Indemnification & Warranties

September 15, 2016

Overview Indemnity and Warranties

Indemnification = undertaking by one party to compensate the other party for certain costs and expenses. Customizes risk allocation.

•  Obligates Indemnitor to protect Indemnitee financially •  Generally no automatic duty to defend (unless statutory, e.g., Cal.), so

must be specified

‌‌Warranties = assurance to the other party that a fact, condition, or quality is and will be true.

•  Expands party’s exposure to breach of contract claims, and all contract damages not excluded are available.

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Indemnification – Overview of Obligations

‌‌Obligation to pay for losses or damages •  Breach of representation or warranty by Obligor •  Breach of agreement of covenant by Obligor •  Losses incurred by Obligee under specified conditions

* Obligation does not arise until end of the dispute. Mizuho Corporate Bank (USA) v. Cory & Assocs., 341 F.3d 644, 650 (7th Cir. 2003); McDermott v. New York, 50 N.Y.2d 211, 216 (N.Y. 1980)

•  Specify whether attorney’s fees and other litigation costs are included in indemnification obligation. Default in some states (Cal., NY), not in others (Ill.)

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(Indemnity): Watch for construction against indemnitee

‌‌There is ample case law construing the indemnity provision narrowly against the indemnitee on the theory that the indemnitee had superior bargaining power

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(Indemnity): Watch for timing/scope of indemnity obligation

‌‌Beware Different Standards and their Timing

‌‌Losses versus liabilities/damages versus claims versus causes of action/claims

•  Difference is both scope and when obligation (and statute of limitations) is triggered

•  (“Liabilities” is broadest)

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(Indemnity): Watch for timing/scope of indemnity obligation

‌‌“Losses”: In general an indemnity for losses, damages, and costs is not payable by the indemnitor until the indemnitee suffers actual loss by being compelled to pay the claim or damages.

‌‌“Liabilities”: An indemnity for “liabilities” is broader and requires the indemnitor to pay as soon as the indemnitee becomes liable. No payment or actual loss is required.

‌‌“Claims/causes of action”: In general, indemnification for claims and causes of action arise when a claim or suit is filed

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Timing issues: double-edged sword

‌‌The event of loss or damage versus the event of liability can be substantially different in time: indemnitee can "become liable" much earlier:

1.  triggering the obligation to pay indemnification amounts much sooner than might otherwise be expected by the relevant parties, but also

2.  triggering the running of the statute of limitations for the indemnification against liability if the indemnifying party fails to perform.

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(Indemnity): Watch for scope of indemnity. Typical:

‌‌Customary indemnified claims include 1.  Breach of representations or warranties 2.  Breach of other contractual obligations 3.  Violations of law 4.  Losses incurred by indemnitee under specified conditions 5.  Third party claims for specific matters such as IP infringement or

misappropriation.

‌‌Consider “backstop” provision such as “any other breach of any obligation or duty under this Agreement or under applicable law.”

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(Indemnity): Watch for scope of indemnity. Expanding scope:

1.  Tax liabilities 2.  Environmental, health and safety liabilities 3.  Known or assumed liabilities 4.  Intentional misrepresentation or fraud, and 5.  Violations of law.

‌‌Coordinate with the representations and warranty clauses and limitation on liability provisions, including liability “caps” and “baskets” for different categories of claims and contractual statutes of limitations for claims.

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(Indemnity): Watch for scope of indemnity. Narrowing scope:

‌‌Can be narrowed in a variety of ways, including: •  Personal injury and death •  Real and personal property damage •  infringement of intellectual property •  Breach of confidentiality •  Violation of law

‌‌“Liability baskets” or “sublimits” •  Shields indemnifying party from need to indemnify unless and until

losses resulting from covered claim exceeds defined amount •  Structure as a threhold or a deductible

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(Indemnity): Watch for scope of indemnity. Narrowing scope:

‌‌Watch indemnity carve-outs and exclusions (“except to the extent that”) for (1) negligence (2) wrongful or unlawful acts, (3) other contributing acts or omissions of indemnified party, (4) consequential and related damages, (5) general limitations on liability, and (6) other exclusions relevant to the contract

‌‌In the case of mutual indemnity clauses dealing with the same or related subject matter, “tie breaker” carveouts are necessary to avoid conflicting provisions.

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(Indemnity): Watch for scope of indemnity. Overbroad or defective indemnified claims

‌‌ “any act or omission of Indemnitor or any of its employees or agents in whole or in part, including but not limited to (a) or (b)”

‌‌ “any intentional acts of [A] in connection with the production and distribution of the Products”

‌‌ “any liability arising out of or connected with the performance of work under this Agreement”

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No Indemnity for Sole Negligence or Punitive Damages as Public Policy

‌‌In most states, any obligation in a construction contract to indemnify or hold harmless another person from that person's own sole or active negligence or willful misconduct is void as against public policy and wholly unenforceable, subject to certain limited exceptions.

‌‌Generally most states preclude indemnity for wrongful acts or most forms of punitive damages

E.g., Davis v. Commonwealth Edison Co., 61 Ill. 2d 494, 336 N.E.2d 881, 885 (1975); Public Serv. Mut. Ins. Co. v. Goldfarb, 53 N.Y.2d 392, 400-401 (N.Y. 1981)(punitive damages); Cal. Civ. Code §2773 (indemnification of future acts void); §2774 (indemnification of past acts permitted if not a felony)

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Who Gets Indemnified

‌‌Scope of coverage a matter of negotiation. Other parties may be appropriate: “permitted assignees and successors in interest”, “licensors”, “licensees”, “distributors”, “customers”.

‌‌“Company” Determine whether Company is a sufficient indemnifying party, and whether joint indemnitors [such as a corporate parent] would be appropriate

‌‌In merger or other acquisition transaction, Company will be owned by the Buyer after the closing and cannot function as an indemnitor. Principal selling stockholders commonly act as indemnitors postclosing subject to negotiated limits on liability.

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Who Gets Indemnified: Direct Versus Third-Party Claims

‌‌While indemnification is often associated with third party claims, the obligation to indemnify can exist for direct claims between the two parties to the contract.

‌‌Include express language either way (to encompass direct claims; to limit to third party claims)

‌‌Consider effect on “hold harmless” language; may negate unless limited to third-party claims

‌‌Consider effect on limitations of liability elsewhere in contract

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Who Gets Indemnified: Non-parties to Contract

‌‌Third parties such as suppliers or licensors or distributors not covered by indemnification provision unless expressly included. The assumption of risk inherent in indemnification clauses is a matter of express agreement and such clauses generally do not apply to nonparties

E.g., Knight v. Jewett, 3 Cal.4th 296 (1992)

‌‌Consider also third party beneficiaries and assignment provisions

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(Indemnity): Generally, watch out for:

‌‌Exclusive rights and remedies

‌‌Coordination with limitations of liability, waivers of consequential damages

‌‌Effect on force majeure provisions

‌‌Survival provisions (termination/expiration of agreement)

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(Indemnity) Duty to Defend

‌‌Obligation to pay for defense of third-party claims against Obligee caused, in whole or part, by action/inaction of Obligor

‌‌Separate from duty to indemnify; Under the common law of most states, an indemnitor generally has no duty to defend unless the contract specifically requires such defense. (Contrast: California)

‌‌Arises immediately upon claims or suits upon obligee

‌‌Not applicable to a direct suit between the parties (question usually arises when contract does not otherwise have a prevailing party attorneys’ fees provision)

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(Indemnity) Duty to Defend: Issues to Watch Out For

‌‌There is a big difference between agreeing to defend against proven liability of indemnitor (narrow) versus claims and suits based upon claims of the indemnitor’s liability (broad). ‌‌

•  Latter obligates full indemnity, even if the indemnitor is proven not to be liable. See, e.g., Crawford v. Weather Shield Mfg. Inc., 187 P.3d 424, 432 (Cal. 2008)

•  In former, indemnification duties are contingent on indemnitor’s liability; in latter, duties are dependent only on the nature of the claims made against the indemnitee

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Limiting (or Expanding) Indemnification & Defense—Fully Customizable

‌‌Limiting the “nexus phrase”: •  “Caused by” •  “Result from” •  “Solely result from” •  “To the extent they arise out of” •  “Except to the extent” they are “caused by the acts or omissions” of the

indemnitor

‌‌Limiting to occurrence-based indemnities: •  Environmental harms •  Claims arising in specific jurisdictions •  Losses associated with specific pending litigation

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“Hold Harmless” – What Does It Mean?

‌‌Conflict in authorities as to whether a “hold harmless” clause is or is not a form of indemnification provision per se ‌‌ ‌‌Many courts hold that "indemnify" and "hold harmless" are synonymous or duplicative and tend to use the terms interchangeably.

•  E.g., Medcom Holding Co. v. Baxter Travenol Lab., Inc., 200 F.3d 518, 519 (7th Cir. 1999); Praetorian Ins. Co. v. Site Inspection, LLC, 604 F.3d 509, 515 (8th Cir. 2010); Majkowski v. American Imaging Mgmt. Servs., LLC, 913 A.2d 572, 588 (Del. Ch. 2006)

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“Hold Harmless” – What Does It Mean?

‌‌Some courts have held that “hold harmless” acts only as an exculpatory provision that releases the indemnitee from liability to the indemnitor.

‌‌“One is offensive and the other is defensive—even though both contemplate third party liability situations. ‘Indemnify’ is an offensive right—a sword—allowing an indemnitee to seek indemnification. ‘Hold harmless’ is defensive: The right not to be bothered by the other [contract] party itself seeking indemnification.”

‌‌Queen Villas Homeowners Assn. v. TCB Property Management, 149 Cal. App. 4th 1, 9 (2007); see also Exxon Mobil Corp. v. New W. Petroleum, LP, 369 Fed. Appx. 805, 807 (9th Cir. 2010); Fernandez v. K-M Indus. Holding Co., 646 F. Supp. 2d 1150, 1159-1160 (N.D. Cal. 2009).

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“Hold Harmless” – What Does It Mean?

‌‌Watch drafting: hold harmless may create obligation to pay costs and expenses even though recoverable damages do not include liabilities, claims and causes of action (likely duplicative of defense obligation, if there is one)

•  Exclude hold harmless provision from indemnification provision

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Procedural Rules for Indemnity and Defense

‌‌Indemnification and duty to defend should include procedural rules for handling third party claims. Such rules should include:

•  Notice by indemnified party of claims •  Right to control defense of claims •  Right of other party to participate with own counsel/select counsel •  Right of other party to control if [example] (1) failure to defend or

inadequate financial resources to defend, (2) scope or validity or enforceability of IP at issue, or (3) adverse judgment of third party claim would establish a precedent that would be materially damaging to the continuing business interests.

•  Obligation to advance or periodically reimburse legal fees and costs during litigation

•  Compromise and approval rights, including consents to judgment

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Indemnity and Warranties

‌‌Materiality and other qualifiers: often representations and warranties will have qualifiers, e.g., “products will be free of material defects”

‌‌Watch for: •  Double qualifiers which are replicated in the indemnity provision •  Back-door qualifiers (if warranty does not have one but indemnity

clause does) •  Indemnification limits, which will operate as limitations on warranties

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Indemnity and Warranties

If concerned about financial wherewithal of indemnifying party, consider (1) obtaining representations and warranties insurance, (2) escrowing part of purchase price to satisfy seller’s indemnification obligations Watch for assignment rights of indemnitor to assure warranties will be sufficiently backed up

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