Managing disputes in Canada and the U.S.: All about indemnity clauses

Andrew Bernstein (00:05): Hi everyone. I'm Andrew Bernstein, a litigator at Torys Toronto, and I'm here with my colleague Erica Goldman, a litigator from Torys New York. Welcome back to our occasional series on cross-border contract disputes.

Erica Goldman (00:17): Today we have a very special guest on the show. One of our corporate partners, Danielle Kline. Danielle, thanks for coming on the program. I thought corporate lawyers hated contract disputes.

Danielle Kline (00:28): Well, Erica, we do, but we love thinking about how we can draft to avoid them.

Andrew Bernstein (00:32): Danielle, why do you hate fun?

Erica Goldman (00:35): Andrew, only litigators and sociopaths find disputes fun.

Danielle Kline (00:40): Erica, how confident are you that those are two separate categories?

Andrew Bernstein (00:45): Ooh, shots fired! Danielle, I'm sure you didn't agree to come onto this webcast just to mock us.

Danielle Kline (00:50): To be clear, I'm not mocking Erica.

Andrew Bernstein (00:52): Okay, but let's get down to business. Today, we're going to talk about indemnity clauses. Erica, what's an indemnity clause.

Erica Goldman (01:00): Like so much in contracting, indemnity clauses are provisions in the contract that are really about risk allocation. So an indemnity clause allows you to take a risk that allocate that the law would otherwise allocate to one party and impose it on another. But Danielle’s the corporate lawyer, so perhaps she can give us a more concrete example.

Danielle Kline (01:18): Thanks, Erica. Simply put, an indemnity clause allows two parties who will be responsible for the losses or damages arising in connection with specific circumstances to reallocate that risk. Where the loss would ordinarily flow to one party, i.e., the owner of a business, an indemnity clause can allow the parties to agree that the other party will be responsible. For example, not the current owner of the business, but the former owner of the business.

As an example, if you buy the shares of a company, you're buying all of that company's liabilities. Those liabilities are sometimes known before you buy the company, but they can also be unknown or uncertain, and if the liabilities were not factored into what you agreed to pay for the business, and they turn out to be material, it can make for a really unfortunate investment.

So, sometimes the buyer says, well, that's not my risk to take on. I'm only prepared to pay the price we agreed for, your company shares, but I'll only pay that price if you agree that you're going to be on the hook for certain liabilities. A clause that has one party agreeing to be liable for a claim that, without that clause, would be the liability of the other party, is an indemnity clause.

Andrew Bernstein (02:31): Okay, well done! So indemnity clauses themselves can sometimes cause problems, especially if you're using boilerplate, because as soon as you're transferring risks from the party that the law imposed it on, for example, at the buyer or in our case the indemnified party and you're imposing it on someone else, the indemnifier or the seller in our example, issues arise and there are knock off effects that need to be agreed on. And the boilerplate doesn't usually deal with those knock off effects or doesn't deal with them particularly well. So let's take Danielle's example, the buyer now controls the company and therefore has to pay for the lawyers, and has the power to instruct the lawyers with respect to a claim that the seller already agreed that it would be liable for it. So how do you deal with that?

Danielle Kline (03:20): Well, Andrew, we ordinarily deal with it by prescribing who has control of the litigation, as well as other procedural points like who's going to pay for those lawyers. But even that level of detail doesn't solve for disputes around indemnification. They can still get pretty messy, because what happens if there's a fight about whether or not a claim is even the subject of indemnification?

Erica Goldman (03:42): So you get these situations in which someone says we are not accepting liability. We are not accepting that we have to pay for counsel, but we want to control the litigation just in case we were wrong about it not being our responsibility. And that's really a nonstarter. The contract should force the parties to decide are they indemnified or aren't they.

If they're indemnifying, they have to pay and control, with some exceptions, which we'll cover in a bit. And if they're not, then they don't. And the contract should contain a default rule. If you don't answer within a certain period of time, after getting a notice of claim, you're deemed to accept your indemnification obligations.

Andrew Bernstein (04:15): Now, there is one situation that you have to account for, which is what happens if there's multiple claims, some of which fall within the scope of the indemnity and some don't? So let's say that there's an indemnity that the company's products don't use any third party IP. And then you have a claim from a disgruntled former employee who says, you wrongfully dismissed me and you stole my IP. The wrongful dismissal claim may not be properly indemnified, but the IP claim is.

Danielle Kline (04:40): So what do you do there?

Andrew Bernstein (04:41): Well, our best advice is to have three options accept, reject or reserve, with the default option usually being accept, but sometimes that can change. The rights that are associated with accepting, rejecting or reserving will differ depending on what the indemnifier’s position is at the time the live dispute is going on.

Danielle Kline (05:02): That all makes sense. But how and when do you sort all of that out?

Erica Goldman (05:07): Well, that's also important because the last thing you want to have is the indemnifier and the indemnified fighting at the same time as the company is fighting the plaintiff in the claim. So although we don't see this as often in the US yet, we highly recommend putting into your contracts an arbitration clause which allows the indemnified party to pursue indemnification in a confidential forum where the plaintiff can't see it.

And also, a tolling arrangement which suspends the limitation periods. Sometimes the main claim just has to work itself out before you can finalize the indemnity arrangements, and when that happens, it's best to have an option to wait.

Danielle Kline (05:42): So are there any special US-based rules we should know about?

Erica Goldman (05:46): No particular US-based rules per se, but I mentioned earlier that there can be certain exceptions or carve-outs to seller control in our scenario, for example. We generally recommend including carve-outs for reputational risk where the claims involve reputational risk, a key business partner or customer, where a conflict of interest is alleged between or among those parties, or for claims that are not seeking purely monetary relief.

We also usually recommend contracting for a shift in control if the indemnifier fails to vigorously prosecute the defense. We've also seen in the US increasing use of reps and warranties insurance in place of traditional indemnity provisions. So once a claim is made and if the insurer accepts coverage, the issue of control tends to get overlooked, but this would be a mistake because to the extent a third-party claim falls outside the scope of the RWI policy, your contract should still provide those claim procedures.

And finally, let's assume the parties reach a settlement! The issue of who controls the settlement framework is also crucial. We typically provide that the indemnifier can't settle for other than monetary damages, with a complete release of the indemnified and conversely, the indemnified can't settle without the consent of the indemnifier.

Andrew Bernstein (07:04): Okay. Well, thanks Erica, that's really interesting. And thanks Danielle for joining the litigators today. I hope we've convinced you to hang out with us more often.

Danielle Kline (07:11): No promises.

Erica Goldman (07:12): That's just for Andrew again, right?

Danielle Kline (07:14): You're getting the hang of this, Erica!

Andrew Bernstein (07:16): Thanks everyone.