If given the choice, you want to be the one to present your own contract when entering into an agreement with someone. Why? Because when you draft your own contract you can choose to include, or not include, anything you want. But knowing how to spot red flags in contracts you didn't draft yourself is an important skill for an entrepreneur to have. There are quite a few to discuss but today we're going to talk about indemnification clauses.
First off, a definition. "Indemnification" means a promise to repay someone for their losses or damages if a specified event occurs. Basically what this means is you're being asked to act as an insurer for the other party. An example:
Parker is hired to paint a mural on the side of a building for a local business. Upon hiring Parker, the business has her sign an agreement that includes an indemnification clause that states:
Contractor will indemnify and hold harmless from any and all claims, losses, actions, damages, interest, penalties, and reasonable attorneys' fees and costs arising by reason of Contractor's performance under this agreement.
While working on the mural one day, Parker's assistant drops a paint can that lands on a passerby and injures their shoulder. The passerby sues the business. Even though Parker was not personally responsible for the injury that occurred, she will still have to pay the business' costs of defending the lawsuit as well as any damages the passerby is awarded. This is because the indemnification clause states she will be responsible for any claim that is determined to "arise" from Parker's services for the business.
So the point is, be wary of these types of provisions!
How do you spot an indemnification clause? Some will be easier to spot because they'll include words like "indemnification" or "hold harmless" but sometimes they won't. You'll have to read through the contract and make sure you don't find any provisions that require you to defend or repay the other party.
If you find this kind of language in a contract you're asked to sign, your first and best option is to strike the language from the contract. If that's not an option, try some of these other strategies:
1. Try to revise the indemnification clause. If the clause it overly broad, like say it indemnifies the other party from any breach of the agreement, try to narrow its scope by specifying only specific injuries to third parties and/or situations under your control.
2. Add an indemnification cap. This would limit your liability to a specific amount. It might not fly with the other party, but it's to your advantage to try.
3. Limit indemnity to a lawsuit. This will prevent you from being liable to pay for the mere threat of a lawsuit. Better yet, try to contain your liability to just instances in which you lose a suit with a third-party.
Each jurisdiction has its own rules in regard to the use of indemnification clauses in contracts. Some only allow them if the protection extends to both parties to the contract, others only allow them if they protect those that are not involved with the contract. So if you have specific questions, it's best to consult with an attorney in your jurisdiction to help you sort it out.
One final note for freelancers and other independent contractors. If you're contracting to do work for a company, be on the lookout for a contract that contains an indemnification clause regarding the IRS reclassifying you as an employee. If the IRS or another government agency decides to reclassify you as an employee, you could be liable for really steep penalties plus back taxes and other fines. These are not cheap. So if you see language trying to shift this burden onto you such as "if Contractor is determined to be Client's employee, Contractor will indemnify and hold Client harmless from any and all liabilities..." you definitely want to think twice before signing.