2021-03-11
An indemnity clause exists in a variety of agreements such as Original Equipment Manufacturing (OEM), purchase/sale, work for hire or patent licensing agreement. If ignored, its risks are high for the “indemnitor” (the party who bears the duty to indemnify). As such, sellers and suppliers should consider the following before agreeing to the clause:
(a) scope of indemnification,
(b) costs to bear to perform, and
(c) legal exposures in case of a breach.
The key is the cost to perform such a duty. Otherwise, the indemnitor is entering into uncharted territory which could be costly if unheeded.
What does an indemnity clause mean in Layman’s Term? Colloquially, this can be expressed as a “clean up the mess for me if any problem should arise” clause. This clause essentially takes away the buyer’s risks and costs should any third party raise issues concerning the goods or services supplied.
Typically, a buyer (“indemnitee”) requests that the seller (“indemnitor”) to “defend and hold harmless” the buyer during a third-party claim against the buyer related to the goods or services supplied by the seller. Without proper limitations, the indemnitee does NOT have to show that: (a) the third- party claim is legally reasonable (as opposed to a frivolous one), (2) the indemnitee itself is not at fault attributable to the claim, or (c) the part of the goods or services supplied by indemnitor caused for the claim (in a sale of component case).
In addition, the indemnitor is usually required to pay for attorney fees, which in certain cases may cost millions when followed by a lawsuit.
A simple example of an indemnity clause may resemble the following:
“At Buyer’s request, Supplier will defend and hold harmless any third party claim against Buyer, Buyer’s affiliates, or their directors, managers, or employees from and against any costs, damages, and fees (including attorney and other professional fees) attributable to any such claim for (a) intellectual property right infringement (b) personal death or injury, or (c) Seller’s breach of any terms of this Agreement due to the good or services sold by Seller.”
The key phrase “defend and hold harmless” is a duty to act before the fact – not just to pay damages after the fact. In other word, the indemnitor’s main duty is to come forward and resolve the third-party claim for the indemnitee upon receiving the indemnitee’s notice of such claim. Therefore, it constitutes a breach if the indemnitor fails to act timely and resolve the claim. In such cases, the indemnitee can sue outright without waiting for actual monetary damages to arise.
In particular, to trigger the seller’s duty to indemnify, the buyer is NOT required to show that the third-party claim is reasonably founded - which means the seller may need to respond to any third-party claim, real or frivolous. This potentially creates uncertain/unforeseeable business risks for the seller.
Another example: Company X and its Supplier Y’s OEM agreement specifies Y Supplier’s duty to indemnify as follows:
“Supplier will indemnify and hold harmless Company X and their distributors, customers, licensees, contractors and other representatives, from any damages and expenses (including reasonable attorneys, consultants’, and experts’ fees) that arise out of or result from any third-party claim.”
Company X provides technical specifications/design to Supplier Y to manufacture custom-made goods in Taiwan. Supplier Y manufactures the custom-made goods and sells them to Company X pursuant to Company X’s purchase order to sell them around the world. Long and behold, a third-party claim arises in the United States alleging patent infringement. After Company X notifies the Supplier Y to perform its duty of indemnity according to their OEM agreement, Supplier Y should either: (a) defend Company X in court through litigation, or (b) settle the claim by paying royalty to the claimant.
Either way, this could result in immense costs for Supplier Y – usually millions of USD or more to resolve, depending on the complexity of the case. Furthermore, it would be unfair if it turns out Company X’s technical specifications and design was the real cause to for the problem.
General strategies for negotiating the Indemnity Clause.
In light of the foregoing, potential strategies when negotiating an indemnity clause are presented below:
(1) Restrict the scope of territorial;
(2) Set up maximum indemnification amount each year to e.g., seller’s yearly earnings from the underlying transactions;
(3) Make it a mutual duty to indemnify (as opposed to seller’s unilateral duty to do so);
(4) Add buyer’s duty to cooperate with seller in defending or negotiating the claim;
(5) Add exceptions to seller’s duty, which specifies that the duty of indemnity does not apply if: (a) buyer itself was at fault by e.g., making its own alterations to the goods, (b) the claim turns out to be frivolous and not legally reasonably founded, or (c) the goods supplied was made pursuant to buyer’s specifications, design and/or instructions;
(6) Restrict seller’s duty to pay damages for breaching its indemnity duty to direct damages which excludes indirect, incidental, or consequential damages; and
(7) Restrict to the extent possible the survivability of seller’s duty to indemnify following termination of the underlying sales or OEM agreements.
Please note that while a few example strategies have been outlined above, your success in achieving the most favorable terms will depend on your law firm’s ability and experience to negotiate the details in the contract.
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