Indemnification is the action of protecting (someone) by promising to pay for the cost of possible future damage, loss, or injury. In a contract setting, it is a provision where one party promises to pay the costs of potential future liabilities incurred by the other party as a result of some defined set of circumstances that might occur because of the contractual arrangement.
The most common example of an indemnification agreement is an insurance policy. In an insurance policy contract, the insurer agrees to pay for certain liabilities that might be incurred by the insured due to accidents or risks such as property damage to a car in a car accident, injuries to a visitor at a retail store, or defamation caused by an advertisement. Insurance policies are generally complicated and include grants of coverage, exceptions, and exceptions to the exceptions. This is because insurance policies are very careful about what type of conduct or risk is being covered.
Although not as elaborate as insurance policies, scaled down indemnification provisions are common in commercial contracts. Commercial contracts provide the parties the opportunity to allocate the risks the parties have when they engage in the relationship.
Often there is a risk that one of the parties could become liable to a third party because of the work they are agreeing to do. For example, a website designer who uses pictures provided by a customer doesn’t know whether the customer has full rights to use those pictures. The pictures might be copyrighted by some third party. The designer can get a representation from the customer that they have the rights, but even with such a representation, if a third party actually has the rights, that third party can assert a claim of infringement against the designer for using the picture without his or her permission. There is a risk. Accordingly, the designer may require that the customer back up their representation with a promise that if the customer is wrong about their rights such that the designer is involved in a lawsuit for some claimed infringement, the customer will take care of the cost of the lawsuit and any damages. This would be an indemnification provision.
Another example is in construction. A homeowner hires a general contractor (GC) to remodel his or her kitchen. The GC then hires subs. The subs are to be paid by the GC who is paid by the owner. But if the GC fails to pay the subs, the subs have the right to put a mechanic’s lien on the property as security for the work they did and the materials they supplied. The owner may then have defend against the lien, or might decide it is best to pay the subs directly to remove the lien. The owner is well advised to make sure that his or her contract with the GC includes a promise by the GC to take care of any damages the owner has because of the GC’s failure, including any legal fees and costs in defending against a mechanic’s lien.
Important, But There is More
Indemnification provisions are an important tool for the parties to allocate the risk of losses that might arise out of the relationships in the contract. However, indemnification provisions vary and it is extremely important that they be tailored to the situation. Otherwise, they can be overbroad, or uselessly narrow. In addition, indemnification rights are a specific kind of right to get paid for damages incurred and are therefore somewhat narrower than what a party may actually want when the problem arises. We will discuss this more in the next posts regarding defense rights and advance payment.