Understanding Indemnification: When, Where & Why You Should Use Indemnity Clauses in Your Commercial Contracts

Indemnity clauses are an important and very common risk allocation tool in commercial contracts, from service agreements to intellectual property use agreements for joint ventures. So it’s likely you’ve signed an agreement that contains a clause relating to indemnity.  

But these clauses are often misunderstood. In this post, we seek to help you understand the indemnity clauses in your commercial contracts. We’ll also outline how these clauses can be mutually beneficial and can help you build better business relationships.  

What is an Indemnity Clause?  

Before we dig into the where and why behind indemnity clauses, we’ll start with the what.  

Indemnity clauses are a contractual agreement where one party agrees (the indemnitor) to compensate the other party (the indemnitee) for specified losses, damages, and liabilities that the other party may suffer. In other words, it’s a clause that shifts the financial burden of potential risks from one party to the other.  

Common types of indemnity clauses include:  

• Bare indemnities: These clauses offer broad protections that potentially expose the indemnitor to significant, undefined risks.  

• Proportionate indemnities: The indemnitor covers losses only to the extent caused by its own actions or inaction.  

• Third-party indemnities: The indemnitor pays for claims made against the indemnitee by a third party (such as a customer or a regulatory action).  

• Mutual indemnities: Both parties agree to indemnify each other for specific losses. These are less common, but you may see them in construction contracts.  

Indemnity Clauses vs Hold Harmless Provisions 

Indemnity and ‘hold harmless’ provisions are sometimes used interchangeably, but they aren’t always the same thing. In fact, it varies depending on which state court would determine a dispute. States like Delaware, Ohio, and Colorado consider indemnity clauses and hold harmless provisions to be the same thing. However, a decision in California defines the two concepts distinctly, with indemnity being an ‘offensive’ tool that allows a party to seek indemnification, while hold harmless provisions are ‘defensive’ and offer protection from being sued.   

Indemnity Clauses as a Business Relationship Tool 

Indemnity clauses are sometimes seen as one sided, but they can be mutually beneficial for both parties to the contract. Commercial contracts that include indemnity provisions are not (and shouldn’t be) a zero-sum game.  

So, how can these provisions foster better business relationships? 

Firstly, indemnity provisions allow the parties to customize risk within the relationship. This means each party enters the relationship in agreement about (ideally) the amount of risk it is willing to take when it comes to specific elements of the transaction. In many situations, this is a better outcome than a blanket assumption of risk. Moreover, the clarity that comes from indemnity clauses can build trust between the parties and help to prevent future disputes. 

Secondly, indemnity provisions can introduce or improve efficiencies in the contract. This is particularly relevant where one party has greater control over a particular operational aspect or holds specific expertise. In these cases, it may make more sense for one party to bear the risk in that area. But it’s not about shifting blame; it’s about allocating risk to the party best positioned to understand and (if needed) mitigate it.  

Finally, indemnity provisions create a more predictable contractual framework. Before entering into the agreement, the parties can agree when certain losses (like attorney’s fees) are recoverable. More than this, they can also agree to limit the liability often by setting:  

• Liability caps set a maximum amount that the indemnitor will be responsible for, promoting greater certainty within the relationship. 

• Materiality qualifiers ensure that only significant breaches or losses trigger the indemnity obligation, avoiding more costly disputes over minor issues. 

• Liability baskets (often referred to as “deductibles” or “thresholds”) mean that the indemnitor is only liable for losses once a certain aggregate amount is reached. 

So. indemnity clauses can be flexible when negotiated with another party. 

Mistakes to Avoid in Your Indemnity Clauses 

There are some poorly drafted indemnity clauses out there. The worst of the worst are so broad that they’re likely to be unenforceable. Then there are clauses that attempt to indemnify a party for their sole negligence (which is generally unenforceable too, but also not a great clause to include if the goal is to build trust in a relationship). Though negligence clauses are less common.  

With that in mind, let’s dig into three of the most common mistakes we see when it comes to indemnity in commercial contracts.  

Mistake 1: The language is too broad.  

This is one of the more common mistakes we see. As we mentioned above, overly broad language cause an indemnity clause to be unenforceable. On the other hand, however, it can also expose the contracting parties to greater risks or a wider scope of risks than they intended when drafting the contract. In some cases, this could extend to risks outside the indemnitor’s control.  

The better indemnity clauses we see clearly outline the risks it is intended to cover, and any limits or stipulations to the liability. The contract should outline the specific losses covered, like third-party claims, legal fees, property damage, etc, as well as the events that trigger indemnity, such as intellectual property infringement or a breach of contract.  

Mistake 2: The language is unclear.  

Similar to the first mistake, we often see unclear language in indemnity clauses – with the worst offenders having indemnity clauses that contradict one another. These are problematic because they can lead to misinterpretation, misunderstanding about obligations and protections, and difficulty in enforcement.  

Plain English language throughout the agreement is a good antidote to this mistake. Your agreement should avoid legal jargon, wherever possible, use consistent language and terms throughout, and ideally it would be readable at the Grade 8-10 level.  

Mistake 3: You rely on boilerplate language (instead of negotiating the terms) 

The reality is that generic boilerplate clauses tend to favor the drafting party. This may be a great outcome if you’re the drafting party, or in specific services agreements. But in situations where you’re hoping the agreement can build trust and be mutually beneficial, that’s not an ideal outcome.  

Another less-than-ideal outcome from using boilerplate language is that it may not be interpreted how you’d like it to be in your jurisdiction. There are differences in how indemnity clauses are interpreted across the US, so using a ‘tried and tested’ agreement intended for a different jurisdiction might have unintended consequences.  

Instead, if you negotiate the terms, you can truly tailor the agreement to the relationship you’re building with the other party. It opens a discussion about the risks involved (which is always a good thought exercise in any agreement) and allows you to collaborate on which party is best positioned to control and mitigate the risks.  

Action Items for Businesses 

Your exact action items will vary widely depending on your company’s stage and the situation you’re currently contemplating. But here are some broad action items for company leaders to consider when it comes to indemnity clauses in your commercial contracts:  

• Add a checklist item to review and identify existing indemnity clauses in current contracts. You’ll want to see those reflected in your corporate risk matrices. It’s worth noting appropriate contract review dates on any clauses you’d like to re-negotiate.  

• Determine if the indemnity clauses you currently have are serving your business, and highlight any learnings from contracts where your indemnity clauses are adequate and those that don’t meet your needs.  

• Get appropriate insurance, if you don’t already have it. Consider Representation and Warranty Insurance, Director and Officer Insurance, and Contingent Liability Policies, as well as general commercial liability insurance. Those policies will need to reflect the risks you’ve taken on in existing indemnity clauses.   

• Seek advice from qualified counsel, including advice about how different states view indemnity and hold harmless clauses if you’re contracting across the US (or beyond its borders).  

• If you’re a high-volume contracting company, it may not be realistic or desirable to have a contract review before every agreement is signed. In this case, work with legal counsel to develop internal playbooks for negotiating common scenarios and train your team on applying flexible terms. You’ll also want to clearly identify situations where legal counsel should be looped in.  

Need help with your company’s commercial agreements? Reach out to CGL LLP. Our experienced team of attorneys are available to help. We offer flexible, scalable legal solutions to growing companies.  

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