ARTICLES

What is Indemnification?

Have you ever been confused by a contract discussing indemnification?  Admit it.  You have seen this word countless times and have dismissed it for the confusing legal jargon that it is. 

Simply put, “indemnification” is the obligation of one party to bear the consequences of an act or omission of the parties or some other person.  Still confused?  “Indemnification” says, “don’t worry, I will pay for it.”

The duty to indemnify is a common contractual relationship that is often found in the pre-closing and post-closing activities surrounding the purchase of businesses.  The duty to indemnify also shows up in many other contractual relationships, including license agreements, franchise agreements and leases.  Perhaps the most common form of an indemnification is found in any insurance policy purchase – a duty to reimburse the policy holder upon certain events.

The Scope of Indemnification

Because most indemnification situations consist of a defined contractual duty, contract language often determines:

• The situation for which indemnification is available, often referred to as a loss or claim (i.e., a buyer of a business is sued for the activities of the business prior to its purchase of the business; or in the case of an insurance policy, a hail storm).
• The parties who can be indemnified (owners, employees, etc., or in the case of auto insurance, the driver).
• The process for submitting losses or claims for payment or reimbursement (time limitations, presentation and the manner of notice (i.e., in writing sent via certified mail)).

Negotiated Indemnification

Because the economic benefits of a transaction can vary widely as a result of the duty to indemnify, indemnification clauses can be hotly contested.

While negotiations concerning the class of indemnified persons are generally less controversial, those regarding the definition of a covered claim or loss can be extremely contentious.  For example, a party providing an indemnification may agree to certain claims – such as the performance or non-performance of a contract – because the economic value can be quantified and understood in advance.  Unknown or “open-ended” liabilities such as defective product manufacture, wage and hour claims or personal injury matters may be rejected as an indemnification obligation because of the possible limitless exposure or likelihood of a claim.

This is where a legal practitioner should encourage clients to engage in a “what if” analysis.  Attempting to predict possible problems can at times seem far fetched; however, this process helps an attorney and client anticipate a response and solution to both common and not-so-common problems.  Perhaps the most often forgotten indemnification term is losses due to the attorneys’ fees spent to rectify a situation, a costly and fairly predictable outcome.

Payment on Indemnification

Indemnification not only apportions the types of risks it will cover, but how the losses or claims will be paid for.  Many arrangements call for the first dollar of the loss to be paid by the party that is being indemnified.  Only after a certain threshold is met will the duty to indemnify “kick-in” (think deductibles on insurance policies).  Likewise, indemnification can be limited in exposure.  For example, a seller of a business could limit the amount to be paid on an indemnification to a percentage of the purchase price.

Most insureds rely on the financial health and stability of the insurance company to satisfy its indemnification obligations. But, what options are available to small businesses in ensuring that indemnification obligations will be honored?  We’ll use the sale of a business as an example of financing indemnification provisions:

• Provide for a grant by an owner or owners to the seller to provide funding upon demand (an indemnification guaranty).
• Hold back a portion of the purchase price to allow time to assess possible losses or claims.
• Escrow a portion of the purchase price to ensure a “pot” of funds.
• Provide for a “set-off” against future payments by the buyer if the transaction is financed in part by the seller.

Unwittingly, many businesses look only to the overt financial terms of the contract, such as the purchase price, lease rate, or other charges that are quantified in dollars.  Perhaps no other term to contracts has more ability to sway the economic value of a contract than indemnification. 

If ignored, indemnification clauses can sink a business.  If properly understood, indemnification  can be planned for or used as a tool in moments of crisis.

Because indemnification clauses can be confusing and can dramatically impact other contractual terms, is critical to understand precisely what actions are covered under an agreement.  Contact Skjold ▪ Barthel for assistance in developing or responding to indemnification issues.