Indemnification, Monitoring, and Competition: Evidence from R&D Contracts

Abstract

Abstract This article examines the adoption of indemnification clauses in research and development (R&D) contracts, in which a firm commits to reimbursing its agent against liabilities and legal costs. Indemnification achieves efficient risk sharing but dilutes the agent’s incentives to take precautions. Such incentives may be restored if the firm offers contingent indemnification and monitors the agent’s activities. Additionally, tougher competition can motivate the firm and agent to take more aggressive R&D activities, which leads to higher liability risks. We show that the optimal contract is more likely to include an indemnification clause when monitoring is more effective and market competition is tougher. By investigating R&D agreements between pharmaceutical firms and biotech agents, we find relevant empirical observations. We also observe a positive correlation between the use of indemnification clauses and the use of termination rights that allow firms to terminate projects without cause.