Business Litigation Reporter

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.

Goodwin Procter’s Business Litigation Reporter provides timely summaries of key cases and other developments within dedicated Business Litigation sessions and related courts throughout the country – courts within which Goodwin Procter’s Business Litigation attorneys are continually litigating. In addition, each issue of the Business Litigation Reporter provides a more thorough discussion of one topic of particular importance to the business community. In this issue, we discuss the key elements of indemnification clauses and highlight the drafting decisions that are likely to impact the outcome of any future proceedings. We hope that you find the Reporter useful and welcome your questions and comments.

California

Trade Secrets Can Consist of Ideas, Not Just Information. In Altavion, Inc. v. Konica Minolta Systems Laboratory Inc., 2014 WL 1846104 (Cal. Ct. App. May 8, 2014), the First District Court of Appeal held that generalized ideas, inventions and design concepts, rather than just information, can constitute protected trade secrets.  As such, the court held, “if a patentable idea is kept secret, the idea itself can constitute information protectable by trade secret law.”  Applying this ruling, the court upheld a $5 million verdict for misappropriating digital stamping technology.

Arbitration Clause Barring Classwide Arbitration Held Unenforceable Based on Choice of Law Provision. In Imburgia v. DIRECTV, Inc., 225 Cal. App. 4th 338 (Apr. 7, 2014), the Second District Court of Appeal affirmed an order denying arbitration of a putative class action against DIRECTV.  The court did so on the reasoning that (i) the customer agreement’s arbitration clause prohibited classwide arbitration, (ii) the agreement also contained a general choice of law clause adopting California law and (iii) the enforceability of the arbitration clause was therefore subject to California law, which prohibited the waiver of classwide arbitration.  The court acknowledged that its ruling was contrary to a recent Ninth Circuit decision but rejected that decision as unpersuasive.

Certification of Damages Class Denied in Misbranding Case. In Lanovaz v. Twinings North America, Inc., 2014 WL 1652338 (N.D. Cal. Apr. 24, 2014), which was brought by California purchasers of allegedly misbranded tea, Judge Whyte granted class certification to pursue injunctive relief but not damages.  Relying on the U.S. Supreme Court’s recent decision in Comcast Corp. v. Behrend, 133 S. Ct. 1426 (2013), he held that plaintiff’s expert failed to provide a damages model capable of quantifying the price premium resulting from the allegedly misleading label statements.  The plaintiff has sought permission to appeal the denial of class certification. 

Delaware

Reduced Judicial Scrutiny for Certain Freeze-Out Mergers. In Kahn v. M&F Worldwide Corp., 2014 WL 996270 (Del. Mar. 14, 2014), a 43% stockholder acquired the remaining common stock under a process that required both (i) negotiation and approval of the terms by a special committee of independent directors and (ii) approval by a majority of the other shareholders.  Following the transaction, certain other shareholders sued for breach of fiduciary duty.  The Delaware Supreme Court held that because of the procedural protections afforded by those dual conditions, the terms of the merger were subject to judicial review only under the “business judgment” rule rather than the more demanding “entire fairness” test (which requires that the terms be entirely fair to minority shareholders).

“Clickwrap” Employment Agreements Held Enforceable.  In Newell Rubbermaid Ind. v. Storm, C.A. No. 9398-VCN, 2014 WL 1266827 (Del. Ch. Mar. 27, 2014), the Delaware Court of Chancery upheld the enforceability of a clickwrap agreement that set an employee’s non-disclosure and non-solicitation terms of employment.  In connection with an agreement involving the grant of restricted stock unit (“RSU”) awards, the employee had to visit a third-party website and agree to the terms of the grant program by checking a box indicating that she had read and agreed to the terms of the grant agreement and clicking an “accept” button.  The court held that the clickwrap agreement, “although certainly not the model of transparency and openness with its employees, was not an improper form of contract formation,” because the employee manifested her assent by clicking the checkbox and “accept” buttons after she had a “fair opportunity” to review the agreement.  The court also rejected the employee’s argument that there was no consideration for the non-compete covenants (since she lost her RSUs when she quit) because, under Delaware law, continued employment may constitute consideration sufficient to form a contract. 

Massachusetts

“Loser Pays” Indemnification Provision Held Unenforceable in Securities Action.  Crown v. Kobrick Offshore Fund, Ltd., 85 Mass. App. Ct. 214 (Apr. 24, 2014), involved a hedge fund’s counterclaim against an investor.  The counterclaim was based on a provision in the subscription agreement stating that the investor would be liable for the hedge fund’s legal fees arising out of any action for securities law violations instituted by the investor and resolved in the hedge fund’s favor.  Acknowledging a lack of controlling precedent and a split in relevant federal court decisions, the Appeals Court held that enforcing such “loser pays” clauses would discourage investors from bringing cases under the Massachusetts Uniform Securities Act and thus violated Massachusetts public policy.

Close Corporation Shareholder Not Relieved of Fiduciary Duties by Wrongful Termination. In Selmark v. Ehrlich, 467 Mass. 525 (Mar. 14, 2014), the Supreme Judicial Court rejected the argument that a shareholder and former employee of a close corporation was relieved of his fiduciary duty as a shareholder when his employment allegedly was wrongfully terminated.  After being terminated from the corporation, the shareholder retained his shares in the close corporation but began working for a competitor and soliciting business from the close corporation’s customers.  In affirming judgment against the former employee, the court held that an aggrieved fiduciary in a close corporation may not “seek retribution” but should pursue any remedies through the judicial system.

New York

Standard for Pleading Unjust Enrichment Claim Clarified. In Philips International Investments, LLC v. Pektor, Index No. 651526/11 (N.Y. App. Div. 1st Dep’t Mar. 18, 2014), the Appellate Division, First Department rejected the defendant’s argument that the decision in Georgia Malone & Co., Inc. v. Rieder, 19 N.Y.3d 511 (N.Y. Ct. App. 2012), had so changed the law of unjust enrichment as to justify a renewed motion to dismiss the plaintiff’s unjust enrichment claim.  Instead, the court held, Georgia Malone had merely clarified that although the plaintiff need not allege privity, it must “assert a connection between the parties that [is] not too attenuated.”  The court also held that, in any event, that standard was satisfied by the joint venture relationship between the parties.

Commercial Division Eyes Potential Rules Designed to Streamline Litigation.

Under a newly proposed rule, parties will have only 90 days to seek assignment of their case to the Commercial Division.  Under the current rules, parties seek such assignment at the same time that they file an RJI (request for judicial intervention), which often does not happen for many months after the case is filed.  The goal is to get the justices of the Commercial Division involved in the management of appropriate cases earlier in the process. 

The Commercial Division is also considering a rule that would allow attorneys working on complex commercial cases to log documents being withheld from production on the basis of privilege to use a category-based approach, as opposed to the traditional document-by-document approach.   The rule would require that a “responsible attorney” (a designation meant to exclude junior associates and paralegals) certify the facts warranting privileged treatment.  Opposing counsel could object to the designations and request a document-by-document explanation, but the court would be empowered to allocate the associated costs to the requesting party.   The new rule would also count a continuous, uninterrupted email chain as a single document, which would further reduce the costs associated with a privilege review.