could be either the indemnifying party or the party seeking the indemnity, depending on the business scenario and the type of claim that arises.
The What
The “What” defines the scope of the clause, and the types of claims the indemnifying party is obligated to cover.
In the tech world, the “What” is typically a request to provide an indemnity related to intellectual property infringement claims. But the scope can also expand to include other issues like data breaches, gross negligence, or specific regulatory violations. The art of drafting the indemnity scope is finding the right balance between a clause that is broad enough to provide adequate protection for the types of claims that are likely to arise to a third-party lawsuit against the indemnified parties, and drafting an overbroad clause that can effectively put the indemnifying party on the hook as an insurance company for the indemnified party’s business operations.
The How
Finally, we have the “How.” These clauses often feel dense, but they cover some of the most important parts of the indemnification obligation.
How is the indemnity invoked? Does the protected party have to give notice within twenty-four hours or twenty-four days? Who gets to pick the lawyer? Who gets to decide whether to settle?
If the “How” is vague, the indemnified party runs the risk of spending more time arguing with the indemnifying party about the defense process (and incurring legal fees in the meantime) than actually defending the third-party claim. At a minimum, to minimize this confusion, the indemnifying party should negotiate language that includes prompt notice requirements and clear control-of-defense rights. This ensures that if they’re the party paying the bill for the shoes, they get to pick the appropriate type and brand of shoes.
Focus on Real and Material Business Risks
Now we get to the caps and carve-outs to the limitation of liability clause for indemnity obligations. This is an aspect that legal professionals often spend our time negotiating. The customer typically wants an uncapped carve-out for everything, while the vendor wants it for nothing. Uncapped liability carve-outs are commonly negotiated in connection with a party’s costs incurred in connection with its respective indemnification obligations. What does this mean? The annual fees paid by a customer shouldn’t limit the vendor’s obligation when the cost of shoes and how it gets to court is typically much higher than such fees.
The reality is that the need for specific carve-outs, super-caps, or uncapped liability isn’t a one-size-fits-all solution. The practical need for these types of carve-outs depends on the type of contract, the sensitivity of the data, and the actual industry practices.
If you are a SaaS provider handling non-sensitive metadata, your risk profile is vastly different from a company handling protected health information or credit card numbers. When we negotiate these points, we need to move away from a template and toward an assessment of practical risk. Work closely with your business clients to understand the practical realities of the business relationship, the industry, and the unique risk appetite of the business teams that you support.
Contract Drafting Tips
I have a personal rule: contracts are 95% business. In an effective contract, your clients should be able to read and understand the obligations. This rule even applies to indemnity clauses, which are a portion of the contract that business teams often perceive to be more “legal” in nature than other commercial clauses. If the clause is so complex or dense that it requires a decoder ring, it is not effective.
Clear drafting reduces friction in the business relationship between the parties in the long term. The contract ideally serves as a guardrail for the business teams to effectively navigate the business relationship. It sets expectations at the outset of the relationship, then gets signed and stored via Docusign Intelligent Agreement Management and is rarely referenced. If a claim does arise and the contract gets pulled out of the drawer, then concise, readable terms helps the business teams quickly and efficiently navigate the dispute with the least amount of friction.
Following the “Who, What, How” framework for drafting indemnification clauses will give you confidence any time you have to step into the shoes of indemnification.
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