Seven Best Practices for Indemnification Clauses (for Outsourcing, M&A, Employment Agreements, Intellectual Property and Any Deal)
January 30, 2013 by Bierce & Kenerson, P.C.
In an indemnification clause, a party contractually promises to cover the losses incurred by another party under contractually described scenarios. An indemnification thus acts like a private insurance policy. The indemnitor pays upon the occurrence of a covered loss. Indemnification clauses are used to allocate specific contingent risks, for liabilities to third parties that might not yet have been identified, asserted or quantified, and which might never occur. Indemnifications are used to address contingencies in a broad range of business dealings, such as mergers and acquisitions, employment agreements, the liability of corporate directors and officers, sale or licensing of software, real estate transfers, strategic alliances and outsourcing agreements.
A recent M&A decision by the Delaware Chancery Court reminds us all of the importance of carefully defining such scenarios. In Winshall v. Viacom Int’l Inc., (Del. Chancery Dec. 12, 2012), the court ruled that the terms of an indemnification clause in an acquisition contract did not cover losses arising after the closing of sale.
THE INDEMNIFICATION TERMS IN THE MERGER TRANSACTION
The Winshall case arose out of the purchase by Viacom of Harmonix Music Systems, a developer of music-based video games, from Walter Winshall and other sellers. The price was $175 million, but the parties agreed to put $12 million of the purchase price into escrow for 18 months after the closing to cover indemnified losses for claims by third parties arising from breaches of representations and warranties by Harmonix and its former stockholders. There were three types of warranties that Viacom asserted to seek the $12 million in escrow:
• IP Infringement. The software for the video games did not infringe the intellectual property rights of any third party, and that Harmonix had, at closing, “adequate rights … as is necessary for the current use” of the Rock Band video game software that it had developed.
• Operations. The business operations of Harmonix did not infringe on the intellectual property rights (IPR) of any third party. Harmonix represented that “neither the operation of the Business, nor any activity of the Company, nor any manufacture, use, importation, offer for sale and/or sale of any Current Game” constituted a violation of any third party IPR, except for patents and foreign trademarks. The “Business” was defined as the “business as currently conducted” and did not include any future software development or any modifications to the software by Viacom as acquirer.
• Knowledge of Infringement. The seller’s top four executives had no actual knowledge of any infringement claim.
THE COURT’S DECISION ON INDEMNIFICATION IN M&A
The Delaware court granted the sellers’ motion for dismissal of the claims, even before trial. Taking into account the facts in a light most favorable to Viacom, the court found that, as a matter of contract law, the merger agreement could not be interpreted to cover any losses or liabilities of Viacom as acquirer that were attributable to events occurring after the date of closing.
Software Infringement. The court rejected the acquirer’s claim that the software infringement claimed by a third party was an indemnified loss. The software had been in the process of development when sold, but Viacom completed the development. “What Viacom was doing with Rock Band over a year after the merger closed cannot be considered ‘current use.’” The third-party had sought damages from Viacom for the finished product, not the unfinished software. The court noted that indemnification was intended to cover cases where the indemnifying party had control over the risk of infringement, not where the allegedly infringing product was completed by the acquirer-indemnitee.
Knowledge of Infringement. The court accepted the affidavits of the former executives of Harmonix that they did not know of any alleged claims of infringement. The court held that even if such executives knew of the existence of a third party’s patent, that alone did not rise to the level of knowing that such third party was asserting a claim of infringement.
BEST PRACTICES FOR INDEMNIFICATION
1. Scope and Scenarios. The parties should define carefully the scope, time reference points and contingencies in any indemnification clause. The seller should be careful to exclude liability for events beyond the seller’s control, such as events occurring after the sale. The buyer should identify the critical factors that it relies upon for freedom from future third party claims attributable to the seller’s actions or omissions.
2. Insurance. Liability insurance can be used to reduce or eliminate the personal liability of the indemnitor. However, insurance for intellectual property infringement can be expensive, carrying a premium that assumes there will be substantial risk of loss.
3. Pricing. In any business transaction, indemnification can be useful to weed out problems that show up in differences of opinion as to pricing. An earn-out contingency can be supported by an indemnification. A director’s fees can be protected by “full indemnification” from lawsuits.
4. Timing. The time frame for indemnified events needs to be agreed and clearly expressed. This is important since, in an M&A deal, the purchaser assumes control of operations, and the seller loses the tools to limit the occurrence of the scenario.
5. Knowledge. Representations that are limited to the knowledge of an individual are very tricky. In a representation of “lack of knowledge” of a claim of infringement, does “knowledge” refer to receipt of a demand letter from the third-party claimant, or does it extend to “knowledge” that a third party has a patent claim that might be infringed by the seller’s product, software or service? Does knowledge include suspicion of a possible infringement, receipt of a legal opinion suggesting there might be a claim? These issues highlight the weaknesses of knowledge-based representations.
6. Due Diligence. Indemnification clauses should not be a substitute for due diligence. Where the buyer has actual knowledge of an indemnified event, the seller should not be held responsible to pay the loss, since that could have been negotiated and repriced before closing.
7. Compliance. A sale of an asset crystallizes attention on the seller’s compliance program. Typically, a buyer will want assurance that the seller has complied, before the sale, with applicable laws on such matters as registration of ownership, permitted uses of property being transferred or used, dealings with parties not legally permitted to do business (e.g., export controls), etc. In licensing, each party will want a continuing compliance commitment by the other. Without good compliance procedures for ordinary operations, the “indemnification” clauses will trap the company and its shareholders, reducing the value of their investment.
For more information, visit our pages on Risk Management and Contract Provisions.