Checkpoints for Reviewing Indemnity Clauses: Their Relationship with Damages, Third-Party Claims and Limitations of Liability

Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.

In English-language contracts and transactions with foreign-affiliated companies, indemnity clauses containing wording such as "indemnify," "defend" and "hold harmless" appear frequently. In domestic Japanese-language contracts as well, it has become common to provide that a party will "indemnify" the other with respect to claims of rights infringement by third parties, personal information leaks and breaches of representations and warranties. At first glance they resemble ordinary damages clauses, but one cannot conclude from the difference in name alone that they are a separate legal device; their scope and procedures differ depending on the governing law and the context of the contract as a whole. Because they are sometimes used with the intent of taking on not only compensation for direct losses arising between the parties but also defense costs and attorneys' fees for lawsuits brought by third parties, settlement payments and the costs of dealing with authorities, close scrutiny of the wording is essential.

When considering an indemnity clause, the area where friction is particularly likely to arise is its interplay with the limitation of liability clause for damages. Even if a cap on the amount of damages is placed in the contract as a whole, if the indemnity clause is drafted broadly to "indemnify against any and all losses and costs incurred," interpretations divide over whether the cap also extends to indemnity claims. Whether to exclude IP infringement, personal information incidents and willful misconduct or gross negligence from the cap, or to set a separate cap, tends to be a focal point in practical negotiations.

The Definition and Scope of "Indemnification"

An indemnity clause is an arrangement under which, when certain events occur, one party takes on the burden of losses and costs incurred by the other party. In English-language contracts it is customary for this to be written together with a duty to defend and a hold harmless obligation, but the use of these words does not immediately mean no-fault liability, unlimited compensation or a limitation to third-party claims.

In Japanese-language contracts, because the legal position of the concept of "indemnification" is not uniform, it is necessary to pin down the meaning of each provision. The parties read from the wording whether it is used in the same sense as damages, whether its main focus is dealing with claims from third parties, and whether it is intended to apply regardless of fault. As for the scope of losses covered by indemnification, the contract specifies concretely which losses are included. The treatment of lost profits and attorneys' fees is also specified, and rather than assuming that these are automatically classified as indirect or special losses, the parties check the governing law and the definitions in the clause. Under Japanese law, the assumption of fines, administrative surcharges and the like arising from legal violations is assessed individually for validity in light of the purpose of the regulations and public policy, which creates the practical difficulty that it cannot be said to be uniformly valid or invalid.

Defense Against Third-Party Claims and Procedural Requirements

When a party receives a claim for damages from a third party for patent infringement or an information leak, it is the procedural provisions that determine the effectiveness of the indemnity clause. The contract should set out procedures such as by when the party receiving the claim must notify the other party, which party leads the defense of the lawsuit and the selection of attorneys, and whether entering into a settlement requires the other party's consent. If the procedures remain vague, this leads to situations where the indemnifying party is asked to pay a large settlement without having been able to take part in the litigation, or the indemnified party cannot obtain advance payment of costs and struggles with its defense.

Organizing the requirements for the indemnity obligation to arise and the grounds for exemption is also important. The contract should make clear whether the indemnitor's intent or negligence is a condition, and whether the indemnitor is exempt where the claim arises from the other party's unauthorized modification of specifications or use outside the contract. As for the indemnity period, the parties decide whether it applies only during the term of the contract or survives for a certain period after termination. In M&A and investment agreements, there are also examples where the period for indemnity claims is set separately for each item of the representations and warranties.

Priority over Limitation of Liability Clauses, and Exemptions

Which of the indemnity clause and the limitation of liability clause prevails is worked out by reading through the contract as a whole. The wording should specify whether the cap on damages also applies to the indemnity obligation and, even where IP infringement or information leaks are made exceptions to the cap, whether liability for them is unlimited or subject to a separate cap. If the order of priority remains vague, there is a risk of bearing excessive liability in a dispute.

The allocation of liability relating to subcontractors and materials provided by third parties should also be set out. Risks such as where liability lies when a subcontractor causes a problem, rights infringement or failures relating to third-party materials such as open source software (OSS), and the illegality of data brought in by the customer are allocated, according to who can control them, by determining who bears them and to what extent. In addition, it is necessary to anticipate whether the agreed indemnity obligations fall within the scope that can be covered by property and casualty insurance, and whether the subcontractor has sufficient financial resources for recourse against it to be practically possible.

Risks to Both Parties and Controllability

For the indemnified party, the main aim is to have the other party take on risks it cannot control itself, such as infringement of third-party rights and the illegality of data provided, and to secure terms under which it can actually receive indemnification. However, if the notice deadline is extremely short or the freedom to settle is excessively restricted, the clause may fail to function in practice.

For the indemnifying party, the starting point is to draw a line between the grounds for indemnification and the conditions for exemption, so that it does not take on accidental external factors or the other party's operational errors. It keeps consistency with the liability cap, also checks the treatment of causes it cannot control, such as failures of external services, and decides on the scope it will accept in light of its insurance limits and exclusions and the financial resources of those against whom it would have recourse. Because indemnity clauses are related to the representations and warranties, confidentiality and limitation of liability clauses, it is important to build the provisions in coordination with those in charge of risk management. The scope of our support when ongoing contract review, including indemnity clauses, is entrusted to us is explained in Legal Outsourcing.

Frequently asked questions

What is an indemnity clause in a contract?

It is an arrangement under which, when a specified event occurs, one party undertakes to bear the damages and costs incurred by the other party. Its purpose is to allocate losses arising from third-party infringement claims, personal information leaks and the like. Because it is sometimes used to cover not only direct damages but also defense costs in third-party litigation, attorneys' fees and settlement payments, it is understood that close examination is needed in light of the governing law and the context of the contract as a whole.

If a contract sets a limitation of liability for damages, does that cap also apply to indemnification claims?

Whether a liability cap extends to indemnification claims is a matter on which interpretations differ depending on the contract wording. Even with a general cap on damages, if the indemnity clause provides for indemnification against any and all damages, the order of priority becomes ambiguous. To prevent the risk of bearing excessive liability in a dispute, it is thought necessary to state expressly whether the cap also extends to indemnification obligations or whether a separate cap applies.

What should an indemnity clause provide regarding procedures when a third party alleges infringement?

It sets out matters such as the deadline for notifying the other party, control of the litigation defense, and consent requirements for entering into a settlement. If the procedures remain ambiguous, the indemnifying party may be unable to participate in the litigation and be faced with a demand for a large settlement payment, or the indemnified party may struggle because it cannot obtain advance payment of costs. It is also thought necessary to clearly set out exclusions, such as cases caused by the other party's unauthorized modification.