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Indemnification and Defense Clauses: WHAT ARE THEY AND WHY ARE THEY IMPORTANT?

Indemnification is an undertaking by one party to compensate the other party for certain costs and expenses. The obligation to indemnify is imposed either by law or contract. Parties to a contract can use an indemnification clause to customize risk allocation. Indemnification clauses can widely vary – in a typical indemnification clause, the indemnifying party promises to reimburse the indemnified party from and against any and all losses, liabilities, claims and causes of action incurred by the indemnified party that cause, arise from, or are related to, the specified events giving rise to the covered event.

In many cases, a party negotiating an indemnity clause will also want to negotiate a defense clause. A defense clause is one in which the indemnifying party promises to defend the indemnified party against third-party claims. The obligation to indemnify and the obligation to defend against third-party claims are separate and distinct. Direct claims are claims that the indemnified party has against the indemnifying party. Third-party claims are claims that a third-party has against the indemnified party.

Depending on the language employed in the indemnity clause, the indemnifying party may agree to compensate the indemnified party for direct claims, third-party claims or both. Indemnification requires the indemnifying party to: reimburse for paid covered losses, advance payment for unpaid covered liabilities as they are incurred but only if the language in the indemnity clause covers liabilities, claims, or causes of action.

The obligation to defend is usually broader than the obligation to indemnify because it may apply whether or not the third-party claim has merit. The obligation to defend includes both, an obligation – to reimburse for covered paid losses and advance payment for covered unpaid liabilities, and a right – to assume and control the defense, subject to the specific terms of the parties’ defense clause. The obligation to defend is generally held to exist only in the context of third-party claims and if the defense clause covers the allegations (not the ultimate merits of the action) in the complaint.

Parties entering into a commercial contract should be particularly cognizant of whether the contract contains a properly drafted indemnification clause; the failure to include a properly drafted indemnification clause may result in the: non-breaching party being unable to obtain certain types of reimbursement (i.e., attorney’s fees) and the breaching party being unable to adequately cap its liability. When drafted improperly, an indemnification clause can subject a party to continuing liability for circumstances beyond its control. When drafted properly, an indemnification clause can be a powerful tool to shield a party from lawsuits and damages.

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