What Is a Contractual Indemnification Provision?
At its most basic level, an indemnification clause is a provision in an agreement where one party agrees to financially ‘indemnify’ or ‘hold harmless’ the other party. More specifically, an indemnification clause is a contractual obligation of one party to compensate another for losses incurred as a result of the conduct of the first party or another third party. As it relates to an employment contract, it requires the employee to reimburse the employer for certain costs incurred by the employer including litigation costs, fines or a settlement or verdict payment. In Canada, such terms in employment agreements have historically been found to be enforceable where it is explicit within the employment contract that the employer is permitted to do so. That said, these terms must not be unconscionable and should follow the terms of the contract generally .
Indemnification clauses can be an effective risk management strategy for employers who purchase insurance policies for the company. The indemnification agreement is a method of transferring some of the risk back to the employee "to prevent portfolio erosion by obligating employees to repay a portion of damages or settle disputes on their own." Alternatively, for smaller employers especially, an indemnification clause can be a protection against costs which might otherwise be prohibitive to the employer’s ability to defend itself. In addition, an indemnification from the employee could protect the employer from any attendant liabilities. For the employee, the benefit is clear, they receive the benefit of working in good faith and with the intention of the contract without worrying about the future risks to the employer, and thus his/her employment.
Significance of the Indemnification Provisions
This provision is particularly important in the event that an employee is subject to a tax audit – the indemnification clause protects an employer from significant loss and expense. It should also be reviewed and customized in circumstances where an independent contractor or outsourced employee relationship exists. For example, a national company faced significant fees and costs because its employee was audited in a state in which the company had no operations.
As a result of having carefully considered and tailored an Indemnification clause, the employer was able to mitigate against substantial costs. To be clear, running a business always involves some level of risk and potential liability. With respect to employees, one way to help manage and mitigate that risk is to have a contract with carefully considered indemnity provisions. It would not be uncommon for an employer to commit to providing full, prompt and complete indemnification and defense of claims against its employee that are the result of his performance of his job duties (even if he acted negligently, so long as he did not act with gross negligence or willful intent to cause harm). In such circumstances, it is also appropriate for the employer to reserve the right to participate in the defense of any lawsuits, though doing so may impact on the employee’s indemnification rights in some states.
These indemnification clauses focus substantial attention on when an employee is expected to defend and/or indemnify an employer. Thus, in the event that the employer is obligated to indemnify its employee and defend him in a lawsuit, the employee then has an additional motivation to assist in the defense. This approach can save a lot of money in legal fees in the event of litigation. Consideration should also be given to addressing the risks created by an employee’s potential misrepresentation to a third party or inappropriate conduct that might subject the employer to liability.
Typical Circumstances Requiring the Indemnification
Sometimes even the best employers find themselves embroiled in legal disputes with third parties. If your employee engages in bad behavior that prompts a lawsuit, even if that behavior was purely personal – an example could be sexual harassment against a customer or client – your employee may not be the only one on the hook for the costs of that lawsuit. In most cases, your business will also be responsible for any liabilities incurred by the employee, if the activity was carried out in the furtherance of a business interest, with your consent or just plain negligence on your part. Conversely, the employee may have to indemnify you for any damages the lawsuit costs "you" (in other words, your business).
A common situation where this comes into play is if your employee accidentally injures a member of the general public, perhaps tripping in a busy aisle at your store and causing harm to a shopper. If the incident is ruled negligence on the part of the employee, you would be on the hook for any damages assessed for injuries and suffering. Your business could then turn around and file a lawsuit against the employee in an attempt to recover some or all of those costs.
Indemnification clauses can also protect your business from property damage. Let’s say your server overheats and causes damage to a client." It then turns out there are sensitive documents on that server, resulting in significant damages to the client. If your employee neglected to perform their duties (restarting and backing up the server every day), they could be held liable for the full cost of repairing the problem. If they’ve signed an indemnification clause, then all your business has to do is recoup fees from the indemnifying party (the employee) rather than coming out of pocket for the entire cost.
If a customer is injured as the result of a slip and fall accident in your store, for example, the injury could prompt a hefty lawsuit. If your employee caused the spill that led to the fall – perhaps by taking over the mop bucket late in the day with no warning signs down – it could be difficult to determine which party is truly at fault.
An indemnification clause would make that determination clear: the company will indemnify the employee for all foreseeable costs incurred in the lawsuit, and the employee must indemnify the employer for any costs incurred as a result of negligent actions. Without an indemnification clause, it could be difficult for either party to prove liability in court; with an indemnification clause, it’s up to the judge to decide the terms of the indemnification.
Drafting a Favorable Indemnification Provision
Not all indemnification provisions are drafted equally and the courts will not enforce a poorly drafted clause. Therefore, when reviewing and drafting an effective indemnification clause, employers should consider the following key elements:
Clear language. Drafting an effective indemnification clause begins with carefully chosen clear language that sets forth the obligations of the parties. The language should be unambiguous so that it is clear the employer intends to be indemnified in all cases except those where the employee is adjudged guilty of gross negligence or an intentional act. The indemnification language should also be clear so that it is unambiguous whether the indemnification provision covers only third party claims, or whether it also covers claims asserted by the individual against the employer.
Scope and limitations. A typical indemnification clause not only obligates an employer to reimburse employees for causes of action brought by outside parties, but also obliges an employer to cover the attorneys’ fees and the costs for all misconduct of the employee. Employers would be wise to strictly limit the scope of an indemnification obligation and make the language narrowly tailored to cover only those expenses they are willing to cover.
Entertainment and indemnification insurance. Importantly, employers in the entertainment industry have different considerations to address when drafting an effective indemnification clause. Many industry standards provide for the procurement of entertainment and indemnification insurance, which provides coverage for alleged negligence claims against individuals or entities. Those industries generally carry large liability limits, which are a significant benefit to employees at the forefront of public relations.
Indemnification requirements. Nevada law does not expressly require companies to provide indemnification, but many companies have adopted corporate bylaws or charters that do require indemnification. Companies should note, however, that not all domestic states allow corporations to adopt bylaws containing indemnification provisions. Thus, a lawyer should review the state of incorporation statutes to determine if a company is prohibited from including certain provisions in its bylaws with respect to indemnity and other liability limiting provisions.
Specific legal requirements. Courts will closely examine corporate bylaws to determine if there has been a violation of a statutory provision, such as those provisions governing the delegation of duties.
Legal Concerns and Challenges
Indemnification clauses in an employment contract can, depending on the wording, have adverse legal implications for the employee and can be vulnerable to legal challenge.
What employees need to appreciate before signing an employment contract is that an indemnification provision will almost always extend liability from the individual who did the wrong into their employer’s pocketbook. A few examples should illustrate.
Perhaps you, as an employee, are sued for defamation for a blog post you write in your capacity as company representative. You hire a lawyer to represent you. The employer’s indemnification provision requires you to pay back the employer for all the indemnity costs paid by it in your defence. If the matter proceeds to trial, the indemnity costs by the employer will quickly run into the hundreds of thousands of dollars. It does not matter whether you wrote your blog post on work time or at home. The indemnification provision in the contract says you pay the costs for your blog post saying what it does. If the employer proves that you acted maliciously, you may even be on the hook for the award against you, an amount that could exceed a million dollars.
This outcome is so shocking that employers routinely have to waive the indemnification clause for the employee to retain legal representation where the wrongdoing in question is not extreme. It also runs counter to one of the most foundational rules of Canadian defamation law, which is the protection of journalistic sources. Even if you were not the author, you may have been deemed to have had input into some blog posts . Given the broad terms of the indemnification clause, without a waiver, the employer can tell you that you are on your own for the legal costs, even though the post you might think is innocent will fairly quickly run into tens of thousands of dollars as it winds its way through the court system.
Suppose, instead, that you are sued for breach of fiduciary duty for sending confidential trade secrets to your personal email account to compete with your employer. The indemnification provision says that you have to repay the employer’s legal costs when it is found that your conduct is, in fact, malicious. You hire a lawyer. You lose at trial and the award against you is $1 million in damages and a half a million in legal costs. The indemnification provision allows the employer to take a garnishee order against your salary until the amount owed is repaid. If the amount is significant, you will likely be unable to keep your job because of the continued stress of the litigation. Even if you can keep your job, you will have difficulty finding a new one because of the extensive public disclosure of the whole saga at trial. Many competitors will be unwilling to take the risk on you and the word-of-mouth amongst their peers will be telling.
These are just two examples, but there are countless more out there to be found. If it was an innocent mistake that got you into trouble at work, those clauses always open up the potential for huge and often life altering outcomes due to the broad language used. Negotiating those provisions is a priority, so that you do not have any surprises later on.
Negotiation of Indemnification Provisions
When it comes to the negotiation of an indemnification clause, both employers and employees should be aware that they may be able to carve out a statement of principle that will apply, as opposed to being governed by all terms and conditions. A statement of principle may have limitations such as fairness or reasonableness, whereas an indemnification clause may not. Among other issues that may be negotiated is the scope of the indemnification obligations involved.
The employer should consider what are the primary risks that they are seeking to protect themselves from and make that clear. The employer may also ask for full disclosure of all facts relating to liability, but may also provide in the agreement a right for them to settle, giving the employee control over certain costs. In addition, a reasonable defence cost can be negotiated, along with the timing of payment of costs. It may be necessary that the employer agree that the employee may retain a separate counsel. An indemnification clause could be written so that the employee will not be indemnified if he or she acts in bad faith.
The employee should point out that a broad indemnification clause may be unfair, and should try to agree to a clause wherein the employer is responsible for indemnifying only when the employee reasonably requires a legal defence.
It is also important to note that confidentiality is a critical value for many employers in an indemnification clause and is often the subject of negotiations.
State-Specific Laws and Rules
State laws and regulations may help to shape the language and enforcement of indemnification clauses. For example, in Arizona, Arizona Revised Statutes § 10-3852 provides that a corporation may not indemnify a director against expenses, judgments, fines, and amounts paid in settlements in connection with a proceeding if the director engaged in an act or omission that consciously and knowingly violated the requirements of applicable law or the director derived an improper personal benefit from the conduct at issue.
At the other end of the spectrum, North Dakota appears to have the broadest permissible indemnification policy. North Dakota General Statutes § 10-19.1-09 provides that a corporation may "indemnify any person who was, is, or is threatened to be made a defendant in, or who is otherwise involved in, any action, suit, or proceeding, whether civil, criminal, administrative, or investigative, by reason of the fact that the person is or was a director, officer, employee, or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee, partner, member, manager, agent, trustee, fiduciary, or servant of another foreign or domestic corporation, partnership, limited liability company, joint venture, trust, government, governmental agency, instrumentality, or any other enterprise, including service with respect to employee benefit plans, or as a citizen or resident of the United States or of a foreign country, or as a director, officer, employee, agent, or partner, member, manager, manager, trustee, fiduciary, or servant of a foreign or domestic corporation having similar or greater rights to indemnification as are provided under this section; provided, however, that the corporation must indemnify the director, officer, employee, agent, partner, manager, trustee, fiduciary, or servant against expenses, judgments, fines, and amounts paid in settlement in connection with any such action, suit, or proceeding to which the director, officer, employee, agent, partner, manager, trustee, fiduciary, or servant was or is threatened to be made, threatened to be made, or is or may be made a named defendant.
Other states also support maximum indemnification for directors and officers, and some provide a good faith defense: Michigan, MCL § 450.1541a; Louisiana, LRS 12:159.B; California, California Corporations Code § 309; Washington, RCW 23B.8.340; New York, Business Corporation Law § 722; Rhode Island, R.I.G.L. 7-1.1-1012; South Carolina, S.C.Code Ann. § 33-8-1; Texas, Tex.Bus. Org. Code Ann § 8.001.
Compliance with federal and state securities laws may also dictate available indemnification in a public company setting.
Summary and Recommendations
In closing, it is important to consider the most effective way to draft indemnification clauses in order to ensure that they are equitable to both parties and provide the necessary protection against liability for the applicable party. Companies will want to make sure that their agreements contain clearly delineated provisions regarding the extent of protection that they provide as well as a concrete definition of what acts are covered. Simply stating that an employer must indemnify the employee is not always sufficient because extraordinarily high damage awards could fall under such an agreement, but still not be included in indemnity protection. Therefore, it is up to the companies to ensure that the indemnification clauses in their employment contracts are carefully written to balance risks, protect employees, and protect the company .
Most employers, however, will benefit from broad indemnification. This is particularly true when the employer requires an employee to sign a standard employment contract that includes an indemnification clause. Without a broad indemnification clause that protects the employer, a lawsuit filed against the employee for breach of fiduciary duty or wrongful termination may result in liability for the employer. Employers should also keep in mind the jurisdictions in which they operate and their own internal policies regarding indemnification. Most companies should, in fact, have a written policy that covers indemnification for Board members and management. Some may even choose to provide their executives with directors and officers insurance policies to cover them in the event of personal liability.