Private Equity Law Review : New York Private Equity Lawyer & Attorney : Geoffrey Parnass : Corporate & Business Law

In my last post, I said that indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

I'd like to explore this here.

The "promise" of indemnification is contained in an agreement that is primarily concerned with something else. For example, in a contract to develop a website, the party that performs the development service will be asked to provide certain assurances and indemnifications to the customer.  The promise of indemnification is in addition to the assurances about the services that are contained in the contract.  For example, the website developer will promise to make good any losses suffered by the customer in case a third party claims that the website infringes a copyright, or in case the website does not meet specifications.

In some respects, a promise of indemnification is redundant.  If the website developer represents in the contract that her work will not infringe a copyright, and it does, then the customer has a right to sue for breach of contract.  A separate promise to indemnify the customer against a claim of infringement is not really necessary, at least as to a claim brought by one contract party against another.  For this reason, some indemnification claims cover only claims by “third parties,” that is, people who are not parties to the contract. In general, it is accepted practice to ask and receive broad indemnification language, even though redundant.   

The "person" who makes the promise to indemnify is someone who has, in consideration of some payment or benefit, undertaken some kind of action, such as building a website.  The action, however, is one that has some risk or uncertainty associated with it.  For example, the finished website may infringe the copyright of someone else or may not meet specifications. The possibility of infringement may not be immediately apparent from an inspection of the website at the time it is delivered.  The possibility may only becomes apparent over time, hence the risk.

The promise to make good backs up some kind of assurance that the person made. The assurance is usually about something specific, such as “this website does not infringe any copyright” or “this website will meet specifications.” The “make good” includes the promise to “indemnify, defend and hold harmless”.  It is a promise to put the injured person back in her original condition, before the covered injury took place. In our example, that might include fixing the website to eliminate the infringing material, meeting the required specifications, refunding the payment if infringement cannot be cured or “defending” any legal costs, for example if the copyright holder sues for infringement.

The promise to make good covers only certain losses, namely, those losses arising out of a breach of the assurance. If an assurance is given that the website will not infringe a copyright, then the losses covered are only those that arise out of the infringement. Thus, before there can be a claim for indemnification, there has to be a loss; and for there to be a loss, there has to be a breach of some specific assurance. Often, where the loss is based on a third party claim, the loss has been established before the claim for indemnification is made. Where the loss is based on the character of the service itself, such as the specifications, then the loss will have to be established at the same time as the claim for indemnification.

The losses covered by indemnification include the costs and expenses of defending or pursuing a claim in court.  the biggest cost here is attorney fees.  In the American legal system, each party has to pay its own legal expenses.  Including attorneys fees in "losses" shifts this burden to the party who is providing the indemnification. 

Indemnification only covers losses "suffered by" the person to whom the assurances were made.  The suffering person is often expanded to include, in the case of a corporation, its officers, directors, shareholders and affiliates.  The losses cannot be speculative and must actually be incurred or suffered.

Related Posts:  What is Indemnification? -- Part 1

                         Indemnification Provisions of a Purchase Agreement

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When the topic of "indemnification" is reached during contract negotiations, the principals often grow silent and wait for their lawyers to speak.  The topic seems taboo, mysterious, off grounds to any but the intrepid legal specialist. 

But this is wrong, for indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  It is akin to a policy of insurance.  It is given where one person wants to back up or support an assurance made to another person. The word itself -- indemnification -- has the ring of insurance.  In fact, real insurance companies, like The National Indemnity Company, use a form of the word in their names.  I will discuss here the section of a business contract (usually near the end) in which one party, or both, agree to provide indemnification.

To illustrate this discussion, assume that a website developer has been hired to create a new website. The customer wants and receives written assurances that the website will not infringe any copyright, and that the website will function according to specifications.  The contract contains these assurances, along with the following simple, mutual indemnification clause:

“Each party shall indemnify, defend and hold harmless the other party (including such other party’s affiliates, partners, officers, directors, employees, agents, and representatives) against any claims and/or liabilities of any nature, including reasonable attorneys’ fees, arising out of or relating to any breach of the warranties made by such party in this Agreement.”

As I mentioned above, indemnification is simply a promise by one person to make good certain losses that may be suffered by another person.  To those like me who love bullet points, indemnification is:

• a promise
• by one person
• to make good
• certain losses
• suffered by another person

In my next post, I will discuss each of these elements in detail.

Related Posts:  What is Indemnification? -- Part 2

                          Indemnification Provisions of Purchase Agreements

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All companies look to forge strong relationships with their distributors. These affiliations are particularly important in industries where distributors add value through education, showrooms, installation or other service elements.

The first question in any distributor affiliation is how much control the supplier should exercise over the relationship. This question often turns on whether the manufacturer produces a commodity product or a proprietary one and the relative size of the parties. Distributors usually will not accept efforts to control the distribution of a product that can be obtained from a number of sources. However, a manufacturer that produces a proprietary product that is in demand has the ability, if it wishes, to exercise important controls over its distribution network.

Some manufacturers build a distribution control system into their marketing plan by setting up franchise systems or exclusive distributorships from the start. Whatever the name, these systems share a common goal from the point of view of the manufacturer: to shape the way its products are distributed in the marketplace.

The past 20 years have seen a marked increase in the control exercised by manufacturers over their products. Antitrust law and policy have adopted the view that consumers benefit when a manufacturer exercises control over its network of distributors in certain ways. Of course, it remains illegal to control pricing policies. That said, there are a wide variety of measures that manufacturers can adopt to shape the way their products get to market.

Perhaps the simplest measure is to grant a customer the exclusive right to sell products in a territory. This is often necessary to entice a well-capitalized distributor to take on a new product line. Other permitted controls include customer restrictions, advertising and trademark policies, stocking requirements for inventory or samples, and full line or exclusive requirements.

Distribution Agreements

Distribution agreements are a popular way to cement the relationship between a manufacturer and its distributors. Contracts are often drafted by the manufacturer and presented to the distributor as a finished deal. However, it is generally possible to negotiate these agreements, especially where the manufacturer is launching a new product or is trying to capture a new market.

Checklist of Material Terms in Distribution Agreements

The following is a checklist of the material items that should be addressed in a distribution agreement:

• What trademarks or trade names may the products be sold under? May the distributor use the trademark as part of its business name? What sort of approvals must be obtained in connection with the use of the trademark?

• Territory: exclusive, a designated primary area of responsibility or wide open? What happens if sales are made outside the prescribed territory? 

• May the manufacturer make direct sales in the territory?

• Are any accounts reserved to the manufacturer, such as national accounts?

• Must the business be conducted from a specific location? Can new locations be added in the future?

• What happens if other distributors sell within the protected territory?

• Can the distributor handle the products of competitors?

• Is the distributor required to carry the full line of products?

• What is the term of the agreement? How is the term renewed?

• Are there minimum purchase requirements?

• Must the distributor maintain a minimum quantity of inventory?

• May the distributor sell to other distributors or only to end-users?

• How are prices determined?

• What protections, if any, are there for price increases?

• Is the distributor required to participate in promotional allowances or other rebate programs instituted by the manufacturer?

• Must the distributor disclose its financial information to the manufacturer? Are there any minimum financial criteria to maintain the distribution?

• Under what circumstances may the distributor be terminated? May either party terminate the agreement without cause? What happens to unsold inventory following termination?

• What training or ongoing technical support is the manufacturer required to provide?

• Is the distributor authorized or required to provide warranty service? What parts will be stocked? How is payment for warranty service to be structured?

• Under what circumstances can the distributor return merchandise to the manufacturer?

• What are the terms of delivery? What are the distributor’s rights to inspect and test?

• Does the manufacturer promise continuous availability of products, spare parts and/or service?

• Will the manufacturer hold the distributor harmless from and actions for patent, trademark or copyright infringement?

• What insurance are the parties required to maintain?

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Although office and manufacturing leases are generally recorded on the books as a liability, they are in fact critical business assets. Substantial investments are made in preparing an office or manufacturing center for occupancy. Also, a company generates good will associated with its location.

When leasing office or manufacturing space, an initial matter to consider is the difference between rentable and usable square footage. Prices are usually quoted on an annual square foot basis, so it is important to know whether the quote is based on actual useable space. Tenants should verify the square footage number provided by the landlord before signing the lease.

It’s also important to make sure that the uses planned for the space are permitted under the lease. The permitted uses should be broad enough to allow possible changes in the business, or to allow for a possible assignment or subletting of the space to a third party. The best use description is “any lawful use.” If the owner’s consent must be obtained to a change in use, it should be given readily unless there is a reasonable objection.

The commencement date of the lease is often different than the signing date to allow for necessary improvements in the space. What happens if the space is not ready on the commencement date? At a minimum, rent should be abated, and if the problem continues for a period of time, the lease should be cancelable at the option of the tenant. The termination date must also be spelled out clearly.

The base rent for the primary term is usually clear enough. What about escalations during the term of the lease, such as annual increases? Are there other escalations, such as cost of living increases? Leases often add a supplemental charge for the expenses of maintaining common areas, heating and air conditioning and operating costs. Care must be taken to make sure that any expenses are directly related to the occupancy of the space (excluding the owner’s overhead expenses). The owner should be required to account for the expenses and justify any requested increases. There should also be provisions for audits of expenses. It is prudent to negotiate clear provisions on any escalations or increases and even to cap any such increases.

The owner generally demands a security deposit for the lease. Sometimes a letter of credit can be substituted for a cash deposit. If cash is required, the interest should accrue to the tenant.

Tenant is generally responsible for the cost of the utilities that it uses when occupying the space. There should be separate utility meters so that the tenant doesn’t end up paying for other occupants or common area utility charges.

It is usually necessary to make certain improvements to the space before the tenant can move in. What will be the cost of these improvements and who will pay them? The owner will sometimes provide a work letter for improvements as an inducement to secure a long-term lease. If so, the owner sometimes wants to specify the company that will provide the contractor services. If that’s the case, it is important to prepare a detailed construction letter setting out all the requirements of the renovation, as with any contractor. Whoever is the contractor should be responsible for obtaining any necessary permits and approvals. At the end of the lease term, the owner will generally own the improvements, but if there are any special fixtures that the tenant wishes to take away, these should be specified in the lease.

If something goes wrong with a structural element of the space or one of the mechanical systems, whose responsibility is it to fix the problem and who pays? It is important to detail these responsibilities, and to factor them into the cost of the lease if the tenant is forced to assume responsibility for them. Leases generally contain a requirement that the space be returned at the end of the lease in the same condition as at the beginning, subject to ordinary wear and tear. Is this consistent with the use that tenant intends to make of the space? The tenant should consider the costs of returning the facility to its original condition if major modifications were made during the course of the lease.

The tenant should have the right to sublet or assign the lease, as long as the new tenant is reasonably acceptable to the owner. The lease will generally spell out the standards of what is an acceptable subtenant or assignee. The tenant should be allowed to assign to an affiliate without the consent of the owner, as long as it remains primarily liable under the lease. The assignment clause should be read carefully to determine if there is a deemed assignment in the event of a change in control of the tenant. If the assignment or sublet is at a higher rental, the owner will often try to keep all or most of the increase.

The owner should warrant certain basic conditions, such as quiet enjoyment, ownership and class of building, if appropriate. If the building is destroyed or rendered unfit for occupation, the tenant should of course have the right to cancel the lease.

Tenants should generally negotiate for options to renew the lease at the end of the basic term. The tenant may also want to secure rights of first refusal on contiguous space in case the space becomes available and the company is outgrowing its initial quarters. Attention should be paid to the rules and regulations of the building as well as things like weekend and evening access, security and exterior lighting, signage and parking spaces.

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No one cares about the law of sales and collections until something goes wrong.   When disputes arise, the parties dust off the “boilerplate” provisions printed on the back of their purchase orders and invoices. Often these provisions are in conflict with one another or do not cover the issue that actually exists. In these circumstances, where the contract involves the sale of goods, the parties must look to the provisions of the Uniform Commercial Code for answers. This Code, adopted in every State, provides a uniform body of rules for sales of goods. For sales of services, the common law of contracts applies. 

The success of the Uniform Commercial Code in regulating the sale of goods has crossed over into general contract law, and many provisions of the Code have influenced the development of general contract law.

Article 2 of the Uniform Commercial Code: Contract Terms and Conditions

Article 2 of the Uniform Commercial Code covers how and when contracts for the sale of goods are formed; warranty obligations; how contracts must be performed; what happens when a party breaches a contract; and what remedies are available when a breach occurs.

Forming Contracts

Any sale of goods for a price of $500 or more must be reflected in written form. The writing must be sufficient to indicate that a contract for sale has been made by the parties and must be signed by the party against whom enforcement is sought. However, this requirement is waived in sales between merchants if one party sends a written confirmation of the contract and the other party fails to object within 10 days of receipt.

Apart from this requirement of a “writing,” the rules of contract formation are very liberal. A contract may be made in any manner sufficient to show agreement, including conduct by both parties that recognizes the existence of such a contract.

A written offer by a merchant to buy or sell goods which gives assurance that it will be held open cannot be revoked during the time stated in the offer. If no time is stated, then the offer must remain open for a reasonable period of time, but not in excess of three months.

If the customer’s purchase order contains one set of terms and conditions, and the acceptance or invoice contains another set, the additional terms of the invoice become part of the contract unless the offer limits acceptance to the terms of the offer or they materially alter it. In addition, conduct by the parties that recognizes the existence of a contract will be sufficient to establish a contract, even though the writings do not establish one. Accordingly, written exchanges and conduct must be tightly controlled to avoid inadvertent contracts.

A party may delegate performance of a contract to someone else, unless the other party has a substantial interest in having the original party perform the contract. Either party may assign its rights under a contract except where the assignment would materially impact the other party’s duties, burdens or risks.

Warranties

Unless the parties otherwise provide, the following warranties are assumed to be made by the seller as to the goods:

1. Seller has title to the goods and the right to transfer them.

2. The goods are delivered free from any security interest or other lien (other than those the buyer actually knows of).

3. The goods are “merchantable” (generally, the goods are fit for the ordinary purposes for which they are used).

4. When seller has reason to know any particular purpose for which goods are required and buyer is relying on seller’s skill or judgment to select goods, there is an implied warranty that the goods are fit for such purpose.

5. A statement of fact relating to goods creates an express warranty that the goods conform to the statement.

6. A description of the goods creates an express warranty that the goods conform to the description.

7. A sample creates an express warranty that the whole of the goods conform to the sample.

Special care must be taken to exclude or modify these warranties if they cannot be supported. Generally, the contract should contain express language that excludes warranties, or states that goods are sold “as is” or “with all faults.”         

Performance

The UCC spells out how contracts are to be performed in cases where the parties have omitted the details. For example, if a buyer has paid all or part of the price of goods and the seller becomes insolvent, the buyer may recover the goods from the seller if the seller’s insolvency occurred within 10 days after receipt of the first installment of the price. Also, the buyer has the right to inspect goods at a reasonable place and time and in any reasonable manner before payment is due.

Breach of Contract

When there are defects in the goods, or a defect in their method of delivery, the buyer has the option to reject or accept all the goods or accept any portion that is acceptable and reject the rest. A notice of rejection must be delivered “seasonably,” the buyer cannot delay unreasonably.   In addition, if the buyer rejects the goods while they are in his possession, he must follow the reasonable instructions of the seller with respect to the rejected goods. If no instructions are received, the buyer may store the goods for seller’s account, reship to seller or resell for seller’s account.

On the other hand, once the buyer has accepted the goods, he must pay at the contract price for any goods accepted. Acceptance occurs when the buyer after a reasonable opportunity to inspect the goods signifies to the seller that the goods are conforming, or fails or make an effective rejection (after having an opportunity to inspect). Although accepted goods may not be reshipped to the seller, buyer retains any claim based on non-conformity of the goods to warranties.

When reasonable grounds exist that make one party feel that performance by the other may be impaired, that party may demand assurances of due performance from the other party. Until he receives such assurances, he may suspend his performance. If the cost of performing the contract suddenly increases dramatically due to an event that undermines a basic assumption of the contract, the seller may delay its delivery or even fail to deliver the goods.

Remedies

When a seller discovers that buyer is insolvent, he may refuse to deliver goods except for cash, including payment for all goods previously delivered. When a buyer receives goods on credit while insolvent, the seller may reclaim the goods on demand made within ten days after the receipt.

When a buyer breaches the contract, typically by not accepting goods or failing to pay for goods already received, the seller may recover damages for non-acceptance or cancel. Damages in the case of non-acceptance of goods is the difference between the market price at the time and place of delivery and the unpaid contract price, less expenses saved as a consequence of buyer’s breach. However, if this measure of damages is inadequate to put seller in as good a position as performance would have done, then the measure of damages is the profit (including reasonable overhead) which seller would have made from full performance. Damages, in the case of non-payment, are the price of goods accepted, plus incidental damages. Alternately, when the buyer has failed to accept goods seller may resell the goods in a commercially reasonable manner and recover the difference between the resale price and the contract price, plus incidental damages. The seller does not have to account to buyer for any profit made on the resale.

When a seller breaches the contract by failing to make delivery or when the buyer rightfully rejects goods, then buyer may cancel and recover so much of the price as has been paid. In addition, the buyer may purchase goods in substitution of those due from seller and recover from seller the difference between the cost of the substituted goods and the contract price, together with incidental and consequential damages, but less expenses saved. Alternately, the buyer may recover damages for non-delivery equal to the difference between the market price at the time the buyer learned of the breach and the contract price, less expenses saved.

The measure of damages for breach of warranty is the difference between the value of the goods accepted and the value they would have had if they had been as warranted. The parties may specify liquidated damages in the agreement, but the measure must be reasonable in light of the harm caused by the breach. Unreasonably large liquidated damages are void as a penalty. Any action for breach of any contract for sale of goods must be commenced within four years after the breach occurs. The parties may shorten the period to one year (but not less).

Article 9 of the Uniform Commercial Code: Security Devices

Article 9 of the Uniform Commercial Code contains a powerful tool to aid in the collection of accounts, although many companies do not take advantage of it. It gives sellers of goods the right to retain a security interest in the goods (or other assets of the buyer) until payment. Without a security interest, the seller must take a back seat to creditors (typically banks) that do take advantage of this law.

Security Interests

A seller of goods can retain a security interest in the goods if the following procedures are adopted:

1. The buyer signs an agreement granting a security interest in the goods.

2. A financing statement is filed in the office of the Secretary of State of the state in which the buyer is located or incorporated.

The advantage of a security interest is that the secured party has a priority to the goods in the event the buyer becomes insolvent. Proceeds from any sale of the secured goods must be paid first to the seller in satisfaction of its account. A security interest in goods disappears once the goods are resold to another buyer in the ordinary course of business.

If buyer defaults in payment, a seller with a security interest in goods may take possession of the goods either by judicial process or without judicial process if it proceeds without breach of the peace. A secured party may also require the debtor to assemble the collateral and make it available to the secured party. The secured party may dispose of the collateral by public or private sale in a commercially reasonable manner. Any proceeds of such a sale must be applied first to the expenses of sale and then to the satisfaction of the debtor’s obligations. The secured party may also accept the collateral in full or partial satisfaction of the obligation under certain circumstances.

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