Beware of Hidden Dangers in Inadequate Indemnifications

Amy manufactures miniature springs. Brad wants to buy those springs to install in plastic frogs he sells to a burger chain as kids’ meal prizes. Brad knows that if a spring in one of his frogs malfunctions and injures someone, he’ll be sued. So, he insists that the contract with Amy include both an indemnification provision and an insurance provision to protect him from a product-liability suit, caused by Amy’s springs. He will have Amy assume responsibility for the cost of any claim made against him and make sure she has enough insurance to pay the damages.

These provisions, in some form, exist in most business contracts, especially between buyers and sellers. Their strength and coverage are, of course, negotiable. As the indemnified person, Brad wants the strongest protections possible.

In Amy and Brad’s contract, Paragraph 10 contains the following:

“Indemnification. Amy hereby agrees to indemnify and hold harmless Brad from and against any and all claims arising out of Amy’s performance under this Agreement.”

Paragraph 11 states:

“Insurance. During the term of this Agreement, Amy shall maintain adequate insurance and name Brad as an additional insured.”

Brad signs the contract and sells his plastic frogs to the burger chain. Soon after, a child is hurt when a spring breaks. The child’s parents sue the restaurant, claiming the springs in the toy frogs are so flimsy they caused the child’s injury. As a result, the burger chain rushed to another toy manufacturer to buy plastic horses instead. The burger chain wants Brad to not only pay for the child’s damages, but also reimburse it for the cost of the replacement plastic horses, and its lost profits and costs.

Brad calls Amy, demanding she indemnify him and the restaurant, pursuant to the terms of their contract. Amy says she cannot help him because she’s about to go out of business. Brad tells Amy to call her insurance company.

Brad is about to learn the hard way why indemnification and insurance provisions are two of the most important provisions of a business contract. The improperly drafted and misunderstood provisions may very well cost him tens of thousands of dollars in damages and litigation costs.

Recall Paragraph 10 of Amy’s and Brad’s contract above — here is what Brad should have been aware of before he signed that contract:

• Include the word, “defend.” An agreement to indemnify someone does not mean to defend someone. “Indemnify” means to compensate another party for loss or damage that has already occurred. Defending an action is not included. Brad now has to hire a lawyer to defend him, even if he has done nothing wrong. Amy’s insurance has no duty to defend him under the contract.
• The secret password. Referred to by insurance companies as a “savior clause,” Brad should have considered adding the words, “to the fullest extent permitted by law.” Some insurance companies require that language be included before they will cover a dispute and want to see the language included in both the indemnification clause and the insurance clause. While this language may not be a legal requirement for indemnity and insurance provisions to be enforceable, if it is recommended by the insurance companies and has the potential to enable them to pay claims faster, then it is worth including.
• Bind and protect broadly. This provision only binds Amy. What if she sells her business or later incorporates? What if Brad’s employees are sued too? A strong indemnification provision also binds and covers others who may be affected.
• Cover widely. This provision does not spell out exactly what falls under its umbrella. Look for a laundry list so there are no questions as to what is covered, such as “claims, demands, liabilities, causes of action, losses, damages, fines, taxes, penalties, costs, expenses, and reasonable attorney fees.” It may look like repetitive legalese, but a repetitive yet robust indemnification agreement is always better than a flimsy and insufficient one. Also, spell out exactly what types of disputes trigger coverage, such as breach of contract and negligence. But, caution: one cannot be indemnified for one’s own negligence.

Now let’s look at the above insurance provision in Paragraph 11.

• Clearly define the insurance coverage. The contract provision doesn’t spell out exactly what coverage and how much coverage Amy is required to maintain. What is “adequate”? For instance, some general liability policies may only cover bodily injury and property damage, not financial losses, such as Brad’s situation with the spring. Amy would have had to purchase that coverage separately for Brad to be covered.
• Be a “named insured.” Brad should have made sure he was not merely an “additional insured” on Amy’s policy, but a “named insured” instead. This distinction is important for triggering coverage. If Brad is sued but Amy is not also sued (as is the situation here), Amy’s insurance will likely only cover Brad if Brad is a “named insured.” It will only cover Brad as an “additional insured” if Amy is also sued. As merely an “additional insured,” if Brad brings a third-party action against Amy, it will not trigger his coverage under her policy. Brad should also have made sure the provision states that Amy must supply him with certificates, demonstrating she has complied with the insurance requirements of the agreement, and inform him at least 30 days in advance of any changes, cancellations, or lapses.

Ideally, here’s what Brad should have put into his contract with Amy:

• Paragraph 10. Indemnification. Amy and her successors, agents, and assigns hereby agree, to the fullest extent permitted by law, to indemnify, defend, and hold harmless, Brad and his successors, assigns, agents, employees, directors, and officers from and against any and all claims, demands, liabilities, causes of action, losses, damages, fines, taxes, penalties, costs and expenses, including reasonable attorneys’ fees, arising out of or in relation to or in connection with (1) any defects in the product, including but not limited to design and manufacturing defects or (2) Amy’s or her successors’, agents’, or assigns’ a) negligent acts or omissions, b) any breach of representations and warranties, and c) breach of contract.
• Paragraph 11. Insurance. Amy shall, on or before the effective date and during the entire term of this Agreement, procure and maintain at least the following minimum insurance coverage and limits: Commercial General Liability Insurance and supplemental insurance written on an occurrence basis with limits of at least $1,000,000 per occurrence and $2,000,000 aggregate to include coverage for, but not limited to, premises/operations liability, contractual liability, personal injury, and product liability, including bodily injury, property damage, and financial loss. To the fullest extent permitted by law, Amy shall list Brad as a named insured on all commercial liability policies and provide certificates of insurance and copies of such policies to Brad. Amy shall not cancel, change, or allow a policy to lapse without providing at least 30 days’ notice to Brad.

Yes, it reads like legalese, until, of course, there is a dispute. Once lawyers and insurance companies get involved, vigorous and well-drafted indemnification and insurance provisions are imperative to protecting the financial health of a business — a lesson Brad learned too late.

Pam Lundborg is a business attorney at Bond, Schoeneck & King, PLLC. Contact her at plundborg@bsk.com