Indemnification in commercial agreements – what is it and should you be concerned about it?

Most commercial contracts contain what is called an “indemnification” provision. Indemnification is an obligation to be responsible for whatever losses another party might suffer if certain events occur. Such losses might include legal fees to defend against a third party claim and damages awarded to the third party as a result of the claim.

Note that this post speaks about commercial contract indemnity, not indemnification in merger and acquisition or corporate finance transactions, which serve a different function.

The obligation to "defend and indemnify" is usually not limited to any certain dollar amount – the party providing the indemnification (the indemnifying party) will usually have to step in, take over the defense of the claim, and pay all damages that the party receiving the indemnity (the indemnified party) incurs as a result of the claim. Indemnification clauses normally provide that the indemnifying party be responsible for not only the damages that are paid to the third party, but also attorneys’ fees that the indemnified party had to spend to defend itself against the third party.

Scope of Indemnification

The best way to for a company to protect itself regarding indemnification obligations is to limit the scope of the indemnification. For example:

Limit the indemnification so it only applies to third party claims. Any claims by the parties to the contract should be covered by the contract itself, and not a separate indemnification obligation. In other words, the indemnification should be about making the indemnified party “whole” when it is sued by someone who is not a party to the contract and not about a direct claim against the other party to the contract.
Limit indemnification to death, personal injury, or tangible property damage that results from negligence of the indemnifying party
Do not indemnify for "breach of warranty" or "breach of contract" or "all acts and omissions"

Intellectual Property Indemnification

If a startup company is licensing its intellectual property to another company, the licensee will likely require that the license agreement include an indemnity for intellectual property infringement claims. As the indemnifying party, consider the following:

Was the technology developed by the indemnifying party so the indemnifying party had control over the development? If yes, the indemnifying party may be more willing to grant the indemnification.
Does the licensed technology include technology from a third party? If yes, did the third party provide an intellectual property indemnification that is as broad as what the indemnifying party is being asked to provide to the licensee? If not, the indemnifying party may end up with liability for a third party's infringement.
Is it appropriate to limit the indemnification to United States patents or trade secrets protectable in the United States?
Will the licensee only be using the technology internally, or will the licensee be including the technology in a product which is further distributed? The risk of an infringement claim (and the potential damages) may increase if the technology is further distributed as part of another product.

Companies may indicate that it is too expensive or not practical to complete a review of all relevant patents and other intellectual property to verify there are no issues, and thus they should not be required to provide the indemnification. This argument is usually not successful to completely avoid indemnification obligations. Someone has to take the risk of infringement (at least to a certain extent), and most often that is the licensor and not the licensee. One exception is technology licensed from universities. A university will generally not agree to any indemnification obligations. A startup company based on technology licensed from a university will usually be responsible for completing its own due diligence to make sure there are not any potential infringement issues related to the technology. Another exception is with intellectual property that was not developed by the licensor, but is merely owned by them now. In those cases, the technology sometimes is licensed on an “as is” basis and no intellectual property indemnification is given. In such a “quit claim” or “as is” license, the licensee is only protected from being sued by the licensor for infringement and it has no protection against third party claims.

Additional Considerations

Do not rely on making an indemnification provision reciprocal as a way to solve concerns with language. If one party to the agreement is selling products, and the only obligation of the other party is to pay for the products, having a very broad mutual indemnity for breach of contract strongly favors the buyer of the products.
Realize that indemnifications are only as good as the assets available to back up the indemnification. If a company provides a very broad indemnification, but is a startup company with limited resources, a broad indemnification is not very useful.
Indemnification obligations should not be limited to insurance amounts. Insurance requirements are another way to limit risk, and may help a company satisfy its indemnification obligations, but the two provisions should not be dependent on each other.
Consider whether the licensee should provide an indemnification to the licensor. If the licensee will be incorporating licensed software into another product and widely distributing the combined product, the combination may result in an infringement claim. The licensor of the original technology should not be responsible for the infringement claim based on the combination.
Add language regarding procedures to follow if there is an indemnification claim. Although this sounds like more "boilerplate", the indemnifying party will want to control the defense or settlement of claims, and will also want the indemnifying party to cooperate in such defense or settlement.

Indemnification is often one of the last issues to resolve in contract negotiations. However, it is important to take the time to think through each party's obligations under the contract, and consider what type of indemnification is appropriate based on the deal. A broad indemnification that may have been reasonable for a startup company to provide will not be viewed favorably when the applicable contract is assigned to an acquiring company that has more assets at risk if there is an indemnification claim.

In a future article, we will discuss “limitations of liability” and how that concept can impact the indemnification obligations of the parties.