Drafting And Enforcing Complex Indemnification Provisions

D. Hull D. Hull Youngblood, Jr. and Peter N. Flocos Youngblood, Jr. is a partner in the Forget about copy and paste. The best indem­ Austin, Texas office nification provisions start with the details of of K&L Gates LLP. Mr. Youngblood the transaction. focuses his practice on government contracting, the security industry and com­plex The purpose of this article is to assist transactional financial transactions, and regularly represents and litigation attorneys in the negotiation and drafting clients in a wide array of local, state, and federal of customized, and therefore more effective, indemnifi- contracting transactions and disputes. He can be cation provisions in a wide range of situations, and also reached at [email protected]. to spot certain litigation issues that may arise out of in- demnification provisions. This article will identify issues Peter N. and strategies and suggested language that can act as a Flocos starting point to protect the client’s interests in the area is a partner in the of indemnification in complex transactions and litigation. New York City Readers should note that this article is for informational office of K&L Gates purposes, does not contain or convey legal advice, and LLP. Mr. Flocos, may or may not reflect the views of the authors’ firm or who began his any particular client or affiliate of that firm. The infor- legal career as mation herein should not be used or relied upon in regard a transactional lawyer and then to any particular facts or circumstances without first con- became a litigator, sulting a lawyer. Drafters should use this article in con- focuses his junction with their own research on the applicable laws practice on “deal of indemnification in the pertinent jurisdiction. litigation,” insurance coverage litigation, and other This is not a survey of the substantive law of indem- complex business and commercial litigation. He can nification in every state and federal jurisdiction. While be reached at [email protected]. selected published opinions will be mentioned and occa- sionally discussed, this article will not focus on case law. Instead, the article is intended to be a practical guide that

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illustrates real-world strategies, tactics, and tech- Purpose of Indemnity • Indemnification niques to be used when negotiating and enforcing is a method for a legally responsible party to shift indemnification provisions. a loss to another party. This article will focus on Because the law allows great flexibility in craft- those circumstances in which indemnification, or ing the terms of an indemnity provision, it is im- the transference of a risk, arises from a contract, portant that the parties to a transaction consider even though a duty to indemnify can be imposed their particular circumstances, issues and needs, by law through common law or equitable prin- and draft accordingly, rather than unthinkingly ciples, or through statutes. See, e.g., American Tran- stech, Inc. v. U.S. Trust Corp., 933 F. Supp. 1193, 1202 “copy and paste” an indemnification provision (S.D.N.Y. 1996) (indemnity may be found pursu- from a prior deal. Indeed, one recent study of ant to an “implied in fact” theory when there is a “middle market” transactions (below $1 billion) special contractual relationship supporting such a over the 2002 to 2008 period suggests significant finding, or pursuant to an “implied in law” theory variance in at least certain terms from deal to deal of indemnity, when one is vicariously liable for the in any given year and over the years as well. See gen- tort of another because one of the tortfeasors was erally Houlihan Lokey Purchase Agreement Study (May primarily liable for the tort). The true purpose of 2009). Similarly, the applicable jurisdiction’s statu- contractual indemnification is to provide one party tory, administrative and common law must always (such as a buyer) with a clear contractual remedy be consulted when drafting, analyzing or enforcing for recovering post-closing monetary damages aris- indemnification provisions. ing from: Moreover, the perspectives of litigators and • Breach of a covenant; corporate-transactional lawyers often differ regard- • Breach of representation or warranty; ing the impact and effect of indemnity provisions • Claims by third parties against the indemnitee; in transactional documents. Accordingly, it may be or productive for the parties to seek a litigator’s review • Other claims provided in the relevant agree- of indemnity language being negotiated, at least ment. when there are or may be particular concerns or sensitivities on certain issues. Indemnification provisions provide just one method through which the parties to the con- Several types of transactions will be discussed tract can allocate losses, but it may not always be in this article including corporate acquisitions, real the preferred method of risk allocation. Each fact estate (and the related environmental issues), and situation should be analyzed to determine the best confidentiality agreements. Indemnification in the method of risk allocation. For example, a seller of context of litigation (usually relating to settlements) property, with more knowledge of the detailed his- and related insurance issues will also be included. torical use of that property, may be more willing to Many of the examples used relate to the sale of provide an indemnification to the buyer for losses a business, because indemnification provisions are arising from environmental complications, than to common in the agreements pertaining to such sales. provide a specific representation as to environmen- However, the issues discussed in that context are ap- tal conditions. However, the buyer of that same plicable to many types of transactions and agree- property might only be willing to accept indemni- ments — especially those that involve representa- fication from the seller if the indemnification has tions, warranties, guaranties, and related issues. value based primarily upon ability to pay. Complex Indemnity Provisions | 23

Depending upon how it is drafted, an indemni- clusive remedy for all or certain wrongs, specific fication provision might afford the indemnitee very performance may be waived, and/or certain types different remedies as compared to “regular” con- of damages may not be recoverable. tract or tort law remedies. For example, a violation of a specific representation might provide a basis Plaintiff ’s Perspective for rescission of the contract under contract or tort Plaintiffs have a number of issues to consider law principles; whereas an indemnification for an when choosing to rely exclusively upon common incurred loss might only subject the seller to repay- law remedies, rather than creating a contractual ment of damages. right of indemnification.

ALTERNATIVES TO INDEMNITY • A buyer Recoverability or other indemnitee can limit its risk in many ways In a breach of contract claim, the plaintiff other than (or in addition to) a detailed indemnity. might have a solvent defendant to pursue. How- For example, under a buy/sell agreement the fol- ever, in many situations, the plaintiff may not be lowing actions would also provide the buyer the means to limit its risk: in privity of contract with the party having the re- • The agreement can specify that only certain li- sources to pay the damages sought. For example, abilities are assumed by the buyer; the seller is often a subsidiary of a parent, and once • Purchase price adjustments can be made con- all the assets of the subsidiary are sold, the subsid- tingent on the fulfillment of specific condi- iary has no assets and the cash may have been “up- tions; streamed” to the parent. Absent a “veil piercing” • The buyer may defer payment of the purchase claim, a guarantee from the parent or a tort theory price with a right of offset against the deferred against the parent, a plaintiff asserting a contrac- amount (typically a note); tual claim may be able to obtain relief only from • The buyer may escrow part of the consideration those with whom the plaintiff is in privity. with a third party with a right of offset; or • The buyer may use a subsidiary to purchase Attorneys’ Fees the seller or its assets. This generally provides a Jurisdictions differ as to whether a prevailing shield to all of buyer’s assets (from third-party plaintiff may recover attorneys’ fees in connection claims) and generally limits the buyer’s risk to with common law claims. Some states provide for the amount invested in the subsidiary. the recovery of attorneys fees in contractual claims, but not in tort actions. See, e.g., Moody v. EMC Ser- COMMON LAW REMEDIES • Many agree- vices, Inc. 828 S.W.2d 237, 246 (Tex. App. 1992) (re- ments in complex transactions permit an aggrieved covery of attorneys’ fees arises only from contract party to pursue any and all common law remedies, in addition to contractual indemnity remedies. A or statute); see also Phillips v. Barton, 24 Cal. Rptr. party should be cautious when choosing to rely 527, 532 (Cal. Ct. App. 1962) (same). The practical upon these remedies rather than negotiating a spe- effect is to require that the plaintiff, absent a con- cific indemnification provision. tractual indemnification, must suffer and survive a As discussed below, one should also be aware truly substantial injury and related damage before that agreements may limit remedies in some fash- the cost to pursue the remedy exceeds the damages ion, e.g., the contractual indemnity may be the ex- incurred. 24 | The Practical Lawyer August 2010

Defendant’s Perspective resentation or other provision) will be dealt with. On the other hand, a defendant may have a An example involves a determination of the rem- very different view of common law or statutory edy the claimant will be entitled to receive, which remedies. could include some or all of the following: • An automatic reduction in purchase price/post Unlimited Damages closing adjustment; When the plaintiff pursues a common law • Pursuing a breach of contract claim (which claim, there are no buckets, caps, or other limita- may result in a court-ordered reduction in pur- tions as such upon the amount of damages that the chase price); and/or plaintiff can recover. The damages that the plain- • Indemnification. tiff can seek are technically unlimited, subject only to common law legal or equitable doctrines, such as REMEDIES OTHER THAN CONTRACTU- the Hadley v. Baxendale rules regarding of recovery AL INDEMNIFICATION • There are a number of consequential damages. of ways to attempt to achieve protections similar to those that indemnification can provide, including: Longer Statutes Of Limitation • Pursuing common law claims under the ap- Additionally, a plaintiff can wait until the end of plicable agreement (e.g. purchase agreement, the statute of limitations period to assert a common merger agreement, etc.) for breach of contract law claim (which can be up to six years in some ju- or misrepresentation; risdictions). Contractual indemnification provisions • Pursuing common law claims based on fraud may require that claims be asserted within a de- and/or fraud in the inducement; fined period of time much shorter than the statute • Anti-fraud provisions of the securities laws; of limitations for common law laws — sometimes and/or as short as days after the indemnitee knows of an • Rescission (and partial rescission). indemnifiable claim. BENEFITS OF INDEMNITY PROVISIONS Low Barrier To Harassment • Because parties are generally free to craft their Defendants may perceive that only the cost of own terms in a contractual indemnity, there are nu- litigation stands between the defendant and harass- merous protections that such indemnity provisions ment by a plaintiff asserting meritless claims. can provide: • Through the use of drafting techniques such ALLOCATION OF RISK • The indemnification as a definitions section, the protected group of provision of an M&A or other agreement could “indemnitees” can be much larger than just the cover almost any subject and is intended at bottom parties to the agreement (e.g. non-signatories to do two simple things: such as directors, employees, agents, a subsid- • Determine when indemnification “kicks in”; iary corporation, or a parent corporation, may and be included); • Assign responsibility after the execution of the • A claimant may be able to recover more under agreement. indemnity provisions (including attorneys’ fees and other additional losses) than could be re- Initially, the parties must determine how a par- covered at common law. Indemnity provisions ticular problem (e.g., a breach of an agreement rep- may also limit a claimant to remedies or dam- Complex Indemnity Provisions | 25

ages more narrow than those available under and Drafting Contract Boilerplate, 250 (Tiny Stark ed., common law claims; ALM Pub. 2003). Contracts of surety and guaranty • Parties can resolve uncertainties relating to how differ from indemnification agreements, which do a party will be protected as regards notice re- not “answer for the debt, default or miscarriage of quirements, tax treatment of losses, selection of another,” but instead make good on the loss which defense counsel in case of litigation and other results to the indemnitee from the debt, default, or matters; miscarriage. See, e.g., State ex rel. Copley v. Carey, 91 • Indemnity may cause the indemnitor to be S.E.2d 461 (W.Va. 1956). more serious about the representations made, Indemnity differs from the concept of contri- if a breach would trigger a specific and identifi- bution as well. Contribution requires those having able indemnification obligation. joint liability to pay a proportionate share of the loss Another benefit to the indemnitee is that a third to a party who has discharged their joint liability party (such as a lender or bonding company) may and is a cause of action held for example by a joint view the indemnification provisions as part of its se- tortfeasor against all other parties who are liable curity. A number of jurisdictions allow a party to for the underlying tort. See, e.g., Rosado v. Proctor & be indemnified for its own negligence, and some Schwartz, Inc., 484 N.E.2d 1354 (N.Y. 1985). Con- jurisdictions even allow a party to be indemnified tribution arises by operation of law, so an express from its own gross negligence, at least if the indem- contract is not required (although contribution like nification is between “sophisticated parties.” For indemnity may be addressed contractually). example, in Valero Energy Corp. v. M.W. Kellogg Constr. By contrast, in indemnity, the party seeking in- Co., 866 S.W.2d 252, 258 (Tex.App.1993), the court demnification has not necessarily committed any held that a “waiver and indemnity provision absolv- wrongdoing, yet faces exposure to liability by virtue ing contractor of all liability sounding in products of a transaction or other relationship with the sup- liability and gross negligence in connection with posed wrongdoer. See, e.g., Stark, supra, 249. More- construction of addition to refinery did not offend over, an indemnification agreement shifts the entire public policy” when both the owner and contractor loss to the alleged wrongdoer (the indemnitor), not were sophisticated entities. merely a portion as in contribution. Once the parties understand the difference be- INDEMNIFICATION DISTINGUISHED tween representations and warranties on the one FROM GUARANTY, SURETIES, AND CON- hand, and indemnification on the other hand, it TRIBUTION • Indemnity contracts differ from may be easier to resolve disputes between the seller guaranty and surety contracts. While indemnity in- and the buyer. Understandably, the seller may fear volves the right of a party to shift a loss to the party representing something that is not actually known who is supposedly responsible or at fault, a guaranty to be absolutely true, while the buyer may believe is a promise to answer for the debt, default, or mis- that the seller is in the position to know and should carriage of another person. See, e.g., 38 Am. Jur.2d make clear and direct representations about every- Guaranty §2 (1998). The concept of a surety differs thing. slightly from that of a guaranty in that a surety’s It is important to be clear in distinguishing be- promise gives rise to a direct, primary and immedi- tween two different scenarios: direct claims and ate duty to pay the debt of another, whereas a guar- third-party claims. Under a direct claim, Party A antor is collaterally liable only upon default of and to a contract agrees to indemnify Party B from loss- non-payment by the principal. See, e.g., Negotiating es incurred as a result of the conduct of Party A. 26 | The Practical Lawyer August 2010

These may include Party A’s violation of a term, SPECIFICITY OF INDEMNITY PROVI- representation or warranty given in the context SIONS • A potential problem with the standard of the underlying transaction. Under third-party short-form indemnification provision is that it may claims, the parties to a contract agree to indem- fail adequately to address the key issues that need to nify each other from various types of claims by that be considered on both sides of the table with suffi- may be brought by third parties, i.e., persons not a cient specificity. An example of short-form language party to the agreement. For example, a third party might be the following or some similar variant: may sue the buyer of a business on a liability that was not intended to be transferred or assumed in The Contractor agrees to defend, indemnify, and hold harm- the sale. less X, from any and all damages, liability, and claims, aris- ing from Contractor’s Conduct. Enforcement of Indemnity Agree- ments • As an aid to efficiency, the parties can Such a provision (even if many of the key terms are stipulate to the following enforcement-related mat- defined and expanded) does not deal with a num- ters in connection with an indemnity agreement: ber of potential questions and issues, including the • Cover and pursuits of costs of cover; following: • Should there be more than one indemnitor (if • Automatic withdrawal from escrow, possession so, should the liability be joint and several)? of collateral, or exercise of offset rights; • Who are the indemnitees? Do third parties • Waiver of ability to dispute fees sought; have the right to enforce the indemnification • Waiver of bond requirements for an injunc- provisions? tion; • What losses or expenses are covered by the • Waiver of jury trial; indemnity? For example, is the indemnitor re- • Stipulation as to facts so as to facilitate entry quired to pay the indemnitee’s attorneys’ fees of an injunction or other enforcement order; incurred in enforcing the indemnification pro- and/or vision? • Other agreed self-help remedies. • What is the duration of the indemnity? • Is there a ceiling or a hurdle on the indemni- Parties should examine, however, the degree to tor’s liability? which the applicable jurisdiction’s law allows such • Does the indemnity limit or even eliminate the provisions to be enforced. For example, there does right to pursue common law remedies? not appear to be much case law directly addressing • Are recoverable “damages, liability and claims” the issue of whether in an M&A context a specific intended to include any loss or damage, even performance remedy will be awarded in case of if beyond common law contract or tort mea- breach merely because the parties have agreed to sures of damages? Only “direct” damages? Are such a remedy. A court may want to satisfy itself, “consequential” damages intended to be recov- independent of such an agreement, that the tradi- erable? tional policy criteria for entry of injunctive relief • What are the procedural mechanisms by which are met, although presumably a stipulation as to the indemnitee is to enforce the indemnity? factual matters such as the existence of irreparable harm would be given weight by the court. It may not be necessary or practical to draft a com- prehensive indemnification provision that deals Complex Indemnity Provisions | 27 with all of these issues. However, the issues that “Damages” shall mean each and every injury, wound, wrong, have a high probability of occurring should be hurt, harm, fee, damage, cost, expense, outlay, expenditure, or considered and addressed. If there is a high likeli- loss of any and every nature, including, but not limited to: hood of a particular type of claim, the process and (i) Injury or damage to any property or right; issues raised by that claim should be resolved in the (ii) Injury, damage or death to any person or entity; (iii) Attorneys’ fees, witness fees, expert witness fees and ex- indemnity provision. penses; and (iv) All other costs and expenses litigation. Definitions One way to provide significant clarity to indem- “Proven” shall mean that a court of competent jurisdiction nity provisions is the creation of proper definitions. has entered a final unappealable judgment on a Claim ad- Most complex documents now include extensive judging an entity or person liable for a monetary judgment. definition sections. Yet, surprisingly, indemnifica- tion provisions may employ important terms that If customized definitions are used in the con- are undefined or insufficiently defined. For exam- text of an indemnification agreement, then the ac- ple, in an operation and maintenance agreement tual terms of the indemnification may be relatively the following definitions might be created for use simple rather than the long run-on sentences found solely in the indemnification agreement between in a number of indemnification agreements: the Contractor and Owner: Subject to the terms and conditions of this Article X, Con- tractor shall provide a defense for the Owner from all Con- “Claims” shall mean all claims, requests, accusations, al- tractor Defended Claims. legations, assertions, complaints, petitions, demands, suits, actions, proceedings, and causes of action of every kind and Likewise, the actual terms that impose an obliga- description. tion to indemnify may be equally simple:

“Contractor’s Conduct” shall mean any act, failure to act, Subject to the terms and conditions of this Article X, Con- omission, professional error, fault, mistake, negligence, gross tractor shall indemnify Owner from any judgment arising negligence or gross misconduct of any and every kind, of from any Contractor Defended Claims, which are Proven Contractor, its employees, agents, representatives, or subcon- against Owner. tractors, or employees, agents, or representatives of such sub- contractors, arising out of: Identification Of Indemnitees (i) Any workers’ compensation claims or claims under simi- When negotiating the parties to be indemnified, the indemnitor’s goal is to limit the universe of the lar such laws or obligations related to this Agreement; indemnities. On the other hand, the indemnitee (ii) Performance of this Agreement (or failure to perform); may want to expand the class as much as possible. (iii) Breach of this Agreement; or To the extent that an indemnitor indemnifies any (iv) Violation of any laws. affiliate of the indemnitee, the affiliate may satisfy the criteria for being a third-party beneficiary of “Contractor Defended Claim(s)” shall mean all Claims the indemnity. which allege that Damage was caused by, arises out of, or was In that regard, however, when identifying the contributed to, in whole or in part, Contractor’s Conduct. indemnitees under an indemnification agreement, 28 | The Practical Lawyer August 2010 how specific must the identifiers be? As an exam- or seller of the business sold) will have the right to ple, assume that the seller of a business indemnifies force the indemnitor to perform its contractual ob- the following entities: buyer, subsidiary corpora- ligation to indemnify any “non-signatory” indem- tions, parent corporation, shareholders, directors, nity beneficiaries. If that signatory indemnitee par- officers, managers, members, partners (other cor- ty has been merged into the indemnitor, or if the porate participants), agents, representatives, attor- indemnitee and the third- party beneficiaries are neys, permitted assigns, affiliates, employees, and no longer on good terms (e.g. terminated employ- lenders. This appears to provide broad coverage ees), the third parties may have a right to indemnity but how far can you go? Merely identifying the but no practical means of enforcement. parties to the indemnification agreement can be A solution (from the third-party beneficiary’s quite tricky. How detailed must you be in identify- perspective) is to explicitly make these parties third- ing a party in order for that party to be indemni- party beneficiaries (at least as to the indemnifica- fied? Is “partner” enough? Is “agent or employee” tion provisions). However, in doing so, the signatory enough? parties may want to protect their ability to amend The term “officers, directors, employees and all other provisions of the agreement (outside the joint owners” has been held by at least one court to indemnification provisions) without the consent of be sufficiently precise, but not to include a consul- the third-party beneficiaries. tant to the party to the indemnification agreement. See, e.g., Melvin Green, Inc. v. Questor Drilling Corp., 946 Duty To Defend vs. Duty To Indemnify S.W.2d 907, 911 (Tex. App. 1997). While the terms “hold harmless” and “indem- nify” may appear together, generally the terms are Third-Party Beneficiaries duplicative in that “hold harmless” refers to the duty A signatory to an indemnification provision of indemnity, i.e., protecting an indemnitee from a (such as the buyer of a business) can be indemni- covered loss corresponding the underlying injury it- fied and has the standing to enforce that right to self, such as loss from breach of a representation. be indemnified. But are non-signatories entitled By contrast, the duty to defend is the obliga- to make claims under the indemnity? When other tion to provide a defense to a covered claim. The parties are not signing the contract, how do these duty to defend does not depend on the outcome of other beneficiaries of the obligation of defense and the claim, whereas the duty to indemnify does not indemnification get protection and enforce those arise unless the outcome of the claim is adverse. indemnification provisions? To be a third-party Thus, the duty to defend and duty to indemnify beneficiary of a contract, the contract must express are separate and distinct obligations. A party de- an intention to benefit that party or an identifiable fends against a claim — there is no defense to be class to which the party belongs; absent express provided against a loss, damages, or a judgment — declaration of such intent, it is generally presumed whereas a party can indemnify another entity from that the third party is not a beneficiary and the par- a loss, damage, or obligation to pay a judgment. ties contracted only to benefit themselves. Because the duty to defend and the duty to in- If there is a “no third-party beneficiary clause” demnify are distinct obligations, the contract may in the agreement, as may be the case, then general- impose a duty to defend the underlying claim even ly no entity, other than the signatory parties, would in the absence of a duty to indemnify. Hollingsworth have the standing to enforce the indemnity agree- v. Chrysler Corp., 208 A.2d 61 (Del. 1965). In oth- ment. Only the signatory parties (such as the buyer er words, the contractual duty to defend a claim Complex Indemnity Provisions | 29

may be broader than, and arise more often than, provide a defense against a Claim is found not to have been the duty to provide indemnity from a loss or judg- reasonably justified, under the commercially reasonable stan- ment. dards observed in the _____ industry, then the Indemnitor A number of practical drafting issues arise in that has refused to so provide a defense: (i) shall be obligated connection with providing for a duty to defend to pay all of the Damages and out-of-pocket expenses in- apart from the indemnification of litigation ex- curred by the Indemnitee in defending said Claim, including, penses, such as: but not limited to, the value of the time, including travel time, • The indemnitee’s requirement to give the in- that all of the employees, agents and representatives of the demnitor notice of a claim by a third party; Indemnitee dedicated to, or expended in furtherance of, the de- • Which party controls the defense; fense of said Claim; (ii) without any further action from any • Who must consent to settlement and compro- Party, hereby intentionally relinquishes and waives any and mise of the third-party claim; all rights of every nature to dispute, defend against or contest, • The treatment of multiple claims when some in any manner, (including but not limited to the waiver of are indemnified and some are not; every defense of every nature) the claim of the Indemnitee • Remedies when an indemnitor refuses to de- regarding the amount of, reasonableness of, necessity for or the fend an indemnified claim. Indemnitor’s obligation to pay, the costs, fees and expenses, and other Damages incurred by the Indemnitee in defending Remedy For Refusal To Defend An the Claim. Indemnified Claim The following sample provision addresses the is- Losses / Damages; Waivers Or sue of wrongful refusal to provide a defense against Limitations On Types Of Damages or indemnify a claim. Under the sample language, When drafting indemnification provisions, loss- the repercussions for such a wrongful refusal are es and damages that are intended to be recover- significant — the indemnitor in essence loses the able or not recoverable should be carefully defined. right to contest the reasonableness of the defense Without sufficient specificity, as can be provided by expenses — but the indemnitor also has the right a clear definition section, a court may have difficul- to refuse to defend or indemnify when a legitimate ty determining whether or not the following types basis for that refusal exists: of items are intended to be recoverable under the indemnity: Refusal or Failure to Defend. Any Party may refuse to pro- • Fees and expenses (accountant, attorney, vide a defense hereunder, if such refusing Party, in reliance experts, etc). In some jurisdictions, an indemni- upon an opinion of qualified counsel, has determined that a tee is entitled to recover attorneys’ fees and ex- valid basis exists for determining that the Claim, for which penses in connection with an indemnifiable loss a defense is sought, is not required to be defended pursuant to unless expressly prohibited under the contract; the terms of this Agreement, and a refusal to defend under • Consequential or indirect damages; such circumstances shall not be a material breach of this “lost profits.” Recovery of “consequential Agreement. However, if the Indemnitee shall be required by a damages,” and/or indirect damages, may be final judgment to pay any amount in respect of any obligation waived or limited in the transaction agreement. or liability against which the Indemnitor is required to in- Subject to provisions in the transaction agree- demnify under this Agreement, the Indemnitor shall promptly ment, the standard of Hadley v. Baxendale must reimburse the Indemnitee in an amount equal to the amount be met to recover consequential damages un- of such payment. Further, if such refusal, or any failure, to der a contractual theory. Indemnitors may at- 30 | The Practical Lawyer August 2010

tempt to limit or eliminate recovery of conse- Amount Of Indemnity — Financial Limits quential damages because the amount of the Financial limits on the amount of indemnity recovery is too unpredictable. Damage waiver can take several forms, as discussed below. or limitation provisions also may refer to lost profits, losses based on multiples of earnings, Baskets diminution in value losses (i.e., the indemnitee A basket is a type of limit on the total amount may not suffer an out-of-pocket loss yet its as- of the indemnification obligation. For example, a sets or business may decrease in value), or simi- deductible basket provides that the indemnitor is responsible only for those damages exceeding the lar types of losses. A court may have difficulty basket amount. Indemnitees may seek to have the categorizing certain types of damages as “con- basket be inapplicable in cases of fraud by the in- sequential” or “direct” under the common law demnitor. Buyers and sellers of businesses may ar- definitions of those terms. Accordingly,- par gue about the applicability of the basket to post- ties should consider whether their intention is closing claims for warranty work to be performed to exclude recovery only for lost profits, losses by the seller. Buyers may want the basket to apply based on multiples of earnings, diminution in to this work, in order to eliminate dealing with any value losses, etc. that are consequential dam- sort of small post-closing claim by the seller for ages, or whether their intention is to exclude warranty work. Sellers may try to make the distinc- recovery for any such types of losses, whether tion that reimbursing them for warranty work is they are direct or consequential. Indeed, par- completely different than indemnifying them from ties may wish to draft their own definition as to claims asserted by an unrelated third party. what does and does not count as a “consequen- tial damage”; Hurdles And Caps • Fines; A hurdle is the threshold amount of damage • Costs. “Costs” may be interpreted simply as that the indemnitee must suffer before a claim for “costs of court,” e.g., as administrative expens- indemnification can be made. When drafting this es such as filing fees and transcript fees. That type of provision, consideration should be given to interpretation is much narrower than the full whether the parties intend a separate hurdle to ap- ply to each claim or instead that a single hurdle ap- “expenses of litigation,” which would include ply to all claims such that once fulfilled the hurdle any costs, fees, and expenses related to the liti- no longer acts as a limitation upon the indemnitor’s gation, such as expert witness fees, travel time, obligation. The parties also should consider wheth- travel expenses, etc. An example of a broader er the indemnitor is liable for the entire loss, from form of provision is set out below: the first dollar, once the threshold is hit (referred to as “first dollar” hurdle clauses), or whether instead “Losses” means all Liabilities, losses, damages, injuries, the hurdle is to act more like a deductible basket. harm, diminution in value, expense, expenditure and dis- Depending upon how basket and hurdle issues bursement of every nature (including, without limitation, are handled, the parties may also wish to consider costs of investigation, travel expenses, value of time expended providing for a “cap” on the indemnity, which is a by personnel), fines, fees and expenses of litigation (including maximum amount that the indemnitee can recover without limitation reasonable attorneys’ fees incident to any under the indemnity under any set of circumstanc- of the foregoing), costs and costs of court. es or defined set of circumstances. A sample pro- Complex Indemnity Provisions | 31 vision containing both a $50,000 hurdle (not first A recent study of middle-market transactions dollar) and a cap of $2 million is set out below: (less than $1 billion) over the 2002 to 2008 time period provides interesting data regarding the fre- Dollar Limitations. The Contractor shall not be liable to quency of, and terms and sizes of, baskets, hurdles indemnify and hold harmless Owner for any Damages aris- and caps. See Houlihan Lokey Purchase Agreement Study, ing from the Claims, until Owner has first suffered, sustained at pp. 9-18 (May 2009). or incurred aggregate losses relating to such matters in excess of $50,000, at which point the Contractor will be liable to indemnify Owner and hold it harmless from and against all Exclusivity Of The Contractual such Damages in excess of the $50,000 deductible amount. Indemnification Remedy In addition, the Contractor shall not be liable to indemnify As indicated previously, to the extent the agree- Owner for any Damages in excess of $2,000,000. ment does not provide that the contractual indem- nification provision is the exclusive remedy available Double Dipping Basket to the indemnitee, the indemnitee may be able to If the agreement in question contains material- pursue common law claims against the indemnitor ity qualifiers, then the indemnitor may argue for and thereby “sidestep” the contractual indemnity, a “double dip” limit on liability. For example, in including sidestepping any baskets, hurdles, caps, a stock purchase agreement, a representation or etc. For this reason, indemnitors may demand that warranty may be subject to a materiality qualifier the indemnification agreement between the parties such that the representation is breached only if it be the sole and exclusive remedy for a breach of is untrue in a “material” respect. In that case, the a representation or warranty, and even for other materiality qualifier may act as an implicit limit types claims such as tort claims arising out of the on the amount of any indemnification obligation transaction. pertaining to breaches of the representation. If the indemnification obligation in addition provides an Method Of Payment express limit, then the indemnitor will contend its Generally, one party to a transaction is paying obligation is in effect is “doubly” limited. Accord- for something, and the other party is getting paid. ingly, the parties should consider the effect of ma- What therefore is the method of payment to be teriality qualifiers upon indemnity claims. Sample used by the receiving party when an obligation of language addressing the interplay of materiality indemnification arises? For example, if the seller of qualifiers and damages recoverable under anin- a business is getting all cash for the sale, the buyer demnity clause is set out below: may request that an indemnification obligation owed to the buyer be paid in cash. Where more Materiality. With respect to any claim for indemnification complex consideration is received by the seller, the relating to a breach (or alleged breach) of a representation or issue of how the seller will pay an indemnification warranty that may only be considered breached if the defect, obligation to the buyer may be similarly complex. inaccuracy, mistake or misrepresentation is material, the ma- If the seller is being paid with cash, a prom- teriality of such defect, inaccuracy, mistake or misrepresenta- issory note and stock in the buyer, the seller may tion will be considered for purposes of determining whether request that any indemnity obligation be satisfied a breach of such representation and warranty has occurred, by an offset of the then owing principal balance of but will not be considered in determining the amount of the the promissory note, and/or the return of shares Damages arising out of such breach. of the buyer’s stock. The more restricted the stock 32 | The Practical Lawyer August 2010 is with respect to transfer to third-parties, the more may want to clarify that “prior disclosures” are only important this right is to the seller. acceptable if contained in the disclosure schedules, If the offset of a deferred payment obligation on the grounds that without such clarity, the seller is the method of payment, the description of the will argue that informal disclosures, such as verbal offset is may be straightforward. The amount of disclosures, are sufficient. the indemnity obligation is deducted from the de- Another potential alternative is a buyer repre- ferred payment obligation. This may be handled sentation stating that, as of the closing, the buyer in a manner similar to a pre-payment of a note, has no knowledge of any violation of any of the with the credit first applied to accrued but unpaid seller’s representations or warranties. If the buyer is interest, and then to unpaid principal. However, if found to have had such knowledge, the buyer may stock is to be used as a method of payment to satis- be subject to a claim by the seller that the buyer fy an indemnity obligation, then the parties should breached that representation to the seller. consider: A sample anti-sandbagging provision could • Whether only shares acquired by the seller in provide the following: the transaction can be used for payment (not shares purchased otherwise); Anti-Sandbagging. No information or knowledge of Buyer, • Whether fractional shares can be returned (any nor the results of any due diligence or investigation by Buyer balance to be paid in cash); and of the Company, shall affect, waive, modify, limit, or dimin- • How to determine the value of the shares re- ish: (i) any representation or warranty of Seller contained in turned (e.g., agreed upon floor per share, verifi- this Agreement or the Related Documents; or (ii) Buyer’s right able price determination, average market price to rely upon such representations and warranties of Seller. over the preceding 20 days, or other formula). Other formulations might provide more specifi- Actual Knowledge Of Buyer; cally that the buyer’s remedies themselves (as op- Anti-Sandbagging posed to the representations or the ability to rely) An “anti-sandbagging” provision is intended are unaffected by the buyer’s knowledge (see, e.g., the to protect the buyer of a business from knowledge ABA Model Stock Purchase Agreement and Model that it may gain during a due diligence investiga- Asset Purchase Agreement). The reported case law tion. Basically, the provision is intended to preserve appears to deal mostly with a “right to indemnifica- a buyer’s remedies, at least in some fashion, even tion or other remedy not affected” type of formu- though the buyer actually knew that a representa- lation. No case law appears to address directly the tion or warranty was untrue at the time the trans- “representations and warranties not affected” for- action closed. Sellers may object to such provisions, mulation versus the “right to indemnification not citing theories of waiver and fairness. Buyers on affected” formulation. An anti-sandbagging provi- the other hand may demand this type of provision sion may also contain language that the purpose because they believe that the seller will as a result of the due diligence investigation is to confirm the be put to the task of clearly updating disclosure accuracy of representations and warranties. schedules before the closing. In any case, without an anti-sandbagging pro- As an alternative, sellers may propose a provi- vision, the seller may argue that the buyer’s actual sion that establishes “no prior disclosure” by seller knowledge at closing of the seller’s breach of a rep- of a representation or warranty issue as a condition resentation or warranty precludes the buyer from precedent to buyer’s assertion of a claim. Buyers seeking a remedy in connection with that breach. Complex Indemnity Provisions | 33

See Galli v. Metz, 973 F2d 145 (2d Cir. 1992); Hen- or offset of other obligations, the payment to dricks v. Callahan, 972 F.2d 190 (8th Cir. 1992). the indemnitee would be increased or reduced (or refunded as the case may be) after the in- The Effects Of Tax Law And Other Recov- demnitee has actually incurred the tax or re- eries Received By The Indemnitee ceived a recovery from another source. It may A common issue to resolve is a party’s claim be a benefit to one or more of the parties for that an indemnitee should not incur a windfall, or the adjustment in the amount of an indemnity suffer an unreimbursed loss, as a result of indemni- payment to be treated as an adjustment in the fication, in light of tax benefits or losses that the in- purchase price; demnitee may realize on the indemnification pay- • The determination of the precise amount of ments. A similar issue is presented by the fact that tax owed may take longer than the life of the the indemnitee may recover monies from sources indemnification. Parties accordingly sometimes other than the indemnitor for the loss at issue. De- make the adjustment subject to further adjust- pending upon the jurisdiction, litigation may re- ment upon the final and unappealable determi- solve such issues, even if the parties do not include nation of the amount of tax owed. a provision for such tax consideration, in light of doctrines such as the “one recovery” rule and the Mechanics Of Indemnity “collateral source” doctrine. Indemnity provisions may require some type of In any case, the parties may wish contractually notice to be given by the indemnitee to the indem- to address the effect of tax law and recoveries by nitor. If the notice clause is drafted as a covenant, the indemnitee from other sources on the indem- then the indemnitor will argue that failure to deliv- nification right. For example, “Net Tax” and simi- er notice is a breach of the indemnity agreement. lar provisions take into consideration that amounts The indemnitor would contend that it is entitled to paid by the indemnitor to the indemnitee will be damages based on the lack of notice and that, if reduced by: delivery of notice is a condition precedent to the • All insurance proceeds received by the indem- indemnitor’s obligation to indemnify, the failure to nitee as compensation for the damages at issue satisfy the condition precedent relieves the indem- under the indemnity obligation; nitor of its obligation to defend or indemnify. The • All tax benefits recognized by the indemnitee delivery of notice may be a particularly significant as a result of the damages at issue under the issue when indemnification is being sought because indemnity obligation; and/or of a claim by a third party. • All amounts received by the indemnitee from Indemnity provisions may be drafted to state any source (other than the indemnitor) as pay- that defective notice does not excuse the indemnifi- ment of the damages at issue under the indem- cation obligation unless or except to the extent that nity obligation. as a result, the damages to be indemnified are in- creased or the indemnitor is otherwise prejudiced, A Net Tax provision might also address the fol- e.g., the indemnitor’s ability to provide a defense is lowing issues: somehow prejudiced. The following is an example • Whether indemnity payments are to be first cal- of such a provision. culated and paid as though none of the forego- ing adjustments were to be made. If so, there- Notice. Each Indemnitee must provide written notice to the after, through additional payments, repayment, Indemnitor within 10 days after obtaining knowledge of any 34 | The Practical Lawyer August 2010 claim that it may have pursuant to Section X (whether for its Defended Claims. The Owner and Contractor agree to com- own Losses or in connection with a Third Party Claim); pro- plete such reimbursements within 30 days after receipt of any vided that the failure to provide such notice will not limit the such accounting by defense counsel described herein. rights of an Indemnitee to indemnification hereunder except to the extent that such failure materially increases the dollar Transfer Of Relationship amount of any such claim for indemnification or materially When an ongoing customer (or other) relation- prejudices the ability of the Indemnifying Party to defend ship is being transferred from the indemnitor to the such claim. Such notice will set forth in reasonable detail the indemnitee, e.g., the transfer of customer relation- claim and the basis for indemnification. ships in connection with the sale of a business, the indemnitee may want to defend all claims that arise Joint Claims with the newly acquired customers, even if the In some situations, both the indemnitor and seller-indemnitor is obligated to defend the claim the indemnitee will be targets of a claim by a third and may ultimately be responsible for the loss. De- party and neither party will be responsible for all pending on the circumstances, the buyer-indemni- the damage sought. The contract may require one tee may not want the claims defended vigorously, party to provide a defense for both of the target and instead may want the claims simply paid off, parties, but that does not necessarily mean that the so as to protect its relationship with the customers, indemnitor must ultimately bear the full cost of whereas the seller-indemnitor may want to defend that defense. One method of distributing the cost the claim vigorously, and never pay any portion of of defense to the various parties is to provide that the claims, with little regard to the impact that such defense counsel will allocate its fees and expenses a posture may have on the buyer-indemnitee’s rela- between the defendant parties, if in fact such an tionship with the customers. Possible compromises allocation is possible. An example of that language include: (assuming allocation is possible) is set out below: • The buyer-indemnitee is allowed to control the defense but must also assume responsibility for Division of Fees. Counsel retained hereunder for the defense all or a specified portion of the litigation ex- of a party hereunder shall be instructed by the party retain- ing them to regularly estimate in good faith the portions of penses and any adverse judgment; or all costs, fees, and expenses of such defense which relate di- • The seller-indemnitor retains control of the rectly to Contractor Defended Claims and Owner Defended defense, but cannot settle without the buyer- Claims. All fees of such defense counsel shall be allocated indemnitee’s consent. between Contractor Defended Claims and Owner Defended Claims. The division of fees (which shall not disclose any See John Seegal, Allocation of Post-Closing Risk in Pri- information other that the amounts of fees, and costs) shall be vate Company Acquisitions, in Acquiring or Selling the Pri- provided to Contractor, Owner and all defended parties, and vately Held Company (Practicing Law Institute 2006). such accounting shall be irrevocably binding on the Owner, Contractor and the defended party. Owner shall promptly pay Selection Of Counsel Contractor for the costs, fees, and expenses paid by Contrac- An indemnitor may expressly be given the right tor to such defense counsel relating directly to the defense of to select counsel to provide the required defense. Owner Defended Claims. Contractor shall reimburse Owner The indemnitee may also be given a “right of rea- for the costs, fees, and expenses paid by Owner to such defense sonable refusal.” An example of such a formula- counsel that are directly related to the defense of Contractor tion is as follows: Complex Indemnity Provisions | 35

Selection of Counsel. Any party obligated to provide a defense who is selected by the party providing the defense, and such hereunder shall do so with qualified counsel that is selected counsel shall be deemed to have been approved by the party by the party providing the defense, where such counsel is ap- to be defended, without further action by said party, unless proved by the other party; but such approval shall not be the party to be defended establishes: (i) a substantive conflict unreasonably withheld. of interest with such counsel; or (ii) a substantial cause or Such a provision may lead to future complications reason to withhold such approval. if the indemnitor and indemnitee end up as adver- saries in litigation related to the defense of the un- SURVIVABILITY OF INDEMNIFICATION derlying third-party claim (e.g., from contribution • Transaction agreements may provide that repre- disputes). For example, the counsel selected by the sentations and warranties, and the rights to indem- indemnitor may become privy to confidential infor- nification for breaches thereof, remain in effect (or mation about the indemnitee that might be helpful “survive”) only for some specified period of time. to the indemnitor in a direct action between the In theory, the time specified should be intended to two, and that counsel may also be the regular coun- give sufficient time, post-closing, to determine the sel for the indemnitor and therefore also involved veracity of the representations and warranties. This in making demands on the indemnitor’s behalf for is, however, a general guideline and moreover, dif- contribution or indemnification from the indemni- ferent types of representations or indemnity rights tee. Although applicable rules of ethics may prevent may be treated differently as far as survival periods. counsel from becoming involved in such a scenario, For example, the following types of representations the parties may wish to avoid the situation entirely or warranties may be given indefinite survival: by agreeing in advance upon a law firm that will • Taxes. While taxes may be defined as “exclud- provide the defense, so long as no conflict of inter- ed” from an asset sale transaction, unpaid per- est would preclude the representation. sonal property taxes may follow the assets, and The “shall not be unreasonably withheld” stan- the buyer of the assets may be subjected to li- dard may also present complications. For example, ability for such taxes. Accordingly, indemnifica- if an indemnitee refuses counsel proposed by the tion from any liability for the seller’s pre-closing indemnitor, and the underlying case is lost, the in- taxes may be demanded by the buyer in asset demnitor may claim that the indemnitee’s refusal purchase transactions. Some parties use stat- to approve the proposed counsel caused the loss utes of limitation as the limit of survivability and therefore excuses the indemnitor’s obligation for representations regarding taxes. However, to indemnify. The indemnitee would argue that its considering that those limitation periods may approval was not “unreasonably withheld.” On the be tolled or extended, many parties request other hand, the seller-indemnitee may believe that that representations and warranties relating to the benefits of the consent requirement outweigh taxes, and the right to seek indemnification for the costs. If the seller does wish to compromise the their breach, be indefinite; issue, it might do so with the following type of pro- • Environmental. The fear of the unknown, vision, that at least preserves certain protections for and the potential for very significant costs of it: environmental remediation, may motivate par- ties to seek indefinite duration for environmen- Selection of Counsel. Any party obligated to provide a defense tal representations and warranties and the re- hereunder shall do so with qualified counsel with demon- lated right of indemnity for breach thereof; strable experience defending claims of the type to be defended, • Title. When acquiring realty or personal prop- 36 | The Practical Lawyer August 2010

erty (including stock or other assets), a buyer PUBLIC POLICY • Although a number of ju- may demand indefinite duration for the repre- risdictions permit indemnification against the con- sentations and warranties relating to the seller’s sequences of one’s own negligence, a provision in- ownership of and title to the items and related demnifying the indemnitee for its negligence may right of indemnity for breach thereof. The buy- be void as against public policy in some jurisdic- er may take a similar approach to representa- tions. Depending upon the jurisdiction, indemni- tions regarding liens and rights of others to the fication for gross negligence may be enforceable. property in question; Even when indemnification for negligent or even grossly negligent conduct is valid, indemnification • Corporate Authority. When an entity contracts have been held invalid in certain jurisdic- makes a representation that it has the authority tions where the indemnity covers the indemnitee’s to enter into a transaction, such that the agree- intentional or malicious conduct. In determining ments are binding and enforceable upon that how severe the indemnitee’s mental state may be party, the other party may seek to make those consistent with permitting indemnification, a court representations and warranties, and the related may consider the sophistication of the parties and rights of indemnity, unlimited in duration. may allow more leeway for indemnification the more sophisticated are the parties. For example, The following types of representations or war- in Valero, supra, 866 S.W.2d at 258, the court held ranties may be given long, although not indefinite, that a “waiver and indemnity provision absolving survival: contractor of all liability sounding in products li- • Third-party claims. Many buyers argue that ability and gross negligence” in connection with the duration of indemnification from claims by construction of a refinery did not offend public third parties against the buyer should extend policy where both owner and contractor were so- for a significantly longer period of time than phisticated entities. the right to indemnification for claims between the buyer and seller. Third parties do not have REPRESENTATION AND WARRANTY IN- any obligation to commence a lawsuit earlier SURANCE • Certain insurers are now offering than the statute of limitations, and “discovery” “representation and warranty insurance” as a po- tential supplement to or substitute for a private or other tolling doctrines may extend the limi- contractual indemnity. The target market appears tations period for a significant period of time. to be middle market transactions and/or repeat Accordingly, with respect to third-party claims, M&A buyers, e.g., private equity firms. the buyer may request that the survival period Although insuring language and other provi- be stated not in terms of a period of specified sions, including exclusions, may vary from policy years, but instead in terms of the “applicable to policy, in general terms the concept of the in- statutes of limitation, as they may be tolled surance is to cover losses resulting from breach of or extended by agreement or by operation of a representation or warranty. The policy may be law.” structured to correspond to (and may even attach) • Securities claims. If a sale of securities is the transaction agreement in question. The policy involved in the transaction, buyers may request period may simply match the representation and that the duration of indemnity for Section 10(b)/ warranty survival period in the transactional agree- Rule 10b-5 violations be as long as possible. ment, although if so, the policyholder may be able Complex Indemnity Provisions | 37 to purchase an extension. Policy exclusions may in- Insurers also claim that the insurance has vari- clude such items as: ous benefits for sellers in an M&A transaction, such • Loss arising out of any breach of which the as facilitating a “clean exit” in which worries about insured’s “deal team members” had “actual future claims are eliminated, hold-backs, or escrows knowledge”; are eliminated or satisfied, and sale proceeds quick- • Loss payable under any purchase price adjust- ly distributed to the seller or its owners; protection ment provisions in the transaction agreement; for “passive sellers”; and increase in the sale price. • Loss payable under any indemnification provi- The authors express no opinion regarding sion in the transaction agreement; these claims by insurers or on the advisability of • Loss arising out of consequential, special, indi- representation and warranty insurance in general. rect, multiplied, punitive, exemplary damages; • Loss arising out of injunctive, equitable or non- Parties should, however, consider various issues in monetary relief; evaluating whether to employ such insurance prod- • Loss arising out of any “estimate, projection or ucts instead or in addition to negotiating a private forward looking statement”; and indemnity in the transaction agreement. For exam- • Other transaction specific exclusions added by ple, parties should consider these questions: the insurer. • Is the insurer more financially creditworthy than the transaction counterparty? Certain information suggests that limits of up to • Can the insurer offer broader indemnity com- $150 million are available per transaction, with the pared to what could be negotiated with the premium being two to four percent of the amount transaction counterparty? Even if so, is the pre- of the limit and the deductible being one to two mium worth it? percent of transaction value, and that over 500 rep- • Can the insurer offer enough in limits as com- resentation and warranty policies have been issued pared to the transaction counterparty? Even if worldwide over the past 10 years or so. so, is the premium worth it? Insurers claim that the insurance has various • Will the insurer pay its coverage obligations benefits for buyers in an M&A transaction, such as more quickly and reliably, and with less dispute enhancement of the indemnity in the transaction agreement (including possible extension of survival or need for litigation, as compared to the trans- periods for reps and warranties); alleviation of con- action counterparty? Even if so, is the premium cerns about collecting on the transaction agreement worth it? indemnity (e.g., concerns about the financial condi- tion of the seller and the difficulty and expense of CONCLUSION • Indemnity provisions are inher- suing the seller); and a potential competitive advan- ently flexible and should be built to suit the transac- tage in bidding because the buyer can accept less tion. When they are, they can do much to mitigate indemnity protection from seller and then supple- the risks undertaken and provide a considerable ment with the insurance. degree of security.

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