For many reasons, one of the most contentious terms in any contract negotiation tends to be an indemnity clause. First, it’s an explicit definition of liability once fault is determined, and may even impose obligations before any formal determination of fault. Second, the liability impositions may have a practically unlimited cap. Finally, many people have a poor understanding of the meaning and attendant consideration of the technical terms involved: indemnify, hold harmless, and defend.
The last item needs to be settled before the other two can be meaningfully approached. People often incorrectly read the three terms together as a single concept but they have very distinct meanings.
- Indemnification is the practice of guaranteeing a third party claim against your counterparty. Imagine that you have a contract with a staffing agency to supply temporary staff working on your property, and in the course of their assigned duties, one of those temps causes a third party to be injured. The injured third party sues you and the staffing agency and secures compensation for personal injuries. Both you and the vendor have financial liability in some proportion as a result, however your contract required the staffing agency to indemnify you for any third party claims that arose in the performance of the contract. This means that the staffing agency will take over the full liability for the damages—they have indemnified you for the loss.
- Hold harmless means that one party agrees not to seek damages from the other for their own losses. Let’s say I have purchased 25 sets of body armor to be shipped to a location in Africa, and my agreement with the seller called for them to obtain the required export licenses from the U.S. government. They also negotiated a hold-harmless clause for any acts of negligence on their part. When the time comes to ship, I discover that they submitted incorrect information on the license applications and the licenses are invalid as a result. I would ordinarily be able to recoup my costs and losses for delay by offsetting payments or filing a lawsuit, but in this case I’ve given up that right by agreeing to hold the vendor harmless for negligent acts.
- An agreement to defend brings an abundance of additional considerations along with it. In the most basic sense it means that the obligated party will step in and assume the costs and burden of defending the other. It is however possible to negotiate different rules for who funds the defense, who controls it, and whether settlement or strategy requires advising the other party or obtaining their consent. Going back to the example in part A above, this obligation would mean that the staffing agency is actually required to fully provide for my defense in court. Unless we’ve negotiated otherwise, they will both fund and control the litigation, including authority to settle.
Now that the meaning of the terms is clear, you can see how the parties can end up assuming an obligation before any factual determination is even made. My obligation to defend my counterparty is a proactive agreement to assume and fund defense, not an option for them to seek contribution from me for their defense costs after the court issues a decision—unless we write it that way. Even if the parties want to dispute whether the clause applies, that engenders yet another costly arbitration or trial.
Another factor to consider is the size of the obligation being assumed. Without a clear limitation of liability clause, which is probably the second-most hotly contested contract term, the size of these obligations is difficult or impossible to estimate. Fixing liability at the value of the contract provides the guarantor with an assurance that they will at least not lose more than they could have gained. This may be unacceptable to the guaranteed party though, because it is not hard to imagine a scenario where the damages caused could surpass the value of the contract. Determining a limit that addresses the concerns of each party is a challenging exercise on its own, and no two transactions will have exactly the same set of pressures. The starting points are obvious—the guarantor wants a low limit, while the guaranteed wants no limit—but after that, the variables are highly individual.
One strategy that may help brings the two ends together on both indemnity and liability limitation is imposing mutuality of obligation. Anyone with two children and one cookie is familiar with the concept: One splits the cookie, and the other chooses which piece they want. This forces each party to put themselves in the other’s shoes and leads to less extreme positions. This is not a cure-all because there are many situations where the dynamics make mutuality impractical or at least extremely unattractive, but when it applies it helps to circumvent a very difficult topic.
Taylor Brown is assistant general counsel with PAE Government Services Inc.