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Contracts

Sep. 22, 2021

Tips for effective indemnification provisions in commercial contracts

Discover some effective terms for seeking and obtaining indemnification that protect both parties and reduce the likelihood of disputes.

Asim Bhansali

Partner, Kwun Bhansali Lazarus LLP

Scott Taylor

Associate, Kwun Bhansali Lazarus LLP

Indemnification provisions in commercial, non-insurance contracts protect a party from certain liability based on its use of the counterparty's products or services. Because such provisions are ubiquitous in contracts between corporate entities, disputed interpretations often arise, especially in the context of indemnification for third-party claims of intellectual property infringement. These disputes can be complicated and costly to resolve. Careful drafting with an eye towards clarity can help avoid such disputes or provide easier resolution when they arise. Thus, this article suggests effective terms for seeking and obtaining indemnification that protect both parties and reduce the likelihood of disputes.

Require the Indemnitee to Provide All Available Information Regarding the Claim

Requiring an indemnitee to provide the indemnitor "all available information" regarding a third-party claim seems straightforward. Problems can arise, however, if the indemnitee asserts that it has provided "all" information, but the indemnitor deems the information insufficient to determine whether the claim is indemnifiable. Parties can preempt this dispute by defining the phrase "all available information" as constituting all relevant documents, facts, and allegations regarding the claim in the indemnitee's possession, custody, or control. If the indemnitor deems the information insufficient, this clause should require the indemnitor to specify (1) why the information is insufficient, and (2) what further information is required. Of course, if the parties do not agree that the claim is indemnifiable based on the available information, then litigation will likely ensue. But defining "all available information" and requiring the indemnitor to detail why the proffered information is insufficient and what other information is required will simplify the issue as a straightforward breach of contract. Doing so will help avoid a breach of implied covenant claim, which is disfavored and can complicate litigation over an indemnification provision. See Vikco Ins. Servs., Inc. v. Ohio Indem. Co., 70 Cal. App. 4th 55, 70 (1999) ("Implied covenants are disfavored at law.").

Require the Indemnitee to Grant the Indemnitor Sole Authority Over the Claim

The indemnification procedure should give the indemnitor sole authority to control the defense and settlement of a covered claim and require the indemnitee to grant such authority when tendering the claim. This requirement makes sense because the indemnitor bears the ultimate risk of liability and therefore it has the greater interest in avoiding such liability. It follows that the indemnitor is in the best position to determine the defense strategy and the reasonableness of any settlement offer. However, because the indemnitee is the party being sued, it has a right to participate in its defense. Thus, this clause should require that the indemnitor keep the indemnitee apprised of the status of the claim. It should also allow the indemnitee to participate, at its own expense, in the defense of any claim by selecting its own attorneys in relation to such participation.

Require the Indemnitor to Obtain the Indemnitee's Consent Before Settling a Covered Claim

Requiring the indemnitor to obtain the indemnitee's consent before settling a claim -- except where settlement includes an unconditional release with no further obligation of the indemnitee -- ensures that the indemnitor will not agree to a settlement that is favorable to the indemnitor (e.g., cheap) but burdensome to the indemnitee (e.g., requiring the indemnitee to perform beyond its contractual obligations). However, this clause should specify that the indemnitee cannot unreasonably withhold consent. The reason is simple -- the indemnitor controls the purse strings and should not be precluded from accepting an otherwise reasonable settlement if the indemnitee is not in complete accord.

Require the Indemnitee to Seek the Indemnitor's Consent Before Settling a Potentially Covered Claim

Requiring the indemnitee to seek the indemnitor's consent before settling a potentially covered claim addresses the situation where the indemnitee is defending itself because the indemnitor disputes that the claim is indemnifiable. In such situations, the indemnitor's refusal to accept tender of the claim might not absolve the indemnitee from complying with the indemnification procedure, because such compliance will be at issue in any subsequent litigation. See Oasis W. Realty, LLC v. Goldman, 51 Cal. 4th 811, 821 (2011) (noting that "plaintiff's performance or excuse for nonperformance" is a required element of a breach of contract claim).

Thus, the indemnitee can assert substantial compliance with the indemnification procedure by seeking the indemnitor's consent before settling a disputed claim because doing so is consistent with the indemnitee's obligation to provide all available information regarding the claim. Further, this requirement provides the indemnitor an opportunity to reassess the claim and evaluate the reasonableness of any settlement offer. It also comports with basic fairness -- if litigation between the parties ensues, the indemnitee should not be permitted to recover the costs of a settlement that the indemnitor was not privy to.

Require the Indemnitee to Obtain the Indemnitor's Consent Before Settling a Covered Claim

In the case of an undisputed claim, the indemnitee should be required to obtain the indemnitor's consent before settling because the indemnitor is ultimately on the hook for the costs of the settlement. Obviously, if the indemnitee has complied with the indemnification procedure and granted the indemnitor sole authority over the claim, then the indemnitee cannot unilaterally settle the claim. But this clause provides extra protection to the indemnitor by ensuring that it has final say on any settlement regarding a covered claim.

No contract is immune to differing interpretations. But parties can reduce the risk of disputes by using clear language and preemptively addressing areas where disputes might arise.

These tips target potential disputes and provide mutually beneficial terms to keep your clients out of court or simplify the issues in the event of litigation.

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