Not all parties to contracts are created equal. In fact, more often than not one party to a contract may have considerably greater bargaining power and financial resources than the other party. This can give the stronger party an incentive to misbehave. So how can you protect yourself when you are the “David” in a David v. Goliath scenario? Consider using an indemnification[1] clause to help level the playing field.
Indemnification clauses can be among the most important provisions to include in contracts for several reasons. First, the mere existence of an indemnification clause can help ensure that a party gets what it bargained for under a contract, by giving the other party a reason to “think twice” before breaching the agreement. Second, in the event the other party does breach the agreement, a well-crafted indemnification clause can give the non-breaching party more leverage to resolve matters favorably, before trial. Third, an indemnification clause can help the non-breaching party recover its legal expenses incurred in enforcing the contract, thus removing the most costly obstacle to a “David” standing up to a “Goliath”.
Illustration – The David v. Goliath Scenario. Assume David and Goliath enter into a contract where David will pay $50,000 upon Goliath’s delivery of widgets. But, when it comes time for Goliath to deliver the widgets, he refuses. Goliath may have accepted a higher offer from someone else for the widgets because he knows that David has fewer resources than Goliath and is unlikely to sue.
Let’s look at David’s options. David would almost certainly be entitled to recover “contract damages” for Goliath’s breach – such as the difference in price David must pay to acquire substitute widgets from an alternate source. But actually winning and collecting those contract damages comes with its own significant costs. If David were to sue Goliath for breach (assuming he could afford to) David must hire an attorney. However, under American contract law principles, David will not be entitled to reimbursement for the attorneys’ fees that he incurs fighting Goliath. This results in a very real likelihood that David’s costs to pursue a lawsuit against Goliath will be greater than the amount he may actually recover in damages. This means that David may end up “winning” the lawsuit, but lose money overall after factoring in legal costs.
In short, because the American contract law on damages does not generally reimburse plaintiffs for their attorneys’ fees in contract breach actions, plaintiffs like David face an economic disincentive to stand up for their rights. Conversely, breaching parties like Goliath can have a perverse incentive to breach, particularly if the other party is financially weaker. This is where an indemnification clause can help level the playing field.
I. Anatomy of an Indemnification Clause.
Indemnification clauses can help address the shortcomings of American contract law on damages by shifting liability or expense from one party to the other.
Here is a simple indemnification clause from a two-party contract:
Indemnitor shall indemnify, hold harmless, and defend indemnitee, to the fullest extent, from and against all claims, demands, actions, suits, costs and expenses (including, without limitation, attorneys’ fees and costs), losses, damages, settlements, and judgments (each, a “Claim”), whether or not involving a third party claim, arising out of or relating to: (i) any breach of any representation or warranty of indemnitor in this Agreement; or (ii) any breach or violation of any covenant of indemnitor in this Agreement, in each case whether or not the Claim has merit.
The three basic components of an indemnification clause are (1) the Parties, (2) the Claims, and (3) the Trigger Events. Each is explained below.
- Parties. The effect of an indemnification clause is to shift certain expenses and legal responsibilities from one party, the “indemnitee” or benefitting party, to the contract’s other party, the “indemnitor” or obligated party.
- Claims. “Claims” are the things the indemnitee is protected from or against. Claims can be:
- an allegation (such as a claim or demand asserted by the indemnitor or a third party);
- a formal legal proceeding (such as an arbitration, lawsuit, settlement, or judgment); or
- a monetary amount (such as a loss, liability, cost, or expense incurred by the indemnitee).
(While this article focuses on “Direct Claims”, meaning a Claim by one party to the contract directly against the other party, indemnification clauses can also be used to shift liability and expense associated with a Claim asserted against the indemnitee by a third party, known as a “Third-Party Claim”.)
- Trigger Events. Usually, an indemnification clause is limited only to those Claims that arise out of, or result from, certain enumerated occurrences or circumstances (the “Trigger Events”). For our simple indemnification clause above the Trigger Events are limited to breaches of the indemnitor’s representations, warranties, and covenants (i.e., the indemnitor’s promise to do something) in the contract. But there can be many other types of Trigger Events; for example, the indemnitor’s violation of laws, its products or services infringing the rights of others, its acts causing personal injury or property damage, etc.
II. Indemnification for Direct Claims.
With an understanding of the components of an indemnification clause, now let’s reconsider how our illustration might play out if the contract between David and Goliath had contained our simple indemnification clause.
In this instance, David could still sue Goliath for his contract damages. But now, David has a bigger, more powerful “stone in his sling”. Specifically, because his lawsuit is a Claim of a specified Trigger Event (Goliath’s breach of his covenant/promise to deliver widgets as required by the contract), David can also make a claim for reimbursement of David’s attorneys’ fees in bringing the lawsuit. The fact that Goliath may now be saddled with having to pay David’s legal fees will likely influence David’s decision to enforce his contractual rights against Goliath.
III. Effects of Indemnity on Indemnitor Breaching Party.
As we can see, having an indemnification clause for Direct Claims substantially changes the economic calculus in favor of the plaintiff. It has considerable effects on the defendant breaching party, as well.
- The Threat of Having to Pay for Two Sets of Lawyers. In a lawsuit to enforce a contract with an indemnification clause, the breaching indemnitor is faced with the possibility of ending up paying for two sets of attorneys—its own and the plaintiff/indemnitee’s. Adding an indemnification clause to the mix has a substantial economic and psychological effect on the indemnitor. While protracting and delaying litigation is a time-honored tradition for some defendants, the benefits of being stubborn is much less compelling when weighted against the potential of having to pay both sides attorney’s fees. This fact weighs more and more heavily on indemnitors as legal fees mount and litigation progresses.
- Encouraging Settlement and Dispute Resolution. The example above assumes that a lawsuit was filed and proceeds all the way to trial and judgment. However, the vast majority of lawsuits are concluded before judgment, either by settlement or dismissal. Having an indemnification clause can be beneficial to resolving a lawsuit early on and even before a lawsuit is filed because as the indemnitee’s attorneys’ fees rise, the typical benefit of delay and protraction to the indemnitor diminishes. This increases the likelihood of earlier and more reasonable settlement.
- The Indemnitor May “Think Twice” Before Breaching the Contract At All. Of course, David would probably be happiest if Goliath simply performed the contract and avoided a dispute entirely. The mere presence of a clause that could make Goliath responsible for David’s costs of enforcing the contract may give him ample economic incentive to play by the rules of the contract from the outset.
III. Conclusion.
While the particular facts and circumstances of the parties should always be considered, in many circumstances including a properly-drafted indemnification clause can enhance the parties’ likelihood that they will receive what they bargained for under the contract.
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If you have questions regarding indemnification clauses or need further guidance on how to structure your business relationships, contact Scott Harris at SHarris@fh2.com or (770-399-9500).
[1] As used in this article, the terms “indemnity” and “indemnification” include three slightly different legal obligations: indemnity (to reimburse for an incurred expense or cost), hold harmless (a release from liability), and defend (the agreement to defend against a legal claim). The three are slightly different concepts, but their effect is the same. They shift liability or expense from one party to the other.
