Commercial agreements
Indemnification - what is it, and why is it so important to have in your commercial agreements
Imagine that you need to use an IT service. So you contract for an SaaS product and sign up to the terms and conditions accordingly. A customary license agreement (i.e. you are not buying the software, you are paying for a right to use it for a period of time). It could be a web shop solution, a CRM system, music or pictures you may use, or a function that you include in your end product - the list could go on forever.
And you deploy the SaaS product in your business with great results. Then, one day, you get a claim for millions of dollars from a third party, claiming that you have infringed on their IP rights! And it turns out that the IP in question is part of the SaaS product you are licensing - and using accordingly in good faith. It then turns out that the SaaS company has used IP they are not entitled to use... So how can it be your fault? And why are YOU getting dragged into a lengthy and costly lawsuit - and will you be down millions of dollars when all dust has settled? Well, here is where the specific wording of your (assuming that you have one) indemnification clause in the SaaS agreement comes into play.
What is an indemnification clause?
Basically it refers to you, or your counterpart to your contract, promising to pay the other party to the contract for specific types of damages or losses that they/you might suffer in relation to (in this article) third party claims that have a connection to the commercial agreement between you and your contractual counterparty.
Keep in mind that indemnification clauses are contractual obligations, and hence we cannot assume that there is any one-size-fits-all model - but instead we need to look at what meaning they are given in the specific contract, and also to what extent mandatory law may impact their validity and their interpretation in the jurisdictions where they come into play. (In this context it should be noted that they, for example, may cover other claims than third party claims, and in M&A deals they are frequently used in relation to first party claims, but for the sake of this article we will stick to the third party claims.)
Sounds a bit complex? Well, I will not argue against you. But because of this fact, and the fact that they can have a great impact on your business, understanding them and ensuring you have appropriate coverage may, for any business, turn out to be a huge advantage.
Such coverage could be concern huge claims and litigations. So let's provide you with some key understandings regarding the indemnification clauses and concept!
A typical indemnification clause
As the example in the beginning of this article indicates, a typical indemnification clause may effectively state that if someone licenses intellectual property rights from you, then they should be able to trust that you own or otherwise have the right to utilize such IP rights that you are monetizing.
Therefore, if a third party comes after that someone for using the product that you are providing due to said product infringing on their intellectual property rights, I would want you to promise that you will cover my costs and losses. After all, it is your fault and not mine that you did not have the rights to the intellectual property that you claimed is yours. Sounds reasonable, right?
The terminology
Indemnitor - the party promising to pay, to cover the losses and costs.
Indemnitee - the party that is entitled to receive compensation, to be held indemnified. The indemnitee can be more than one person, it can be a broader scope that could also include certain third parties.
Covered losses?
What types of losses are covered? Typically losses of any kind, damages, monetary obligations, costs, and expenses such as lawyer fees.
What type of events are included?
It can be IP infringements, it can be breach of warranties stated in the contract (such as a warranty that the party owns all relevant intellectual property), or it can be something else.
Also, the wording connecting the type of losses and the type of events that will trigger the indemnity are of relevance. It could be a more narrow wording requiring the losses to be "directly caused by", or a more broad wording that covers any losses "arising in connection with" a certain event. The first type of wording will mean that the scope of the indemnification is more limited, and the latter type of wording will mean it covers more.
Actions to take to get the costs/losses covered
If a party promises to cover your costs and losses (to indemnify you), that party will typically place some demands on you in order to ensure that the costs and losses they need to pay for are not bigger than they need to be. Hence there will often be requirements to notify your counterparty within a short timeframe, to take actions to defend against claims, to allow your contract party to step into your legal proceedings, etc. So ensure that you know also what is actually required for you to get your costs and losses covered. Otherwise the indemnification might not give you the risk mitigation that you are counting on.
The connection to limitation of liability
Most commercial contracts will include a limitation of liability clause. Such a clause will typically have a cap as regards the total amount that a party commits to paying the other party for warranty defects, contract breaches etc. Sometimes the clause will also include a liability cap for indemnification obligations. That means that the promise to indemnify for eg IP infringement, where you risk having to pay millions of dollars in damages after a court order, might actually only be covered to, say, the total annual fee you have paid your counterparty and with a hard cap of eg USD 150 000. In such a case you will end up still paying the most of the millions of dollars for infringement for a third party intellectual property rights, when they actually were due to the SaaS product (that you are using and paying for) was infringing on the third partys rights. And when it comes to tech - a regular customer will typically not be in any position check if the IT/SaaS services that it uses relies on some component, patent, copyright or other IP right that it does not have the legal right to use.
So back to our story
When you are attacked for infringing someones IP rights and it is in fact the SaaS product that you have licensed that is to blame? Then, if you have a proper indemnification clause you can turn to the seller of the license and they will cover your losses. So if you lose in court and need to pay damages for having used a third party's IP rights without entitlement, the licensor will have to pay you the same amount and typically (depending on how the clause is written) cover other costs such as legal fees as well. Sometimes they may even step in and take the role of defending the case directly, that will be dependent on the wording of the clause and the more precise situation.
Summary indemnification
Indemnification clauses are important in long term contracts. They can provide a risk allocation that makes more sense given the set-up.
When checking the contract, or the fine print in a set of terms and conditions - keep the details in mind and think of the big picture. What is actually covered? Is there a limitation of liability that also covers what you can get under the indemnification clause? What are the demands on taking action and notifying the other party, and are they reasonable for you and your business? So check not only the indemnification clause - but make sure to read it in combination with the whole contract.
N.B. this is not to be read as legal advice in any specific matter and only as general insight in relation to commercial contracts and relationships. If you have any questions or need to consult, please feel free to reach out to the author at katarina.stranderg@stgcommerciallaw.com
London, 7 May 2024
Author: Katarina Strandberg
What is an indemnification clause?
Basically it refers to you, or your counterpart to your contract, promising to pay the other party to the contract for specific types of damages or losses that they/you might suffer in relation to (in this article) third party claims that have a connection to the commercial agreement between you and your contractual counterparty.
Keep in mind that indemnification clauses are contractual obligations, and hence we cannot assume that there is any one-size-fits-all model - but instead we need to look at what meaning they are given in the specific contract, and also to what extent mandatory law may impact their validity and their interpretation in the jurisdictions where they come into play. (In this context it should be noted that they, for example, may cover other claims than third party claims, and in M&A deals they are frequently used in relation to first party claims, but for the sake of this article we will stick to the third party claims.)
Sounds a bit complex? Well, I will not argue against you. But because of this fact, and the fact that they can have a great impact on your business, understanding them and ensuring you have appropriate coverage may, for any business, turn out to be a huge advantage.
Such coverage could be concern huge claims and litigations. So let's provide you with some key understandings regarding the indemnification clauses and concept!
A typical indemnification clause
As the example in the beginning of this article indicates, a typical indemnification clause may effectively state that if someone licenses intellectual property rights from you, then they should be able to trust that you own or otherwise have the right to utilize such IP rights that you are monetizing.
Therefore, if a third party comes after that someone for using the product that you are providing due to said product infringing on their intellectual property rights, I would want you to promise that you will cover my costs and losses. After all, it is your fault and not mine that you did not have the rights to the intellectual property that you claimed is yours. Sounds reasonable, right?
The terminology
Indemnitor - the party promising to pay, to cover the losses and costs.
Indemnitee - the party that is entitled to receive compensation, to be held indemnified. The indemnitee can be more than one person, it can be a broader scope that could also include certain third parties.
Covered losses?
What types of losses are covered? Typically losses of any kind, damages, monetary obligations, costs, and expenses such as lawyer fees.
What type of events are included?
It can be IP infringements, it can be breach of warranties stated in the contract (such as a warranty that the party owns all relevant intellectual property), or it can be something else.
Also, the wording connecting the type of losses and the type of events that will trigger the indemnity are of relevance. It could be a more narrow wording requiring the losses to be "directly caused by", or a more broad wording that covers any losses "arising in connection with" a certain event. The first type of wording will mean that the scope of the indemnification is more limited, and the latter type of wording will mean it covers more.
Actions to take to get the costs/losses covered
If a party promises to cover your costs and losses (to indemnify you), that party will typically place some demands on you in order to ensure that the costs and losses they need to pay for are not bigger than they need to be. Hence there will often be requirements to notify your counterparty within a short timeframe, to take actions to defend against claims, to allow your contract party to step into your legal proceedings, etc. So ensure that you know also what is actually required for you to get your costs and losses covered. Otherwise the indemnification might not give you the risk mitigation that you are counting on.
The connection to limitation of liability
Most commercial contracts will include a limitation of liability clause. Such a clause will typically have a cap as regards the total amount that a party commits to paying the other party for warranty defects, contract breaches etc. Sometimes the clause will also include a liability cap for indemnification obligations. That means that the promise to indemnify for eg IP infringement, where you risk having to pay millions of dollars in damages after a court order, might actually only be covered to, say, the total annual fee you have paid your counterparty and with a hard cap of eg USD 150 000. In such a case you will end up still paying the most of the millions of dollars for infringement for a third party intellectual property rights, when they actually were due to the SaaS product (that you are using and paying for) was infringing on the third partys rights. And when it comes to tech - a regular customer will typically not be in any position check if the IT/SaaS services that it uses relies on some component, patent, copyright or other IP right that it does not have the legal right to use.
So back to our story
When you are attacked for infringing someones IP rights and it is in fact the SaaS product that you have licensed that is to blame? Then, if you have a proper indemnification clause you can turn to the seller of the license and they will cover your losses. So if you lose in court and need to pay damages for having used a third party's IP rights without entitlement, the licensor will have to pay you the same amount and typically (depending on how the clause is written) cover other costs such as legal fees as well. Sometimes they may even step in and take the role of defending the case directly, that will be dependent on the wording of the clause and the more precise situation.
Summary indemnification
Indemnification clauses are important in long term contracts. They can provide a risk allocation that makes more sense given the set-up.
When checking the contract, or the fine print in a set of terms and conditions - keep the details in mind and think of the big picture. What is actually covered? Is there a limitation of liability that also covers what you can get under the indemnification clause? What are the demands on taking action and notifying the other party, and are they reasonable for you and your business? So check not only the indemnification clause - but make sure to read it in combination with the whole contract.
N.B. this is not to be read as legal advice in any specific matter and only as general insight in relation to commercial contracts and relationships. If you have any questions or need to consult, please feel free to reach out to the author at katarina.stranderg@stgcommerciallaw.com
London, 7 May 2024
Author: Katarina Strandberg