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May 24, 2017

Contractual Indemnification and Limitation of Liability -- Tips and Tactics

Orange County, California

Presenters Kevin S. Asfour, Partner Complex Commercial Litigation and Disputes K&L Gates LLP 10100 Santa Monica Blvd., 8th Floor Los Angeles, CA 90067 310.552.5016 kevin.asfour@klgates.com

Mark L. Hammes, Associate Corporate/M&A K&L Gates LLP 10100 Santa Monica Blvd., 8th Floor Los Angeles, CA 90067 310.552.5062 mark.hammes@klgates.com

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Agenda What is indemnity? Legal sources of indemnity obligations (statutory,

equitable, and contractual) and related rules Legal rules governing contractual

elimination/limitation of liability Practical drafting considerations and examples

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What Is Indemnity?

What Is Indemnity? “In general, indemnity refers to the obligation resting on one party

[indemnitor] to make good a loss or damage another party [indemnitee] has incurred.” Prince v. Pacific Gas & Elec. Co., 45 Cal.4th 1151, 1157 (2009).

Although indemnity provisions are often geared toward protection against third-party claims, they are not necessarily so limited, i.e., an indemnity obligation can also include first-party losses incurred directly by the indemnitee. See Dream Theater, Inc. v. Dream Theater, 124 Cal. App. 4th 547, 555 (2004).

Often (though not always), an indemnity obligation will include responsibility for funding and/or conducting the defense of third-party claims, not merely for payment of an eventual judgment.

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What Is Indemnity? (Cont’d) Indemnity considerations are present in a very wide range of

scenarios, such as: Services agreements IP licensing Construction contracts Employment Corporate governance Products liability M&A transactions Landlord/tenant Countless others

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Sources of Indemnity Obligations

Sources of Indemnity Obligations

Statutory indemnity

Equitable indemnity

Express contractual indemnity

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Statutory Indemnity (Examples) Employer/employee

“An employer shall indemnify his or her employee for all necessary expenditures or losses incurred by the employee in direct consequence of the discharge of his or her duties, or of his or her obedience to the directions of the employer, even though unlawful, unless the employee, at the time of obeying the directions, believed them to be unlawful.” Cal. Lab. Code § 2802; see also Cal. Govt. Code § 825(a) (public employee indemnity).

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Statutory Indemnity (cont’d) Corporation/D&O

A corporation “shall” indemnify its directors, officers and other agents if they are sued by reason of their corporate role and are “successful on the merits in defense.” Cal. Corp. Code § 317(d); accord 8 Del. C. § 145(c).

Surety “Where one, at the request of another, engages to answer in

damages, whether liquidated or unliquidated, for any violation of duty on the part of the latter, he is entitled to be reimbursed in the same manner as a surety, for whatever he may pay.” Cal. Civ. Code § 2779.

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Equitable Indemnity “Equitable indemnity is an equitable doctrine that apportions responsibility

among tortfeasors responsible for the same indivisible injury on a comparative fault basis.” 14A Cal. Jur. 3d, Contr. & Indemn. § 55.

One form of equitable indemnity is implied contractual indemnity, i.e., an obligation of one contracting party to indemnify the other for third-party claims that can arise even without an express indemnity provision in the contract. “The right to implied contractual indemnity is predicated upon the indemnitor’s breach of contract, the rationale being that a contract under which the indemnitor undertook to do work or perform services necessarily implied an obligation to do the work involved in a proper manner and to discharge foreseeable damages resulting from improper performance absent any participation by the indemnitee in the wrongful act precluding recovery.” West v. Superior Court, 27 Cal. App. 4th 1625, 1633 (1994).

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Equitable Indemnity (cont’d) However, an express contractual indemnity provision can effectively “preempt”

implied contractual indemnity provisions that might otherwise arise. See, e.g., E. L. White, Inc. v. Huntington Beach, 21 Cal. 3d 497, 507-08 (1978) (“[A]n express indemnity clause is accorded a certain preemptive effect, displacing any implied rights which might otherwise arise within the scope of its operation.”).

Equitable indemnity obligations can arise even in the absence of any

contract between the indemnitor and indemnitee, e.g., in the case of joint tortfeasors. See Prince v. Pacific Gas & Elec. Co., 45 Cal.4th 1151, 1161 (2009).

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Express Contractual Indemnity Parties generally have “great freedom” to write their own

indemnity agreements. See, e.g., Prince v. Pacific Gas & Elec. Co., 45 Cal.4th 1151, 1157 (2009); Crawford v. Weather Shield Mfg. Inc., 44 Cal.4th 541, 551-52 (2008).

Contractual provisions are subject to default statutory “gap-filling” provisions (which can be modified/eliminated by the language of the contract) found in Cal. Civ. Code 2778: “In the interpretation of a contract of indemnity, the following rules are to be applied, unless a contrary intention appears:

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Express Contractual Indemnity (cont’d) Cal. Civ. Code § 2778 (cont’d):

“1. Upon an indemnity against liability, expressly, or in other equivalent terms, the person indemnified is entitled to recover upon becoming liable;”

“2. Upon an indemnity against claims, or demands, or damages, or costs, expressly, or in other equivalent terms, the person indemnified is not entitled to recover without payment thereof;”

“3. An indemnity against claims, or demands, or liability, expressly, or in other equivalent terms, embraces the costs of defense against such claims, demands, or liability incurred in good faith, and in the exercise of a reasonable discretion;”

“4. The person indemnifying is bound, on request of the person indemnified, to defend actions or proceedings brought against the latter in respect to the matters embraced by the indemnity, but the person indemnified has the right to conduct such defenses, if he chooses to do so;”

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Express Contractual Indemnity (cont’d) Cal. Civ. Code § 2778 (cont’d):

“5. If, after request, the person indemnifying neglects to defend the person indemnified, a recovery against the latter suffered by him in good faith, is conclusive in his favor against the former;”

“6. If the person indemnifying, whether he is a principal or a surety in the agreement, has not reasonable notice of the action or proceeding against the person indemnified, or is not allowed to control its defense, judgment against the latter is only presumptive evidence against the former;”

“7. A stipulation that a judgment against the person indemnified shall be conclusive upon the person indemnifying, is inapplicable if he had a good defense upon the merits, which by want of ordinary care he failed to establish in the action.”

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Express Contractual Indemnity (cont’d) However, contractual indemnity provisions are subject to

certain public-policy restrictions & outright prohibitions.

A contract cannot provide a party with indemnity for its own future, knowingly “unlawful” acts. Cal. Civ. Code § 2773; see also Cal. Ins. Code § 533 (”An insurer is not liable for a loss caused by the willful act of the insured…”).

By contrast, an indemnity contract can cover already committed

knowingly unlawful acts of the indemnitee, as long as the acts were not felonies. Cal. Civ. Code § 2774.

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Express Contractual Indemnity (cont’d) A party cannot obtain indemnity against an award of punitive

damages. PPG Indus. v. Transamerica Ins. Co., 20 Cal.4th 310, 317 (1999).

A party can obtain indemnity for matters arising out of its own negligence—but any such contractual provision must be “clear, explicit and comprehensible.” See, e.g., Frittelli, Inc. v. 350 North Canon Drive, LP, 202 Cal. App. 4th 35, 50 (2011).

Additionally, where a party contracts to obtain indemnity against its own “active” (as opposed to “passive”) negligence, even greater specificity is required. See, e.g., Building Maintenance Service Co. v. AIL Systems, Inc., 55 Cal. App. 4th 1014, 1021 (1997).

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Express Contractual Indemnity (cont’d) Special restrictions are applicable to “construction contracts,”

including: In connection with any construction contract, a party generally

cannot obtain indemnity for matters arising from its “sole negligence or willful misconduct.” See Cal. Civ. Code § 2782(a).

A general contractor typically cannot obtain indemnity from a subcontractor for matters arising from the general contractor’s “active negligence or willful misconduct.” See Cal. Civ. Code § 2782.05.

For public works construction contracts, the public agency generally cannot obtain indemnity for matters arising from the public agency’s “active negligence.” See Cal. Civ. Code § 2782(b).

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Express Contractual Indemnity (cont’d) Special restrictions applicable to “construction contracts”

(cont’d): For private works construction contracts, a property owner

generally cannot obtain indemnity to the extent the matter results from the owner’s “active negligence.” See Cal. Civ. Code § 2782(c).

For residential construction, specifically, a general contractor cannot obtain indemnity from its sub-contractors to the extent the general contractor was negligent. See Cal. Civ. Code § 2782(d).

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Express Contractual Indemnity (cont’d) Special limitations on a public agency’s ability to obtain

indemnity from “design professionals” (architects, engineers and land surveyors): generally such professionals can only be required to provide indemnity for matters arising from their own negligence. See Cal. Civ. Code § 2782.8.

Special limitations on indemnity provisions in “hauling, trucking or cartage contracts”: generally a party to such contracts cannot obtain indemnity for matters arising from its own “sole negligence or willful misconduct.” See Cal. Civ. Code § 2784.5.

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Contractual Elimination of Liability

Contractual Elimination of Liability By statute, a party cannot contractually eliminate liability

for its own fraud, willful injury to person or property, or negligent violation of statutory requirements. Cal. Civ. Code § 1668; Health Net of Calif., Inc. v. Dept. of Health Svcs., 113 Cal. App. 4th 224, 234 (2003).

Liability for gross negligence, likewise, cannot be eliminated by contract, due to public policy concerns. Santa Barbara v. Superior Court, 41 Cal. 4th 747, 776-77 (2007).

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Contractual Elimination of Liability (cont’d) A party can contractually eliminate its liability for ordinary

negligence, provided that no “public interest” is involved. Whether a “public interest” is implicated is governed by a six-factor test articulated in Tunkl v. Regents of Univ. of Calif., 60 Cal. 2d 92, 98-99 (1963): The contract concerns a type of business generally thought

suitable for public regulation. The party seeking exculpation is engaged in performing a

service of great importance to the public, which is often a matter of practical necessity.

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Contractual Elimination of Liability (cont’d) Tunkl factors (cont’d):

The party performing the service holds itself out as willing to perform the service for any member of the public (or at least a member who meets certain established standards).

Given the essential nature of the service and the economic realities of the transaction, the service-provider holds a “decisive advantage of bargaining strength” against any member of the public who seeks its services.

The service-provider uses a standardized contract of adhesion, and makes no provision allowing the purchaser to pay reasonable additional fees for added protection.

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Contractual Elimination of Liability (cont’d) Tunkl factors (cont’d):

As part of the transaction, the person or property of the purchaser is placed under the control of the service-provider.

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Contractual Elimination of Liability (cont’d) Examples of settings in which courts have found a

“public interest” under the Tunkl test: Medical services (Tunkl v. Regents of Univ. of Calif., 60 Cal. 2d

92 (1963)) Banking services (Vilner v. Crocker National Bank, 89 Cal. App.

3d 732 (1979)) Automotive repair (Gardner v. Downtown Porsche Audi, 180 Cal.

App. 3d 713 (1986)) Residential leasing (Henrioulle v. Martin Ventures, 20 Cal. 3d

512 (1978)) Escrow company recording of title documents (Akin v. Business

Title Corp., 264 Cal. App. 2d 153 (1968))

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Contractual Elimination of Liability (cont’d) “Public interest” found (cont’d):

Harbor security (Pelletier v. Alameda Yacht Harbor, 188 Cal. App. 3d 1551 (1986))

Child care services (Gavin W. v. YMCA of Metro. L.A., 106 Cal. App. 4th 662 (2003))

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Contractual Elimination of Liability (cont’d) Examples of settings in which courts have found no

“public interest” under Tunkl sufficient to invalidate negligence waivers: Leasing of storage unit, where lessor provided option to

purchase insurance which lessee declined (Cregg v. Ministor Ventures, 148 Cal. App. 3d 1107 (1983))

Horseback riding (Guido v. Koopman, 1 Cal. App. 4th 837 (1991))

Motorcycle and bicycle race participation (McAtee v. Newhall Land & Farming Co., 169 Cal. App. 3d 1031 (1985); Buchan v. United States Cycling Federation, 227 C.A.3d 134 (1991))

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Contractual Elimination of Liability (cont’d) No “public interest” (cont’d):

Skiing / ski rental (Platzer v. Mammoth Mountain Ski Area, 104 Cal. App. 4th 1253 (2002); Westlye v. Look Sports, 17 Cal. App. 4th 1715 (1993))

Public swimming pool (Randas v. YMCA of Metro L.A., 17 Cal. App. 4th 158 (1993))

Use of health club facilities (Sanchez v. Bally’s Total Fitness Corp., 68 Cal. App. 4th 62 (1998); Lund v. Bally’s Aerobic Plus, 78 Cal. App. 4th 733 (2000))

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Contractual Elimination of Liability (cont’d) In the commercial context, the UCC expressly allows the limitation

or exclusion of liability for consequential damages, unless it would unconscionable to do so. See Cal. Com. Code § 2719(3); RRX Indus. v. Lab-Con, Inc., 772 F.2d 543, 547 (9th Cir. 1985).

California law also permits contractual liquidated damages clauses in commercial and other business settings, unless the clause is “unreasonable.” Cal. Civ. Code § 1671(b); Cal. Com. Code § 2718(1). In consumer contracts (i.e., for personal, family or household

goods/services, or residential leases), however, liquidated damages provisions are void unless “it would be impracticable or extremely difficult to fix the actual damage.” Cal. Civ. Code § 1671(d).

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Practical Considerations in Drafting Indemnity and Liability Provisions

Practical Considerations in Drafting Indemnity and Liability Provisions

Who is providing indemnification, and who is

indemnified? “Sellers, jointly and severally, will indemnify and hold harmless

Buyer, the Acquired Companies, and their respective Representatives, stockholders, controlling persons, and affiliates (collectively, the “Indemnified Persons”)…”

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Practical Considerations (cont’d) What risks are foreseen and are being indemnified?

Third-party claims for personal injury, property damage, infringement, etc.

Losses caused by actions of counterparty Breaches of representations and warranties by counterparty Breaches of covenants or agreements by counterparty Pre-closing liabilities of target company (tax, warranty, products

liability, etc.) Specific risks identified during due diligence

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Practical Considerations (cont’d) Procedures for making an indemnification claim

What is a “claim?” (lawsuit, written demand, damages, losses) Notice to indemnifying party of indemnification claim Right of indemnifying party to assume defense of or to settle a

claim

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Practical Considerations (cont’d) Control of Defense

“In the case of a Claim involving the assertion of a claim by a third party (whether pursuant to a lawsuit or other legal action or otherwise, a “Third Party Claim”), the Indemnifying Party may, upon written notice to the Indemnified Party, take control of the defense and investigation of such Third-Party Claim if the Indemnifying Party acknowledges to the Indemnified Party in writing the obligation of the Indemnifying Party to indemnify the Indemnified Party with respect to all elements of such Third-Party Claim.”

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Practical Considerations (cont’d) Control of Defense - Limits

“The Indemnifying Party shall not consent to a settlement of or the entry of any judgment arising from any such Third-Party Claim without the prior written consent of the Indemnified Party (which consent shall not be unreasonably withheld or delayed).”

Control of Defense - Exceptions “The Indemnified Party shall be entitled to participate in (but not

control) the defense of any such Third-Party Claim, with its own counsel and at its own expense; provided, however, that the Indemnified Party shall be entitled to settle any Third Party Claim involving criminal penalties or civil fines without the consent, but at the expense, of the Indemnifying Party…”

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Practical Considerations (cont’d) Control of Defense - Frequency in practice*

Can indemnifying party control defense?

Required to acknowledge liability first?

*Unless otherwise indicated, all frequency data is from the ABA Private Target Deal Points Study 2014.

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Yes 85% No 15%

Yes 38% No 62%

Practical Considerations (cont’d) Control of Defense - Frequency in practice (cont’d)

Limits

Exceptions

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Yes 90% No 10%

Yes 78% No 22%

Practical Considerations (cont’d) Control of Defense - Frequency in practice (cont’d)

Common exceptions

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Non-monetary damages 63% Criminal allegations 41% Conflict of interest 40%

Practical Considerations (cont’d) Survival Time Periods

Time periods for general claims Breaches of “normal” representations, warranties, covenants,

and agreements generally survive for 12-24 months Extended time periods

Breaches of “Fundamental” or “Special” representations Breaches of certain covenants Fraud, intentional misrepresentation, willful misconduct,

gross negligence

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Practical Considerations (cont’d) Survival Time Periods

“If the Closing occurs, Sellers shall have liability under Section ___ with respect to any Breach of a representation or warranty (other than those in Sections ___, as to which a claim may be made at any time), only if on or before the date that is ___ years after the Closing Date, Buyer notifies [Target’s representative] of a claim, specifying the factual basis of the claim in reasonable detail to the extent known by Buyer.”

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Practical Considerations (cont’d) Survival Time Periods

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Survival Period Percentage

< 6 months or express no survival 6% 6-12 months 1% 12 months 23% 12-18 months 16% 18 months 36% 18-24 months 1% 24 months 10% > 24 months 5%

Practical Considerations (cont’d) Monetary limitations or caps on indemnification:

De minimis thresholds or deductibles Caps on total amount

Should bear a reasonable commercial relationship to the contract

Exceptions for fundamental representations, special indemnities, fraud, intentional misrepresentation

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Practical Considerations (cont’d) Monetary limitations or caps on indemnification:

Deductible: “Sellers shall not be required to indemnify the Buyer Indemnified Parties for Losses until the aggregate amount of all such Losses exceeds $300,000 (the “Deductible”) in which event Sellers shall be responsible only for Losses exceeding the Deductible.”

Threshold: “Sellers shall not be required to indemnify the Buyer Indemnified Parties for Losses until the aggregate amount of all such Losses exceeds $500,000 (the “Threshold”) in which event Sellers shall be responsible for the aggregate amount of all Losses, regardless of the Threshold.”

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Practical Considerations (cont’d) Deductibles and thresholds in deals

Deductible/threshold size as percentage of transaction value

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Deductible 65% Threshold 26% None/Other 9%

Deductible/ Threshold Size

% of Transaction Value

> 2% 1% 1-2% 9% 0.5 - 1% 38% 0.5% or less 52%

Practical Considerations (cont’d) Cap

“The maximum aggregate liability of Sellers to the Buyer Indemnified Parties under this Agreement (the “Liability Cap”), shall not exceed an amount equal to the Purchase Price…”

Caps in deals as percentage of transaction value

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Cap % of Transaction

Value Less than 10% 50% 10% 9% 10-15% 22% 15-25% 11% 25-50% 5% Purchase Price 3%

Practical Considerations (cont’d) Insurance coverage

Requirement that indemnified party seek insurance proceeds before making claim or reduction of claim for any insurance proceeds received

Insurance that covers indemnity claim (e.g., representation and warranty insurance)

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Practical Considerations (cont’d) Insurance coverage

“In determining the foregoing thresholds and in otherwise determining the amount of any Losses for which Buyer is entitled to assert a claim for indemnification hereunder, the amount of any such Losses shall be determined after deducting therefrom the amount of any insurance proceeds received by Buyer within five (5) years after Closing…”

Frequency in practice

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Practical Considerations (cont’d) Escrows or holdbacks:

Escrow: Parties place funds into escrow with a third-party escrow agent to cover indemnification claims.

Holdback: Buyer retains part of the purchase price for a specified time to cover indemnification claims.

Why? Counterparty risk concerns Administrative burden when many stakeholders are involved

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Practical Considerations (cont’d) Miscellaneous provisions

Exclusive Remedy “Sandbagging” Assignability Dispute resolution

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Practical Considerations (cont’d) Exclusive Remedy

“The remedies provided in this Article ___ shall be the exclusive remedies of the parties hereto and their heirs, successors, and assigns after the Closing with respect to this Agreement and the transactions contemplated by this Agreement…except in the case of actual fraud or intentional, willful or grossly negligent misconduct.”

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Practical Considerations (cont’d) Exclusive Remedy - Frequency in practice

Carveouts

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Yes 90% No 2% Silent 8%

Fraud 88% Equitable remedies 74% Intentional misrepresentation 33%