Most explanations of indemnification begin with the disclaimer that it’s a very complicated topic and can be intimidating for those without a legal background.
No s*#t! You already knew that, which is why you are here. So let’s make this worth your time by starting in plain English: indemnification is about accountability. It is the shifting of “risk,” or the responsibility to pay for various kinds of losses, between people.
Who Takes the Fall
This may sound familiar, because it is the same basic principle as insurance. But whereas with insurance the trigger for shifting risk is an unfortunate event like an accident or illness, the trigger with contracts is one side violating a deal in a way that causes harm to someone who isn’t part of the agreement (a “third party”).
When that person seeks a payout for whatever negative consequences they suffered (or say they suffered), indemnity clauses outline how the people who are signed on to the deal agree to shift around accountability between themselves for compensating the person bringing the lawsuit. You can think of it as the two sides of a deal deciding ahead of time which one will step in to act as the insurance company for the other in certain situations.
The Blame Game
It may seem obvious that whichever side violated the agreement should be held accountable, but indemnity clauses are needed precisely because third parties don’t always know (or care) who violated an agreement they aren’t part of—they just care about getting paid back for whatever harm they experienced, and will try to get that money out of whatever source seems most obvious from their limited vantage point. This may result in the more visible, but ultimately blameless, party getting sued. When this happens, indemnity allows that individual to shift accountability over to the side of the deal that actually messed up.
Say, for example, a coffee shop has an agreement with a vendor called CupzN’Stuff to supply its to-go cups (and, we can only assume, other “stuff”). One day the coffee shop receives a shipment that is defective in a way that is not immediately apparent. Each cup looks fine, but it turns out the bases aren’t fully sealed on, and after about five minutes of holding burning hot coffee the bottoms fall out, injuring customers and ruining their property.
These customers don’t know that the coffee shop isn’t really to blame. They are, quite understandably, going to aim their anger—and their lawsuits—at the business that sold them a cup of coffee that burned them and ruined their stuff.
When the Bottom Falls Out...
But fortunately the coffee shop was smart when it negotiated its vendor agreement with CupzN’Stuff. Their contract includes an indemnity clause that says the manufacturer is responsible if somebody is harmed because of a defective product. So whether or not CupsN’Stuff knew its product was defective doesn’t matter. If customers sue the retailer, ultimately CupzN’Stuff will be on the hook for paying out any money awarded to those scalded coffee consumers.
What’s more, CupzN’Stff would also most likely have to reimburse the coffee shop for the financial burden of going to court. In fact, even if the judge ultimately awards nothing in the lawsuits, CupzN’Stuff would still have to cover the coffee shop’s court-related expenses. These kinds of costs, especially for things like attorneys fees, which can be extremely high, are a significant part of the financial responsibility indemnity clauses address and shift around.
We may take it as a given that we are accountable to the people we sign deals with; but our deals can also have a big impact on people who aren’t signed on to them. Indemnification reminds us that someone has to be accountable to these people, too, and gives us a tool for making sure that when the bill comes due, accountability falls where it should.