Today’s Contracts Enforceability Issues, Part III: Decoding Indemnity Clauses
Some of the most boilerplate-looking provisions in contracts are often the most onerous. Indemnity clauses certainly qualify. For example, an indemnifying party (such as a contractor) could find itself owing the indemnified party (such as an owner and its architect) substantial reimbursements and defense costs (including even provision of an attorney) for the defense of third-party claims (such as the claim of a supplier). This could happen where the indemnifying party (the contractor) was only alleged to have been partially at fault — and even where the contractor may not have been at fault at all.
It is important for indemnitors (those giving indemnity rights) and indemnitees (those receiving indemnity rights) to understand the risks involved with these clauses. A useful way to understand indemnity clauses is to break them down into their constituent parts.
Who Benefits and Who Is Burdened?
First, at a basic level, consider the indemnitors and indemnitees. In some contracts, the litany of individuals and entities included as indemnitors and indemnitees takes up several lines. As painful to read as some of those lists may be, they essentially consist of the following family tree: one of the parties to the contract and a) all of its related individuals and entities within its family of companies (e.g., employees, officers, directors, shareholders, affiliates, parents and subsidiaries), b) its successors and assigns, and c) its agents and other types of entities outside its corporate family.
Two questions to keep in mind when reviewing such lists of names are a) whether the indemnitor has legal authority to bind any entities and individuals who are strangers to the contract, and b) whether the indemnitee has adequately made the proper entities and individuals beneficiaries of the indemnity rights.
It is also important to note that third parties who are strangers to the contract might not be able to be bound to obligations; however, such third parties might be able to enforce benefits that are indirectly conferred upon them. Another important point is that entities and individuals should be appropriately described in light of the types of entities entering into the contract. (For example, an LLC has members, not shareholders.)
Consideration may also be given to whether the indemnity provisions are mutually expressed. For reasons of pure bargaining power, many contracts only allow the party with leverage to obtain indemnity rights (or to obtain superior and non-parallel indemnity rights) as against the party without leverage. Ironically, subcontractors — often the least financially equipped to provide indemnity — are frequently required in their contract to provide broad indemnity protections to all upstream parties and their contractees.
What Rights and Obligations Does the Clause Confer?
While the words “indemnify, defend and hold harmless” are often strung together in such clauses, they mean different things. The words indicate whether the indemnitor is providing a reimbursement or similar benefit (indemnify), a release of claims or covenant not to sue (hold harmless), or a defense obligation (defend) in the event of claims that trigger the indemnity.
Often the reimbursement and release of claims rights overlap with other obligations in the contract, but the defense obligation may be deemed a separate right. Also, the indemnity rights can create separate legal claims with separate elements of a cause of actions, separate statutes of limitations, and entitlement to categories of damages (such as attorneys’ fees, expert witness fees and other litigation expenses) that may otherwise not be recoverable.
What Claims are Subject to the Defense Obligation?
It is important to understand the types of events that trigger indemnity rights and obligations. Many contracts express the triggering events as third-party claims against the indemnitee. However, sometimes the indemnity clause (in sort of a misnomer) is written more broadly such that it is triggered by any breach of contract or error or omission by the indemnitee.
In some contracts, the triggering claims are limited to personal injury and property damage claims (the approach of the AIA in Section 3.18 of the A201™–2007 General Conditions of the Contract For Construction). In other contracts, the trigger is written more broadly to cover economic loss. The former may be covered by certain types of insurance, but the latter may not.
Often special indemnity and defense obligations are enumerated in other sections of a contract that involve special risk areas such as intellectual property infringement and environmental obligations. Sometimes this result is intended; however, in some cases it is an artifact that stems more from the individual who drafted a particular part of the contract rather than any particular purpose. Regardless of the reason, it could be helpful to closely compare such specialized indemnity clauses with general indemnity clauses and check for inconsistencies and contradictions.
Fault, Enforceability and Anti-Indemnity Acts
Often indemnification obligations are expressly related to the negligence, breach or other fault of the indemnitors. This is not, however, always the case, which could be a key issue in some states. Some clauses, for example, are drafted to allocate to one party the obligation to indemnity for losses that are the fault of the indemnitor and the fault of third parties (e.g., where an owner negotiates for indemnity from the contractor for claims caused by the architect).
Even more burdensome are clauses that actually attempt to allocate to one party the obligation to indemnity for third-party claims caused by the fault or partial fault of the indemnitee (e.g., where an owner negotiates for indemnity for all claims except for those caused by the owner’s “sole” negligence).
Some courts have held that it is against public policy to indemnify a party for his or her own negligence. More broadly speaking, legislatures in virtually every state have responded to concerns about the inequity of such clauses by passing so-called "anti-indemnity acts". That such acts are often expressly tied to construction industry contracts is a testament not only to the power of pro-contractor lobbies but also to the lack of leverage of other parties, especially lower-tier subcontractors, to effectively negotiate out of such clauses.
In response to such acts, many drafters (even those seeking broad indemnity rights) add clauses that specifically except out indemnity for claims arising out of the indemnitees’ negligence and provide that if any part of the indemnity is deemed unenforceable, the remainder shall be enforced.
Also, anti-indemnity acts differ from state to state: some are highly nuanced, while others are more obviously material. It is important to understand whether a clause was crafted with the specific terms of a particular state’s anti-indemnity act in mind or with more generic purposes. Choice of law clauses and forum and choice of law statutes may determine which state’s anti-indemnity act governs a particular contract.
Some insurers will argue that defense obligations and other risks assumed through indemnity clauses are not covered by or are excluded from insurance coverage, and case law across jurisdictions may not be uniform on this point. In certain jurisdictions, and in particular circumstances, additional contract language may be necessary. However, even where indemnity obligations are covered by insurance, it may be important to coordinate the insurance coverage provisions in a contract with the indemnity provisions. Unintended coverage gaps may result; for example, when additional insured protection is provided to one group of entities and individuals, but a different group of entities and individuals are the subject of indemnity obligations.
Indemnity clauses are frequently the subject of attention in contract negotiations. At the same time, parties with leverage may be unyielding when it comes to their negotiation, raising questions of whether certain risks may be allocated through insurance. Indemnity clauses can be nuanced and difficult to understand and their enforceability may vary by jurisdiction. To gain a greater comfort level with these important elements of a contract, it is a good practice to speak to your attorneys and your insurance brokers.