Key Issues in Drafting Indemnification Clauses

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Many agreements involving stock or asset purchases contain indemnification clauses – that is, clauses under which one party to the agreement promises to indemnify the other party in the event of future losses arising from the subject of the agreement.  Often a contracting party may be tempted simply to cut and paste an indemnification clause contained in a prior contract.  But few if any contract terms play a larger role in business litigation than indemnification clauses.  As such, whether you represent the buyer or the seller, time spent tailoring your indemnification clause to the specific circumstances of your transaction is time well spent.

The following checklist identifies some key issues to consider when crafting an indemnification clause:

  • Who has the obligation to indemnify?  Typically the entity that is selling the stock or assets will have a duty to indemnify the buyer.  But what about the seller’s parent company or other affiliates?  Many agreements also impose a duty to indemnify on the purchaser, such as in the event that the seller incurs losses arising from misrepresentations by the purchaser.
  • What triggers indemnification?  The duty to indemnify often is triggered by losses arising from either (i) breaches of representations and warranties made in the agreement or (ii) some other defined source of potential losses, such as specific lines of business, assets, or claims.  Each of these trigger terms must be tailored to the specific circumstances of the transaction in question. 
  • What losses are covered?  Defining what “losses” are subject to reimbursement is critical.  Covered losses may be defined to include damages, legal fees spent defending a third-party claim and potentially legal fees enforcing indemnification rights.  Some indemnification clauses will specifically exclude consequential, incidental, indirect, special, punitive or exemplary damages, as well as lost profits, business and goodwill. 
  • What limits apply?  Indemnification clauses may contain limits as to both the amount and timing of indemnification.  The amount may be reduced by specifying a threshold that must be reached – either in the aggregate or on a loss-by-loss basis – before indemnification kicks in.  It may also be cabined through a cap on recoverable losses.  Still other provisions can reduce the amount of reimbursable loss by taking account of actual or potential insurance recoveries or tax benefits.  With regard to timing, the provision may limit the duration of the duty to indemnify, such as by setting an outside limit for indemnity claims or by imposing an expiration date on the representations and warranties that may give rise to such claims.
  • What exclusions apply?  To deter irresponsible conduct, the agreement may bar or limit indemnification arising from an indemnified party’s own conduct, such as fraud, gross negligence or even ordinary negligence. 
  • Who controls third-party claims?  A frequent source of contention involves claims brought by third parties against the indemnified party.  Who will control the defense of such a claim – the selection of defense counsel and experts, the litigation strategy, and the settlement decisions?  Although the party at risk for indemnification may feel entitled to make these decisions, the party actually sued has its own reputational and other separate interests.  A variety of terms may be included to address these and other issues arising from third-party claims.
  • How is the indemnification clause invoked?  Indemnification clauses typically require the party potentially entitled to indemnification to give prompt notice of both third-party claims and any other losses, and such notice requirements are often strictly enforced by the courts.  Agreements may define when, to whom and how notice must be given, as well as the information that must be included in the notice itself.  The parties may also address the impact of a failure to give the required notice, such as a provision stating that late or otherwise defective notice will not relieve the indemnitor of its obligations absent actual prejudice.
  • Is indemnification the exclusive remedy?  Agreements may expressly provide that the right to indemnification – subject to all of its procedural requirements and substantive limitations – is the sole and exclusive remedy available for some or all claims between the parties.  Such provisions are generally enforced by the courts, other than in cases involving actual fraud.
  • What if there is a dispute over indemnification?  An agreement will often specify whether, if a dispute over indemnification cannot be settled through mediation or other discussions between the parties, it will be resolved through arbitration or litigation.  We have previously addressed some of the key considerations that go into arbitration and forum selection clauses in business agreements.  Those considerations are generally equally applicable to provisions addressing indemnification disputes.

Final thoughts.  Indemnification clauses raise a host of issues that should be considered in the context of specific deal circumstances.  These business contract clauses are the most likely to be contested in any future litigation or arbitration between the contracting parties, and, given their significance, should not be prepared with rote boilerplate from an earlier transaction agreement.  Careful crafting and negotiation of an indemnification clause, with an informed understanding of the options for addressing each of the issues listed above, is an important part of any business transaction and is essential to maximizing the prospects for success.

Topics:  Contract Drafting, Indemnification, Indemnification Clauses, Purchase Agreement

Published In: General Business Updates, Mergers & Acquisitions Updates, Securities Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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