As is the case with any commercial contract, one of the many purposes of a distribution agreement is the minimization, management, and allocation of risk between the parties. When things go sideways – because one party did or failed to do something that leads to potential exposure for the other party – a well-drafted distribution agreement will contain indemnification clauses to clarify and place limits on the responsibility and costs for wrongful conduct.
Indemnification clauses are critical components in distribution agreements. In the most basic sense, they delineate where fingers should be pointed and whose checkbook may need to be opened when claims or liabilities from either party or third parties arise. These provisions are often buried within the later pages of a typical distribution agreement, along with other “boilerplate.” I touched on the significance of “boilerplate” in my January/February 2024 article “The Risk of Glossing Over Contract 'Boilerplate,'” including how certain other boilerplate provisions can play a determinative role in the outcome of contract disputes, which necessarily includes indemnification provisions. Indemnification provisions can be a shield and a sword, so regardless of size, all distributors should not shrug off the details of these provisions as just part of the “boilerplate.”
Indemnification clauses in distribution agreements should be carefully tailored to the specific needs, circumstances, services (such as value-add work), and products implicated by the relationship. An agreement that involves multijurisdictional territories, greater distributor responsibility for managing customer and manufacturer or representative relationships, and other matters that pose more significant risks of harm or loss may alter the risk allocation calculus in ways different from other arrangements. That said, indemnification clauses in distribution agreements typically include the following components:
Scope of Indemnification
This clause defines the specific circumstances, claims, and liabilities under which one party (the “indemnitor”) agrees to compensate the other (the “indemnitee”) as well as potential limits on the amount of and types of damages an indemnitee may recover, including:
- Product Liability and General Negligence: If a distributor sells a defective product that causes bodily injury, property damage, or other losses that lead to a claim against the distributor, the manufacturer agrees to indemnify and hold the distributor harmless for any damages incurred by the distributor for claims, damages, or losses arising from that defect or other contract obligations. Similarly, the manufacturer may agree to indemnify the distributor for damages caused by the manufacturer’s negligence in connection with the performance of its obligations under the contract.
- Intellectual Property Infringement: The manufacturer may indemnify the distributor if a third party claims that the distributed product infringes on their trademark, patent, or other intellectual property rights.
- Breach of Contract: Either party may indemnify the other for losses resulting from a breach of the distribution agreement or a breach of contract involving a third party, including some or all representations and warranties.
Indemnification obligations also usually include a duty to defend, meaning the indemnitor must defend the indemnitee against claims covered by the clause and bear responsibility for attorneys’ fees and costs incurred doing so. While it is not uncommon to see “duty to defend” language in an indemnification provision, most often, there is no detail to the scope and nature of the obligations flowing from this duty, which leaves that duty essentially unenforceable.
Limitations on Amount and Types of Damages Recoverable
Risk management not only involves allocating responsibility for specific types of errors or omissions but also defining the scope of that liability and carving out circumstances under which indemnification obligations do not arise or are not applicable.
Most distribution agreements limit the amount and types of damages that are recoverable in an indemnification claim and establish timelines and notification obligations for invoking the provision. These limitations include:
- Cap on Liability: A common limitation is the imposition of a cap on the indemnifying party's liability. This cap is often a predetermined amount or a function of contract value. Caps help to ensure that the indemnifying party is not exposed to unlimited financial risk, which could be disproportionate to the benefits derived from the agreement.
- Exclusion of Certain Damages: Many indemnification clauses exclude liability for consequential or indirect damages, such as lost profits, loss of business opportunities, or reputational harm. This exclusion helps to limit the scope of indemnity to direct damages, which are more predictable and quantifiable (and help avoid battles of experts).
- Time and Notice Limitations: Similar to statutes of limitations, indemnification provisions often place time limits on when the indemnitee must provide the indemnitor with notice of any claims for which indemnification is sought. Failure to give timely notice can result in the forfeiture of indemnification rights.
Exclusions
Indemnification provisions also typically insulate a putative indemnitor from responsibility if a claim arises from an indemnitee’s conduct that involves:
- Gross Negligence and Willful Misconduct: This exclusion prevents parties from being indemnified for their egregious behavior, promoting accountability and fair dealing.
- Non-Compliance with Laws: Damages resulting from the indemnitee’s failure to comply with applicable laws and regulations are typically excluded. This encourages such compliance and avoids indemnification for unlawful conduct.
- Breach of Representations and Warranties: Some agreements exclude indemnification for damages arising from breaches of certain representations and warranties by a contracting party. Caution is warranted as such affects the scope of an indemnification agreement.
The interpretation and application of indemnification provisions are matters of state law, and while generally narrowly construed, they may be affected by other boilerplate, such as what law applies to any contract dispute. When coupled with the risk of a less than adequately drafted indemnification provision, dispute resolution outcomes are more likely to be inconsistent or less predictable. It is, therefore, crucial to consider the legal environment in which the distribution agreement will operate and draft indemnification clauses accordingly. Further, distributors should consider the nature and scope of insurance policies that provide coverage for various acts, as certain risks might well be covered by a distributor’s insurance coverages or that to which the distributor is a named insured.
If you have questions or concerns about indemnification provisions or issues, please contact me at 312-840-7004 or [email protected].
The information contained in this article is provided for informational purposes only, and should not be construed as legal advice on any subject matter. The author expressly disclaims all liability in respect to actions taken or not taken based on any or all the contents of this article.
