The First-Party/Third-Party Claim Distinction in Indemnification Provisions—Unambiguously Broad Is Not Necessarily the Same Thing as “Clear and Unequivocal”

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Indemnification clauses are ubiquitous in commercial agreements of all types. In the M&A context, indemnification is a concept that applies most frequently in the contractual remedies regimes that are provided in private company acquisition agreements for breaches of representations and warranties, or for excluded liabilities. Indemnification is also a concept that arises in entity formation agreements for officers and directors in the corporate context, for members and managers in the limited liability company context, and for general partners in the limited partnership context. We have previously warned about the historical baggage the word “indemnify” carries—i.e. as being limited to third-party claims, particularly with respect to the question of whether attorneys’ fees incurred in connection with first-party or direct claims between the parties are covered.[1] But a pair of recent Delaware decisions reinforces that warning with respect to private company acquisition agreements, while providing some reassurance and relief in alternative-entity formation agreements.

The first case in our pair, Ashland LLC v. The Samuel J. Heyman 1981 Continuing Trust for Lazarus S. Heyman, 2020 WL 6582958 (Del. Super. Nov. 10, 2020), involved a claim for indemnification by the buyers against the sellers respecting an “excluded” environmental liability under a stock purchase agreement (“SPA”).[2] The question before the court, however, was not whether the buyers were in fact entitled to be indemnified for the excluded liability, but whether the buyers were entitled to be indemnified for the attorneys’ fees they incurred in the action brought against the sellers to enforce the sellers’ obligation to indemnify the buyers for the excluded liability (even assuming the buyers were clearly in the right in demanding indemnification for the excluded liability). The indemnification clauses at issue in the SPA specifically indemnified the buyers for all “Losses actually suffered or incurred by any of the Buyer Indemnified Parties, to the extent arising out of [the excluded liabilities or a breach of any covenant of the sellers in the SPA].” “Losses” was broadly defined as follows:

… with respect to any Indemnified Party, and all losses, liabilities, claims, obligations, judgments fines, settlement payments, award or damages of any kind actually suffered or incurred by such Indemnified Party after Closing (together with all reasonably incurred cash disbursements, costs and expenses, including costs of investigation, defense and appeal and reasonable attorneys’ and consultants’ fees and expenses), whether or not involving a Third Party Claim.

Third Party Claim was, in turn, defined as:

… any written claim or demand for which an indemnifying party (an “Indemnifying Party”) may have liability to any Indemnified Party hereunder, other than those relating to Taxes … asserted against or sought to be collected from any Indemnified Party by a third party …

While it may seem pretty clear, on its face, that attorneys’ fees incurred by the buyers in enforcing a claim for indemnification against the sellers for the excluded liability was covered by the broad definition of Losses, particularly considering the phrase “whether or not involving a Third Party Claim,” the sellers argued that Delaware law (and the so-called “American Rule”) required “clear and unequivocal fee-shifting language in the SPA,” which the definition of Losses was supposedly not, to impose upon the sellers the buyers’ attorneys’ fees incurred in enforcing the sellers’ covenants under the SPA. Surely, you say, the court rejected this argument and sided with the buyers. Bzzt…thanks for playing, but if you thought or said that, you are wrong. The court instead sided with the sellers (relying upon and quoting from prior Delaware case law):

Delaware follows the American Rule, “which provides that each party is generally expected to pay its own attorneys’ fees.” The Court should not interpret indemnification provisions “in an expansive way that would be inconsistent with the American Rule.” Indemnification provisions “are presumed not to require reimbursement for attorneys’ fees incurred as a result of substantive litigation between the parties to the agreement absent a clear and unequivocal articulation of that intent.” “There is no specific language that must be used in order for an indemnity provision to provide for recovery in first-party actions.” However, a party is not entitled to attorneys’ fees under an indemnification provision “when there is no specific language in the indemnification provision … that covers fee-shifting.”

Hmm. There is no specific language required, but whatever language is used must be specific in stating that “fee-shifting” is intended, and simply making clear that attorneys’ fees incurred in connection with a claim for indemnification against the seller, whether or not involving a Third Party Claim, is clearly not enough. Got it?

It is worth noting that the court was influenced by the fact that Third Party Claim was defined only to include “written claims” by third parties, which raised the prospect that the reference to “whether or not involving a Third Party Claim” was intended to cover the possibility of other types of third-party claims being covered (i.e., those not in writing), but not necessarily encompassing first-party claims (and an explicit intent to cover first-party claims is required). The court was also influenced by the fact that there was an explicit fee-shifting provision in another section of the SPA that dealt with a termination of the SPA in a circumstance in which the sellers were entitled to a termination fee, the buyers failed to actually pay it, and the sellers were required to sue to collect the fee from the buyers. That provision (Section 8.2(c)) stated that:

The parties acknowledge that the agreements contained in Section 8.2 are an integral part of the Transactions, and that, without these agreements, the parties would not enter into this Agreement; accordingly, if Buyer fails to promptly pay the amount due pursuant to Section 8.2(b), and, in order to obtain such payment, the Seller Parties commence a suit that results in a judgment against Buyer for the amount set forth in Section 8.2(b), Buyer shall pay to the Seller Parties their costs and expenses (including attorneys’ fees) in connection with such suit, together with interest on such amount or portion thereof at the Interest Rate in effect on the date such payment was required to be made through the date of payment.

According to the court:

Finally, the Court notes that the parties knew how to draft explicit fee-shifting language in other provisions which further demonstrates that that the parties did not intend for Losses to encompass fee-shifting on first-party claims. To uphold the parties’ intentions, the Court “must construe the agreement as a whole, giving effect to all provisions therein.” If the parties use fee-shifting language in one section of the agreement and fail to include such language in another, it “indicates a lack of intent to create a clear and unequivocal agreement to shift fees in first-party actions.” The SPA includes fee-shifting language in SPA Section 8.2(c). That section provides that the “Buyer shall pay to the Seller Parties their costs and expenses (including attorneys’ fees) in connection” with any suit the [sellers] commence to recover a termination fee. SPA Section 8.2(c) shows a clear and unequivocal intent to shift fees that is not present under the definition of Losses.

So there you have it. But don’t assume that if the explicit fee-shifting language had not been there in another context it would have changed the result. The Delaware precedent is pretty demanding in its requirements that an indemnification clause be clear and unequivocal in its intent to actually require fee-shifting in derogation of the American Rule, and simply adding attorneys’ fees to the list of items that constitute indemnifiable losses (even if there is language that seems to suggest that it includes attorneys’ fees incurred in actually enforcing the indemnification claims directly against the indemnifying party) may not be enough.

And that becomes even clearer in the second case in our pair—even though it came out the other way (based on the type of agreement containing the indemnification clause, not because it was any more explicit in its fee-shifting intent). International Rail Partners LLC v. American Rail Partners LLC, 2020 WL 6882105 (Del. Ch. Nov. 24, 2020) involved an action by a limited liability company director and certain members of the limited liability company for advancement of fees and expenses incurred in defending an action commenced against them by the limited liability company itself. The indemnification and advancement provisions set forth in the limited liability company agreement were extremely broad. Indeed, the indemnification and advance provision stated that:

“[t]he Company shall indemnify, defend and hold harmless each Covered Person against any losses [and] claims … (including all reasonable fees and expenses of counsel) … arising from any and all claims … actions, suits or proceedings … in connection with any matter arising out of or in connection with the Company’s business or affairs, or this Agreement or any related document.” … If any Covered Person becomes involved in any capacity in any action, suit, proceeding or investigation in connection with any matter arising out of or in connection with the Company’s business or affairs, or this Agreement or any related document, … the Company shall reimburse such Covered Person for its reasonable legal and other reasonable out-of-pocket expenses … as they are incurred in connection therewith …

And the limited liability company acknowledged that the complaining director and members were clearly covered persons and that that the technical, “plain reading” of the advancement and indemnification provision “may appear sufficiently broad to include first-party claims.” But, based upon the line of Delaware cases that the court relied upon in Ashland, the limited liability company defended that, notwithstanding the seemingly unambiguous breadth of the provision, “an advancement provision may only cover first-party claims if it expressly says so.”

But, after thoroughly reviewing the line of Delaware cases requiring extreme specificity in indemnification provisions in order to cover first-party claims, Vice Chancellor Fioravanti distinguished those cases from the indemnification and advancement provision at issue in International Rail Partners. According to Vice Chancellor Fioravanti:

Given the statutory framework, the broad language of the LLC Agreement’s indemnification provision, and the strong public policy in favor of indemnification and advancement, I conclude that the first-party/third-party claim distinction applied in the TranSched line of cases is inapplicable here. I decline to elevate an interpretive presumption applied to commercial contracts above the strong public policy of advancement and indemnification, particularly in light of the “capacious and generous standard” articulated in the American Rail LLC Agreement.

That strong public policy that applies to advancement and indemnification for officers, directors, general partners, and members in the corporate and alternative entity context, even though the underlying agreements are contracts like any other for most purposes, “is to allow … entities to attract talented individuals to act on behalf of the company by limiting the burdens of potential litigation against them.” Thus, the interpretive principles requiring explicitness in indemnification provisions to cover first-party claims, in the context of any ordinary commercial contracts (including private company acquisition agreements), is overridden in this particular species of contract involving an alternative-entities’ formation or governing contract (such as an LLC agreement).

The takeaway:

While it is certainly possible to make an indemnification provision’s definition of Losses sufficiently clear and unequivocal for purposes of fee-shifting for first-party claims, a separate fee-shifting clause is probably better. The peculiar nature of indemnification clauses (with their historical baggage) carry with them additional judicial burdens required to achieve clarity and definitiveness in fee shifting.[3]

Endnotes 

  1. 1. Glenn West, Indemnify is a Funny Word Carrying Historical Baggage—Be Aware and Use with Care, Weil Insights, Weil’s Global Private Equity Watch, December 17, 2019, available here.
  2. 2. “Excluded liability” is a bit of a misnomer in a stock purchase agreement, as opposed to an asset purchase agreement. If you are purchasing the target’s stock, the target retains whatever liabilities it has regardless of any purported allocation of those liabilities between the seller and the buyer. But, parties tend to use that term, even in a stock purchase agreement, understanding it as being a category of special matters for which the seller is agreeing to remain liable, at least as between the seller and the buyer, and to indemnify the buyer and the target if that liability is ever asserted against the buyer or the target. And one should always be conscious of the fact that the distinction between asset and stock purchases does not always hold. See Glenn West, An Asset Purchase That Wasn’t—Beware the De Facto Merger Doctrine in Distressed M&A, Weil Insights, Weil’s Global Private Equity Watch, May 4, 2020, available here.
  3. 3. If you think this interpretive rule is a Delaware anomaly, think again. See e.g., Claybar v. Samson Expl., LLC, 2018 WL 651258, at *3 (Tex. App. Feb. 1, 2018); Kirsch v. Brightstar Corp., 78 F. Supp. 3d 676, 715-16 (N.D. Ill. 2015); Hopper Associates, Ltd. v. AGS Computers, Inc., 548 N.E.2d 903, 904-06 (N.Y. 1989).

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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