Indemnification versus Defense Obligations

Indemnification is the obligation to pay another for a future liability that might arise. When included in a commercial contract, this usually includes coverage of liability in the form of actual damages or losses such as having to pay a third party. In addition, such provisions often include coverage for liability in the form of defense costs, i.e., the cost of dealing with a third party claim even if there is no ultimate liability to the third party. Notably, in some jurisdictions, attorney fees are not covered unless the provision explicitly states that they are.

Defense Different from Indemnification

It is important to realize that the duty to indemnify for defense costs is not the same as a duty to defend. A duty to defend is different and requires that a party step-up to actually defend the other party from the claim being made. This is taking action in defense of the other party when a third party claim comes up such as opposing the claim, negotiating to resolve the claim, and if necessary, mounting a legal defense in court if a lawsuit is filed, or in arbitration if that is the selected dispute resolution forum.

Insurance Example

Again, insurance policies are a good example. Insurance policies not only provide that the insurer will pay for a covered loss, they also provide that the insurer will defend the insured. This means that the insurer will step in to defend the insured from the claim being made. When the insurance company is notified of the claim, they often try to resolve the matter without litigation, but if this does not work, they hire an attorney to represent the insured in the lawsuit.

How Defense Rights Work

Defense rights often compliment indemnification obligations and can be very valuable. However, these rights pose some different questions. Initially, the idea is that the party who will eventually be obligated to pay the losses or damages incurred has a strong incentive to participate in how the claim is handled before any such liability is determined. That party will want to make sure that the defense is mounted in such a way as to reduce the liability, take advantage of legitimate defenses, and to reduce unnecessary costs of the defense—especially if that party will ultimately be responsible for paying those costs of defense.

Differing Interests and Incentives

This works particularly well when the party obligated to provide the defense is also implicated in the claim. That is, the conduct or activities of that obligated party are an integral part of the situation that gives rise to the claim. In such situations, the obligated party may also have a claim against it, have its own defenses that help with opposing the claim, and the parties are essentially on the same team already so that there is a lot of value to being united in the defense of the claims being made by the third party.

On the flip side, the party obligated to provide a defense may not always have the same incentives to defend as the party who is entitled to the defense. When the obligated party has less risk, or is not named, that party may only be concerned with minimizing the total cost of the process. This can mean that it may not be as concerned about proving the defendant’s innocence as it is with keeping its overall expenditures down. Meanwhile, the party entitled to a defense may be very concerned about its reputation and prefer to fight the claims, even if this might increase the total cost of the process.

The Case for More Specific Terms

Other important factors also need to be addressed with defense rights that relate to the incentives and interests of the parties if a claim is brought. While simply including a defense right may be appropriate, a very simple statement in a provision granting defense rights does not state who selects the counsel, what strategy will be employed, who can approve of a settlement, or whether the party receiving the defense has any right to have a say in the defense. It is often appropriate to include language that explicitly states how counsel will be selected, who manages the defense, and whether a settlement can be entered. Another issue when a party has to provide notice to the party obligated to provide a defense that there is a claim that triggers the obligation. A late notice can be prejudicial to the ability of the defending party to mount an effective defense.

Conclusion

Indemnification provisions provide a basic level of rights by giving a party the obligation to pay for losses that another party may incur because of engaging in the contract. Those rights may include coverage for defense costs, but this is not the same as having a right to require that someone mount a defense for you if that dreaded claim arises.

Both indemnification and defense rights look to the practical reality of what is going to happen if such a claim comes up. As a result, it is important to consider and forecast what the parties really want to have happen. Does the party want to be defended as well as indemnified, or just indemnified? Does the party want to control the defense or have a say in who the counsel will be?

While these issues are important, there is another concern that is practically very important – the question of timing. We will discuss this in the next post.

Leave a Reply

Your email address will not be published. Required fields are marked *