What is Indemnification?
Indemnification is a legal agreement by one party to hold another party blameless – not liable – for potential losses or damages. It is similar to a liability waiver but is usually more specific, applicable only to particular items, circumstances, or situations, or in regard to a particular contract.
Black’s Law Dictionary defines “indemnify” as an action establishing “a duty of party “A” to make good any loss, damage, or liability incurred by party “B”.” The basic concept of indemnity is that of “holding harmless” – by means of indemnification, party A agrees to hold party B harmless in the event of possible loss or damage.
By indemnifying the second party, the first party, in effect, agrees to pay for or make good any loss or damages that may occur. In other words, by agreeing to make the indemnitee (the party that receives, or benefits from, the indemnity) NOT liable, the indemnitor (the party granting the indemnity) effectively agrees that he/she IS liable.
How Indemnification Works
Indemnities can be important in protecting you and/or your business from lawsuits or other possible financial liabilities.
Suppose, for example, that you hire a contractor or remodeling company to remodel your company’s office. Your contract with the remodeler should ordinarily include an indemnity clause that protects you against events such as shabby work on the part of the remodeler that later results in someone being injured when a wall of your office collapses on them. In such a case, you should be indemnified against having to pay the injured individual, as you had no control over the quality of the construction. Instead, the contractor or remodeler will have to pay any compensation awarded to the injured party.
Why Indemnification is Important
Indemnification can be important to both parties entering into a transaction or contractual agreement.
If you are granting the indemnity, the provision of reasonable protection against liability may be essential to you being able to do business with the other party. Referring to the example above, if you were the contractor in the situation, unless you are willing to provide indemnification against possible future liability, the company looking to get their office remodeled might not be willing to hire you to do the work.
If you were on the other side of the transaction, that of the company contracting for the remodeling job, without the remodeler granting you indemnification, you may be putting your company at unreasonable financial risk.
It’s important to both parties involved that any indemnification agreement be clearly stated and only applicable to specific and reasonable circumstances or situations. Indemnification clauses that are too broad or general may lead to problems. For example, a company that rents machinery may want to be indemnified against being sued if someone is injured while operating the machinery.
However, it would be unreasonable to grant the company that rents out the machinery blanket indemnification against any legal action. Someone who rents the equipment should still retain the right to seek legal redress against the rental company if, for example, the machinery fails to do what the rental company advertised it as being capable of doing.
Forms of Indemnity
An indemnity may appear in one of several forms, as follows:
1. Indemnity Provision or Clause
An indemnity commonly appears in the form of a clause or provision in a legal contract. An indemnification provision in a contract is a very important commitment, because the indemnitor is foregoing, or surrendering, their ordinary right under the law to sue the indemnitee to recover a loss. Indemnification clauses are commonly specific to products or circumstances, and only apply to one party, in that the indemnitor relinquishes the right to sue the indemnitee, but the indemnitee does not relinquish their right to sue the indemnitor.
2. Indemnity Agreement or Contract
An indemnity agreement frequently appears in the form of a terms of service (TOS) contract where the indemnitor, who is usually a customer of the indemnitee, agrees not to hold the indemnitee liable for any damage or loss that may arise as a result of the indemnitor using the indemnitees goods or services. You’ve probably seen – and entered into – a number of indemnification agreements when you were required to agree to the TOS of a company’s website before you could access their information, goods, or services online.
3. Letter of Indemnity
A letter of indemnity is designed to provide protection against possible financial losses resulting from one party failing to meet all the provisions of a contract. The letter, which is often issued by a third-party guarantor, such as a bank, acting on behalf of one party to an agreement, states that in the event that certain contractual provisions are not met by the other party, then the first party will receive financial reparations as compensation for their loss. Letters of indemnity are sometimes referred to as “bonds of indemnity.”
Indemnity vs. Guarantee
Although similar, an indemnity is different from a guarantee. Indemnification is aimed at providing financial protection, especially against potential lawsuits. Its focus is primarily on preventing financial loss.
In contrast, a guarantee is a more positive or pro-active element, ensuring contractual performance by a party to a contract – even if the guarantee is provided by a third party.
Let’s look at an example that may help you see the difference more clearly. If, for example, you use a software program for tax preparation, the company providing the program will also typically provide you with indemnification against tax penalties that result from the software incorrectly calculating your tax obligation. In addition to the indemnity against possible loss, the software company may further offer a guarantee that by using the software you will qualify to receive the highest possible legal refund.
Crafting a Good Indemnification
Indemnification clauses in contracts have generally been found to be enforceable in a court of law. However, some courts have limited the enforceability in cases where the damage or loss that occurred was held to be unreasonably extreme or logically unforeseeable by the party who would be liable to pay for the damages.
Whether granting or receiving an indemnity, you should always examine indemnification clauses carefully to make sure that they reasonably address legitimate concerns and business risks, but that they are also fair and equitable to all parties involved.
We hope you enjoyed reading CFI’s explanation of indemnification. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™ certification program, designed to help anyone become a world-class financial analyst. The following CFI resources will be helpful in furthering your financial education: