Indemnification – the “I” word.

Indemnification – the “I” word.

We all know indemnification provisions when we see them – those long, complex provisions that seek to allocate risk among parties to a contract.  We have a general appreciation for the indemnification concept – shifting responsibility for a loss from one person to another and compensating someone for a loss already sustained.  But a general appreciation for a concept doesn’t help us much when it comes time to read, interpret and negotiate the details of these complex and often poorly drafted provisions.  If we are going to do a better job of managing our contractual risks then we need to understand why these provisions seem so much more difficult to deal with than other aspects of most contracts.

Think about your own experiences reading contracts.  Most contracts tend to follow a similar form.  The first few provisions are usually commercial in nature – the scope of work, the schedule, the compensation – all commercial terms generally written in plain English.  Then you get to the liability related provisions – the standard of care and warranty, the insurance requirements, maybe a consequential damages disclaimer or a limitation of liability – again not too bad to read and understand, especially with the help of your risk manager or broker on insurance questions.  But somewhere in the liability provision mix is the indemnification provision.  That is the one that gives us all concern.  We just see the provision title “indemnification” or the word “indemnify” and we know that there is a good chance that this provision is going to be a problem.  All the other issues we can deal with fairly effectively.  But if we have a problem with the indemnification provision we know at best it will cause delay (a deal killer in itself) or at worst it could kill our deal directly.

Why do we have this reaction?  What makes indemnification provisions seem more difficult to read and interpret than the rest of the contract? 

Unlike most of the rest of the contract, indemnification provisions are not written in what you could call “plain English”.  These provisions tend to include long, complex sentences and are full of exceptions, exclusions, limitations, and references to other provisions found elsewhere in the document.  They tend to contain more “legalese” – words that you may have seen before but are not part of most people’s everyday vocabulary.  And most important, these provisions are often not well drafted.  Think about how easy it is for someone to go online, find a provision titled indemnification and paste it into their contract form.  Often these provisions are flawed from the start or evolve into edited versions that lack no relationship to the intent of the original drafter.  In my practice I find that a large percentage – not a majority, but somewhere near one-third of all indemnification provisions are nearly incomprehensible.  That fact is a key driver of the uneasy feeling we have when we start to read these provisions.  We know based on our own experience that maybe one in three provisions will have a real problem that will have to be fixed before we can close our deal.

So understanding a bit about why we feel a higher level of apprehension when we reach the indemnification provision in the contract – how can we move forward?  How can we raise our game and close our deals without putting our company at increased risk?  By focusing on three key questions we can quickly improve our fluency with these provisions.

Key Question #1 – Who are the parties?

It is important to take a minute or two and make sure you understand who is who … who is taking on a responsibility … who is indemnifying who?

Keep in mind the words used to identify the parties in the indemnification provision may or may not match those defined in the preamble of the contract or elsewhere in the contract document.  The parties could be identified by their company names or by defined titles such as Contractor and Company.  It could just as easily be Owner and Consultant; Contractor and Subcontractor; Indemnitee and Indemnitor; or Promisee and Promisor.  The key is to understand who is who at the start.  If you are unclear on this basic question then reading and interpreting the rest of the provision will be confusing at best.

Once we understand how each party is designated in the text of the provision we can identify which party who is taking on the responsibility to indemnify the other.  If you are a party taking on a responsibility then caution is the order of the day.  Regardless of whether the provision is unilateral or mutual (reciprocal) it is essential to understand whether you are being asked to take on a responsibility to indemnify.

Key Question #2– What risks are being assumed or transferred?

Now that we understand who is who, and who is indemnifying who, we can move forward to finding the risks being assumed or transferred.  Typically, one party will be indemnifying the other “against all suits, claims or liability” related to certain specified risks such as “bodily injury, death or property damage”, “breach of contract” and/or “violations of applicable law”.  This step involves spotting the nature of the risks being assumed or transferred so they can be assessed in light of your proposed transaction.  Some risks will represent higher levels of exposure than others.

Once the risks are identified we need to find the answers to Key Question #3.

Key Question #3 – How are the risks allocated?

In this step I focus on finding what is sometimes called the “trigger” of the indemnification obligation.  I look for language like: “to the extent, resulting from”; “arising out of”; “in connected with”; or some combination or variation of these words.  This will be important in assessing the nature of the allocation of the risks being assumed.  For example, we might see that one party agrees to indemnify the other “to the extent” of its negligence or willful misconduct in the performance of certain services, and/or for its failure to comply with the terms and conditions of the agreement.

With this approach, in just a few minutes, we were able to parse a complex provision and check some key issues – who are the parties, what are the risks and how are they allocated?  Using these steps you have a simple way to ask questions, enter into a productive dialog with your management and counsel, or the representatives of the other party, and get your deal done.

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