Procedural protections for third-party indemnities

You just bought a business. You are brimming with optimism and ideas. You arrive at work on day four post-closing only to be presented with a thin manilla envelope.  When you open it, you see every business owner’s least favourite words: “statement of claim”.

You recently sold a business. You got an excellent price. You are luxuriating on the beach celebrating (and spending!) your freshly-acquired, hard-earned cash when you get an angry call from the buyer: they have been sued for something that happened while you still owned the company.

Both of you consult your deal counsel and hear every business owner’s second least favourite words: “we will get a litigator to look at the indemnity...”

Indemnities are an important tool in corporate contracts, used to establish a framework in the event of claims from third parties (among other purposes). Both corporate transactions (such as share or asset purchase transactions) and commercial relationships (such as supply arrangements or software licensing arrangements) create the risk of liability to third parties that can often be difficult to detect through due diligence. Claims arising as a result of pre-closing events, in the case of a purchase and sale transaction, or IP infringements, in the case of supply and/or licensing arrangements, are classic examples of events where the parties will negotiate an indemnity in order to allocate the risk among them. Typically, this is intended to take the risk away from the buyer (to whom it would flow at law) and impose it on the seller, and simultaneously seek to time-limit, or monetarily cap, a seller’s exposure in that regard. (This can work the other way around, but it is less frequent.)

The specific matters that are subject to an indemnity obligation are frequently a matter of careful negotiation and are very fact-dependent. However, the process by which the obligation to indemnify is triggered and how the indemnity will operate in the case of an actual claim is often left to chance (also known as “boilerplate”). That is a mistake, as in our experience, paying attention to these procedural considerations at the drafting stage can save a lot of difficulties (and expense!) in the event that a claim is actually brought. Below, we discuss some questions that should be considered at the drafting stage.

Who controls the litigation?

The point of a third-party indemnity is to allocate the risk of a third-party claim, relieving the indemnified party of the risk of claims, and imposing it on the indemnifier. As a result, it is ordinary practice for the indemnifier to control the negotiation and ultimately (if necessary) the litigation. However, matters are rarely so straightforward. Sometimes, litigation will involve a relationship with a key supplier, customer, or employee and, therefore, cause business owners to worry about reputational risks. For this reason, it is useful to limit the indemnifier’s control of the process by including a clause that requires the indemnifier to protect the interests of both itself and the indemnified party and to keep the indemnified party reasonably apprised of the process.

Witnesses and documents?

An indemnity clause should require both the indemnifier and the indemnified party to make commercially reasonable efforts to cooperate with counsel to defend any third-party claim. This includes providing access to witnesses and relevant information/documentation on reasonable notice.

Who pays for counsel?

A typical indemnity requires an indemnifier to hold the indemnified party “harmless” in respect of the third-party claim. That is ordinarily understood to require the indemnifier to pay for counsel to negotiate and defend the claim. While it is common for the indemnified party to wish to have its own counsel, that is not usually within the scope of the indemnity as it is not considered necessary in order to defend the claim. Therefore, the indemnified party should only be permitted to involve its own counsel at its own cost.

What are the notice requirements?

The indemnified party will receive the claim from the third party. It should promptly notify the indemnifier. However, there are a multitude of reasons why this does not always happen as it should, and it is rarely prejudicial to the indemnifier’s interests. An ideal clause will i) require the indemnified party to notify the indemnifier in a relatively short period of time and ii) indicate that a failure to promptly notify will not reduce the obligation to indemnify, unless the delay causes material prejudice to the indemnifier, in which case the indemnification obligation would then be reduced to the extent of the prejudice. The absence of the latter clause can lead to the indemnifying party seeking to avoid or reduce its obligations as a result of short and inconsequential delays in being notified of the existence of the claim.

What happens if the indemnifier hedges?

It is not uncommon for an indemnifier to dispute whether a particular third-party claim gives rise to an indemnity obligation. As a result, providing the requisite notice discussed above may not be enough to get the indemnifier to accept the risk. This is particularly problematic if the indemnity provision provides that control of the litigation lies with the recalcitrant indemnifier. It is therefore useful to structure the indemnity clause in a way that requires an indemnifier to respond to the notice of a claim in one of three ways and within a prescribed period of time:

1. Accept liability. An indemnifier who accepts its indemnification obligation controls the litigation (subject to any consultation rights) and pays for counsel.
2. Reject liability. An indemnifier (or, in this case, a non-indemnifier) who outright rejects its indemnification obligation has no further rights to notice, control or consultation. Moreover, it waives any right to complain later that the third-party claim was litigated or settled in an improvident way.
3. Reserve liability. An indemnifier who reserves its indemnification obligation (i.e., neither accepts nor rejects it, or simply does not respond in the requisite time) loses the right to control the litigation. However, assuming it has responded, the indemnifier i) must be consulted in the selection of counsel (with the indemnified party having the final decision) and ii) has the right to receive notice of significant litigation steps. It can even be structured so that a reserving indemnifier pays for counsel, subject to its right to collect legal costs back from the indemnified party if it turns out that the third-party claim did not actually give rise to an indemnification obligation. The primary benefit to reserving, rather than rejecting, indemnification is that a party who reserves can at any time decide to accept its indemnification obligation, in which case it must agree to pay any past or future defence costs (including counsel fees), and then has the right to control the litigation (subject to the usual consultation rights of an indemnified party).

Of the options described above, reservation of rights is a likely outcome, as it preserves some optionality for the non-responding indemnifier and is sometimes the result of simple avoidance of the issue. For that reason, it is particularly helpful to create a framework that provides for a default option in which the counterparty reserves.

Arbitration and/or tolling?

Once a claim arises, spending time and resources fighting about the scope of the indemnity clause risks undermining the defence of the underlying claim. For that reason, we recommend including a mechanism in your indemnity provision that will allow the indemnifier and indemnified party to focus on defending the claim against the third party in a unified way, without the distraction of their own dispute. The two most common ways to address this are either a tolling provision (which allows an indemnified party to delay the process for pursuing a claim against a recalcitrant indemnifier) or an arbitration clause (which allows the parties to resolve the dispute in a confidential forum, which can often progress more quickly than going to court). It is in both parties’ best interests to win or minimize a settlement in the underlying claim, so introducing these provisions is an easy ask.

Conclusion

Parties spend a lot of time negotiating who will be responsible for what (and for how long and how much). However, the procedural aspects of how to actually implement an indemnification arrangement receive far less attention. In practice, they can be equally crucial in reducing the challenges associated with defending third-party claims. And if a particular indemnification arrangement does not include the required procedural particularity, it isn’t too late to pursue that negotiation when a third-party claim is served. Reasonable parties can and should have a discussion, and perhaps even commit to writing, a process for how a third-party claim can be managed without exposing both indemnifier and indemnified to unnecessary liability.