Introduction:
A “hold harmless” or “indemnity” obligation is either a statutory or contractual obligation of one party (indemnifier) to compensate for the loss suffered by another party or parties (indemnity holder) due to the acts of the indemnitor or, depending on the wording of the agreement, acts or claims of third parties, whether valid claims or not.
One normally finds indemnity clauses in contracts involving business transactions or sale of a business interest to another, but they are also common in insurance agreements, construction agreements, and various service agreements.
Agency can create an obligation on the part of the agent to indemnify the principal or, conversely, a principal may be obligated to indemnify the agent for liabilities incurred while carrying out responsibilities on behalf of the principal. Further, some employment or fiduciary positions held can create a duty to indemnify those to whom one has a fiduciary duty if one’s actions were in dereliction of one’s duties.
Indemnity is normally a concept developed and imposed by the local jurisdiction. Thus, each state has its own law of indemnity, as do most countries. Basic concepts of indemnity, however, are common to most indemnity obligations.
Indemnity versus Other Obligations
Obligation Based on Negligence:
If one has a duty to a person or persons and fails to protect that person or exposes that person to liability due to failure to perform that duty in a reasonable manner, then one is negligent and one may be found by a trier of fact to be liable to the person for the results of that negligence, “damages.” This is not based on contract but on the duty of due care. Thus, if I drive an automobile negligently and cause you physical damage, I may be liable to pay the damages you suffered.
Obligation Based on Warranty:
A warranty is usually a contractual obligation to provide a good or service of a specified represented quality or quantity. It may be imposed by statute as well. An indemnity provides compensation equal to the amount of loss to the indemnity holder in the indemnity contract, while a warranty provides compensation for the reduction in value of the acquired asset or service due to the warranted fact being untrue. (Note that this warranty is common in real estate purchase agreements and if there is no diminution of value in the property there are no damages.)
One point to remember is that warranties usually do not cover problems known to the beneficiary at the time the warranty is given since the beneficiary was aware of the risk and diminution of value and still made the deal. However, indemnities do cover such liabilities since that is precisely why they are entered into, namely, to contractually shift the loss anticipated. As an example, if I am selling you a business and I know there is a chance third parties may sue the business and we enter into an indemnity agreement in which you indemnify me for those anticipated losses, then you still are liable regardless of my prior knowledge.
Obligation Based on Guaranty:
A guaranty is the promise of a person or entity to honor the obligation of another person or entity should that person be unable or unwilling to do so, often in the context of a debt undertaken. Typically, a guarantor will commit to a vendor or lender to pay the debt of the third party if that third party fails to do so.
Obligation Based on Contract:
A binding agreement can impose an obligation to pay or perform based on some exchange of consideration. Typically, if I paint your house, you are obligated to pay me. Indemnity is usually a particular form of contractual obligation, namely, to compensate you for the claims of third parties, so indemnity may be seen as a variation of contractual obligation.
Hold Harmless and Indemnity:
Often the terms “indemnity” and “hold harmless” are used interchangeably since they both accomplish the same goal. Indeed, most contracts utilize phrases such as “X shall indemnify Y and hold Y harmless from all claims made by Z.” At times hold harmless can include providing for complete defense costs as well, but there is no hard and fast rule here since indemnity, depending on the wording of the contract, can also provide for those costs.
What Does Indemnity Pay?
Indemnity can be limited to specified damages or be unlimited and may or may not cover defense costs, including attorney’s fees and court costs. It all depends on the wording of the indemnity agreement. A good indemnity agreement, if it does include defense costs, will also provide for methods of defense.
For example, the indemnity agreement can provide that X will indemnify Y and pay for all defense costs and specify who selects the attorney, who has power of strategic control of the case, and whether any settlement has to be approved by both parties or is at the discretion of X. Requiring approval of settlements is a common clause in professional malpractice insurance agreements since the professional may not want a settlement that reflects badly on his or her reputation even if the monetary cost of the settlement may be small enough to justify it from a cost benefit view of the insurance company.
As a matter of public policy, indemnity is often not allowed for obligations based on intentional wrongdoing. The concept is that the state should not allow a party to intentionally harm another yet face no repercussions. Thus, indemnity may be disallowed for obligations based on embezzlement, fraud, theft, assault and battery, etc. On the other hand, indemnity could be allowed for a judgment based on breach of contract or negligence.
This can lead to complex legal issues between the indemnitor and the indemnitee. Assume a judgment is found against me for breach of contract but part of the case also alleged I fraudulently led the injured party to rely on my promise when I had no plan to perform, thus there is a judgment against me for fraud as well. The insurance company providing my defense will normally have a provision not covering intentional wrongdoing on my part and the law of my state may also prohibit them from indemnifying such judgments…but the judgment is also for breach of contract. Does the insurance company have to pay?
And to further complicate the matter, assume the defense costs are in the hundreds of thousands of dollars. Most insurance contracts, indeed, most indemnity contracts provide that no such costs will be paid if the third-party judgment is based on intentional wrongdoing and that the monies advanced to counsel by the insurer would have to be repaid by the indemnified party. How much does the indemnified party have to repay since there is still coverage for simple breach of contract?
It should also be noted that the strategy for defense can be affected by the lack of coverage for certain types of judgments. The attorney representing the indemnified party, paid for by the indemnifying party, is in a potential conflict of interest. If the judgment is based on certain grounds, the indemnifying party may not have to pay it, e.g. fraud. The attorney may devote most of his or her efforts defending the other aspects of the case since the party that selected him or her has little interest in avoiding a judgment against the indemnified party for intentional wrongdoing.
This is a common issue for insurance indemnity and some states, such as California, require the insurance company to pay for independent counsel to be involved in the case to assure that the insurance defense counsel takes no action that harms the insured.
The lack of indemnity for intentional wrongdoing can also lead to intriguing strategic issues for the plaintiff in such actions. In an effort to assure insurance coverage, particularly when the defendant has few assets, the plaintiff may not plead intentional wrongdoing precisely to avoid the insurance company claiming that no coverage exists even though clear fraud or embezzlement existed.
Indemnity also does not usually pay for incidental damages suffered by the indemnified party, but only for out of pocket costs such as defense costs and the judgment rendered. Thus, if my business volume is injured by the suit or my reputation suffers or if I am forced to attend the trial losing a month of work, that is normally not compensated by the indemnity agreement unless specifically provided for.
Further, if I have cross claims against the party suing, the indemnity agreement will normally require me to hire my own counsel and pursue my own claims in the case or in another case. Indemnity provides protection and does not apply to affirmative claims.
Practical Considerations:
Most people encounter indemnity issues in their insurance policies and those arrangements are highly regulated by state law. There is also a large amount of case law on insurance policy indemnity since insurance coverage disputes have a long history and over the decades have developed a case history that makes the factors in insurance indemnity well developed.
Another common area of indemnity involves sale of business or commercial property interests. Most sellers do not want to concern themselves with possible claims after they have sold their business and most buyers do not want to confront litigation for events occurring prior to purchase. Thus, a common indemnity clause in buy and sell agreements involves the seller indemnifying the buyer for claims occurring prior to purchase and the buyer indemnifying the seller for claims after purchase. As one veteran of business transactions told the writer, “If I keep the business, I keep the profits and face the risk. If I sell the business, I lose the profits, but the risk is with the new owner. If I am to keep the risk, I might as well keep the business and enjoy the profits.” He died a multi-millionaire and walked away from any deal in which the buyer would not fully indemnify him for claims based on events after the sale.
It should be realized that if the indemnifying party does not have sufficient assets to fund the indemnity obligations or files bankruptcy that the indemnified party may have no ready relief. Bankruptcy will normally void the indemnity obligation and the seller of a business that has failed may find him or herself facing liability since the new owner cannot afford to hold him or her harmless. For that reason, sufficient liability insurance on the part of the buyer is a typical requirement of the sale agreement with the seller a named coinsured. (But note insurance will normally not cover judgments based on intentional wrongdoing or gross negligence so that danger still exists and insurance as well as indemnity is often required.)
As with so much in business, the key is well considered and drafted indemnity agreements which provide the appropriate protection and are clear in the obligations and limits of the indemnity. In the United States it is not uncommon for business litigation to involve hundreds of thousand dollars in defense costs, so having indemnity that provides for full legal defense costs is vital to assure adequate protection.
It is also common to have clauses imposing upon the indemnified party the duty to give prompt notice to the indemnifier of any claim and to cooperate in the defense of the claim, including appearance at court and discovery, full disclosure of relevant facts and participation in the defense of the claim. Failure to abide by these obligations can void the obligation to indemnify.
Conclusion:
Life is risk and business is risk. It is the nature of business that if one minimizes risk one normally minimizes profits. But the purpose of insurance and indemnity is to remove or, at least, minimize the risk applying to a party no longer willing to expose him or herself to the risk of the transaction or activity. Along with insurance, indemnity can allow that person to sleep at night knowing that the liability being faced, including the defense costs if so indicated in the indemnity agreement, will be transferred to the party indemnifying.
How vital is it? In today’s world of expensive litigation and common efforts by plaintiffs to enlarge the number of defendants in every case to assure collection, it is a vital part of any contract and every transaction. The key is the right terms being included.
