Indemnity provisions can be complex. For every two-sentence indemnity, there’s an indemnity section filling up a page and a half (and hilariously, the long indemnity may only be four sentences). Indemnities are one of the most quintessential “legal” provisions you’ll come across. So, in what could be a multi-part series, let’s try to simplify indemnities and understand them better so you can make better decisions in your contract negotiations. This is Part I: The Indemnification Simplification.
“An indemnity is a collateral contract or assurance, by which one person engages to secure another against an anticipated loss or to prevent him from being damnified by the legal consequences of an act or forbearance on the part of one of the parties or of some third person.” – thelawdictionary.org
“Indemnity is a contract by which one engages to save another from a legal consequence of the conduct of one of the parties, or of some other person.” – Cal. Civ. Code § 2772
“An indemnity is fundamentally an insurance policy against the losses resulting from a specified event.” – Me
How are we supposed to conceptualize indemnities?
The definitions above illustrate just how much legal jargon can be used to describe an indemnity. It can be simpler though. You should think of indemnities as insurance policies.
Think of your favorite car insurance company. They actually provide customers with an indemnity against damages arising from the customer’s car accident. We call that insurance. Likewise, any contracting party can define their own “car accident” event and stick an indemnity in their agreements to protect the other party against that event. This is insurance against losses resulting from a specified event.
Is it exactly like insurance?
Sellers tend to be very selective about the specific events since they differ in key respects to insurers. Insurance companies have designed an entire business around charging people premiums for protections. A seller instead charges for its time, goods, deliverables, software access, etc. Sellers haven’t done the math to figure out what premium is appropriate for protection against various events. That’s not their business. Still, a seller can provide insurance against incidental events arising from a particular transaction.
A good example of this is when a seller allows the customer to use its intellectual property. They will likely indemnify the customer against damages arising from an intellectual property infringement lawsuit. The lawsuit event is incidental to the transaction, and if customers didn’t receive protection, the potential costs of using that intellectual property could outweigh the benefits.
Why incidental events, and not just any event that causes damage?
Other parties tend to think of indemnities as pure risk allocation. While true to an extent, it’s too easy to allocate risk beyond the purpose of indemnification. Every transaction will involve some risk regarding the success or failure of the actual thing being purchased. The pricing reflects the balance of risks and benefits to each party. The deal itself, excluding indemnity, should encompass many of the risks associated with the transaction.
Take, for example, buying a car. The risk of the car breaking down is not a matter of indemnity, it is a matter of warranty, which is another component of commercial contracts. If it breaks down, you don’t typically call your car insurance company. You pay for it to be fixed, or if you have an applicable warranty, you will get it fixed for free during the warranty period. You buy car insurance to cover events that are likely to happen as a result of the use of the car (accidents), not for the failure of the car itself. In other words, using an indemnity to allocate risk of a car breakdown is not appropriate. The risk is allocated using other contractual principles.
Other times, thinking of indemnity as pure risk allocation assumes that one of the contracting parties should be bearing the risk. This is not always true. Sometimes, there are third parties that you can pay to bear that risk, like actual insurance companies. Returning to the car purchase example, notice that when you bought the car, the dealership didn’t offer car insurance. While it’s normal to address the risk of accidents, it’s not normal for the dealership to be the one addressing that risk. Providing that insurance is a whole different business, and it’s something the buyer can take care of on its own.
So, when you think of indemnity, don’t think of trying to cover yourself against every risk imaginable. Indemnities are a lot simpler when you think of them as insurance policies. Ask yourself: what insurance is appropriate in this transaction? What risks are covered by the pricing or contract obligations, and what risks am I exposed to as a result of the benefits received? Consider the price you’re paying, the risks incidental to the transaction, and the capabilities of the parties to cover those risks.