Why Indemnities Matter

by Pillsbury Global Sourcing Practice
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Most business clients would rather be in the dentist's chair than sit through negotiation of the indemnity and liability provisions of their agreement. Admit it: your eyes glaze over, time appears to visibly slow down, and you wonder at how the lawyers can find this stuff interesting enough to argue about.

As dull as they appear to be, there are some significant issues that can arise from the indemnity clause. One issue that I see more often than not is that suppliers try to put a financial limit on their indemnification obligations. Sometimes the supplier will agree to remove the limitation, but not always. What are the consequences of having a limitation on an indemnification obligation, and why should you be interested?

Let's consider a software license agreement, which includes an obligation by the software owner (the licensor) to indemnify you (the licensee) for third party claims that the software infringes the third party's intellectual property. If that happens, the licensor will conduct the defense of the claim - that is, they will be the one to hire the attorneys, go to court, and argue why there is no infringement.

The agreement also includes a limitation of liability that limits each party's liability to the annual software license and maintenance fees. The liability provisions could be drafted so that the limit applies to the indemnity obligation. Assume that you are paying $200,000 annually to the licensor, and so that becomes the limit of the licensor's indemnity obligations.

$200,000 can be used up pretty quickly in litigation. There will significant costs to investigate and build a case to rebut the claim - reviewing IP registrations and other documents, interviewing witnesses, researching related lawsuits etc. Legal fees, and the fees of experts and consultants that may need to be retained, quickly build. Then comes the discovery and interrogatory phases. You may not even be at the point of a court hearing or close to settlement discussions when the amount spent has exhausted the $200,000 maximum.

So what will happen? Based on your agreement, the licensor could simply walk away and leave you holding the baby. From a practical perspective, it would be foolish for them to do that, as it's their software that is allegedly infringing, and you have no reason to defend their product. The only thing that you will want to do at that point is get out of the litigation as quickly and cheaply as possible, and so handing the defense over to you would be commercial suicide for the licensor. But in negotiating the indemnity clauses, many suppliers and licensors don't consider the practicalities of dealing with the litigation - they are only looking at the total risk profile of the agreement that they are entering into.

If the licensor wanted to enforce the terms of the agreement, they could do so, leaving you in the position where you have to step into their role in defending the case, or pay them to continue to do so. Doing either would be at significant cost to you, not to mention the disruption defending the claim may have on your business.

If you are not able to negotiate out the limitation of liability from the indemnity obligations, then you should do two things: First, try to exclude the costs of defense from the liability cap. Second, pay extra attention to the indemnification procedures. For example, how will the parties handle the situation where the expected liability exceeds the liability cap? Are you free to defend and seek contribution from the licensor up to the value of the cap?  And what if the licensor takes responsibility for defending the claim and it later appears that the cap will be exceeded? You should avoid that scenario by negotiating a requirement for the licensor to waive its limitation of liability in return for assuming full defense of the claim; the alternative (short of having the licensee write a blank check) would be to give you some level of involvement and/or control over defense and settlement, which would quickly become unworkable.

There's no simple answer to this issue, but there are certainly some options that can be explored in negotiations.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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