If you own your own business, sooner or later you’ll encounter a contract with legal terms that will send you scrambling for a dictionary (or a lawyer). We can’t rid the world of legalese (believe it or not, there’s often a good reason for it), but we can try to make reading legal documents a little less mind-numbing by describing a few concepts that appear in almost every contract you’ll ever read and explaining why they may matter to you.
A Quick caveat: Indemnification is one of the most nuanced areas of commercial contract law, so this is necessarily a very simplistic overview. If a contract you’re asked to sign includes an indemnification provision, you should strongly consider asking your legal advisor to review it.
With that out of the way …
An indemnification provision is where parties to a contract spell out remedies available for any breach of the agreement. The indemnification provision may provide for remedies in addition to those generally available at law or that the remedies in the contract are the exclusive remedies available. Indemnification provisions are important where there is a strong incentive to provide for more precise remedies than the default remedies provided by applicable law. This can be very important for significant contracts, but for minor agreements it is sometimes overkill.
A typical indemnification provision will obligate one party (the Indemnitor) to indemnify (i.e. compensate) another (the Indemnitee) for losses the Indemnitee incurs that result from specific things related to the agreement. For example, indemnification usually provides for specific remedies if certain of the Indemnitor’s representations and warranties turn out to be false or if the Indemnitor fails to perform certain of its obligations under the contract.
Indemnification obligations will sometimes include a “cap” on the Indemnitor’s liability, often equal to whatever payment the Indemnitor is making to the Indemnitee pursuant to the contract. They may also include a threshold amount (typically called a “basket”), below which the indemnification does not apply, to prevent the Indemnitor from raising lots of small indemnification claims. The basket may act like an insurance deductible, where the Indemnitor is only responsible for losses above the threshold amount, or it may be a “tipping basket,” where the Indemnitor is responsible for all losses once the threshold is reached, even for losses below the threshold amount.
If an agreement includes an indemnification provision, be sure you understand the scope of your obligations and those of the other party before signing the agreement. In particular, make sure the scope of your indemnification obligations is reasonably related to the subject of the agreement and is not a blanket indemnification covering any losses the Indemnitee may incur, even if outside the scope of your relationship.