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.
Change Mismanagement
January 13, 2012 by Bierce & Kenerson, P.C.
“Change happens.” Sometimes it happens elegantly, with all parties agreeing. But change can be mismanaged, resulting in legal disputes on pricing, service level performance, duty to perform and impact on performance milestones Change mismanagement happens too.
Change as a Matter of Choreography. Contracts for business services resemble complex choreography for artistic dance, where each dancer minimizes effort and intertwines and exits from the scene according to a musical score. “Work flows,” “flow charts” and “algorithms” define the dance steps, the dancers and the music.
In business process management (BPM), “change management” choreographs the changes in the scope of work, pricing, scheduling, service levels and other essential commercial terms of the outsourced services. By contract, the parties can establish a predictable process for permitting such changes to ongoing contracts, without resulting in breach or termination.
Change Mismanagement. Sourcing and procurement procedures must define procedures for managing changes that will not break the contract. Experience shows that both the enterprise customer and the service provider are capable of mismanaging the change process. Such mismanagement results in litigation, waste (investment in the procurement process, startup costs and unwinding costs that may compensate the other party for unamortized profit).
Change Management Mistakes by the Enterprise Customer. Customers can make mistakes in planning that impact eventual operations:
- Inadequate financial analysis of the anticipated impact of the sourcing upon the operation, including neglect of costs of contract administration, price changes in the spot market over time.
- Inadequate “base case” that overestimates baseline demand, underestimates volatility in demand or fails to require internal procedures for governance of internal demand (such as charge-back pricing methodology for transparent allocation of costs of the services and contract administration).
Mistakes can occur in customer’s change management as well. For example, when the customer’s own clientele or consumers witness a severe decline in demand or transaction volume, the minimum monthly fees paid to the outsourcer might weigh heavily on costs. Of course, scalability in such volumes should have been anticipated, and the customer might have decided that the “price” of such minimum monthly fees was a safe bet in avoiding other capital investment that would otherwise have been necessary for continuing to offer the “services” in-house.
Severe volatility in such demand or transaction volumes can be very costly to the enterprise customer in a major outsourcing. For example, a supplier of mobile military equipment hired an IT service provider to ensure a high level of service that anticipated the government customer would be well-served. Then the military procurement strategists decided that the particular mobile equipment was not suitable for the next phase in the war. They wanted more mobility, less protection. So they canceled further purchases and continued only in “repair” mode for the existing fleet of such equipment. When the equipment supplier approached the IT service provider to reduce or redeploy the resources implied in the minimum monthly fees, the IT service provider refused, saying that such a change was too drastic and that the contractual termination fee was therefore due and payable upon presentation of an invoice. When the customer refused, the IT service provider sued. The matter was quickly settled with a substantial payment to the IT services provider and the customer’s loss of its upfront investment in the procurement process (lawyers, accountants, operations personnel and startup transition costs).
Change Management Mistakes by Service Providers. The biggest sin for a service provider is to invest additional time, effort and expense in providing services that are not paid for. Such change mismanagement can easily occur:
- Failure to notify the customer in advance of the need to change pricing due to customer requests for different services, different methods for service delivery or reduced or increased volumes of services.
- Failure to maintain records of changes in the services.
- Failure to obtain customer approval to changes in prices or pricing methodology.
- Failure to obtain customer approval for certain types of changes that have an impact on the smooth internal workflow of the customer’s in-house operations or the customer’s other service providers, and thus hamper the productivity of the enterprise customer.
For example, in 2005, Phoenix Signal and Electric entered into a contract with the New York State Thruway Authority to install cameras and signs along a toll highway. The contractor performed “extra work,” or “extras,” and claimed additional compensation. It claimed the extra work was justified because of the mutually unforeseen difficulty of performance, requiring an additional stage of work to provide sufficient cement foundations for the cameras and signs. Upon judicial review of the contractor’s claim for payment, the Court of Claims and the appellate court found that the additional stage was not an “extra” but was part of the base charges. Further, the courts rejected the contractor’s demands for payment of additional monies because the contractor had failed to meet two conditions precedent to payment: notice to the customer and adequate recordkeeping to enable the customer to audit the need and scope for the additional work. Phoenix Signal and Elect. Corp. v. N.Y.S. Thruway Auth., ___ N.Y.S. 3d ____, Dkt 512433 (Dec. 22, 2011, 3rd Dept App. Div.), NYLJ Jan. 3, 2012, dec.nylj.com/1202536924950. In short, depending on how the contract is written, the customer may refuse payment when the service provider mismanages the “change management” process.
Best Practices. All services agreements should define the parameters, processes and conditions for permitting changes. When the parties fail to plan, they plan to fail, and disputes will arise. A well-drafted Change Management procedure, implemented by regular reviews of performance against the contract terms, can avoid such mistakes.
Failed Deals in Outsourcing of State Welfare Benefits Administration: Anatomy of Unsuccessful Business Process Transformation
October 29, 2009 by Bierce & Kenerson, P.C.
In October 2009, the State of Indiana terminated a ten-year $1.34 billion outsourcing agreement with IBM for the administration of the welfare benefits. This followed a 2007 termination by the State of Texas of a similar privatization of State health and welfare benefits administration, including eligibility determinations, food stamps, Medicaid and the Temporary Assistance to Needy Families program.
These failed outsourcing deals offer lessons for public and private enterprises that want to hire outside contractors to automate procedures that are inherently difficult to automate due to the need for ongoing face-to-face customer relationship management for clients or customers who are not able to easily manage self-service and automation of complex programs. In essence, these deals were sold as process improvements with cost savings, but the face-to-face personal touch was lost.
Indiana History. The State of Indiana hired IBM as lead contractor in 2007 to administer welfare benefits programs. Administration of state welfare benefits such as social services and food stamps requires significant ongoing direct contact with welfare clients. When the “business process transformation” of providing IT-enabled welfare benefits confronted welfare recipients who needed personal attention, the State terminated the contract, claiming that IBM failed to maintain documents, delayed approvals of benefits to qualifying individuals and gave “poor service.”
Lessons for Government Outsourcing. Governmental officials seeking to cut costs and improve the quality of service can learn several lessons from these failed deals. Due to the direct customer interfacing, remote computing and automation do not always improve certain customer relationships.
- Decide whether the function is one that can be improved (such as converting face-to-face interactions with call-center interactions) before being outsourced. In each case, Texas and Indiana were seeking reduced costs through “big bang” transformations of the governmental functions. Officials bought into the notion that software, process automation and self-service for data entry and updates could improve operations. But technology cannot really help where frequent face-to-face meetings are necessary to ensure that individuals qualify for their benefits, that they are evaluated and treated individually, and to see that the individuals comprehend the welfare benefits system. Cost savings can be obtained by using software and process automation, but not for the poor, the undereducated, or those with mental health problems such as bipolar disorder, Alzheimer’s, depression or dysfunctional family circumstances. Rather than outsource the function, perhaps the function of face-to-face “customer” contacts could be improved by using software and IT system management. Providing these tools for face-to-face interaction in such cases offers a less hostile environment to those “clients” with special needs. Full business process transformation and maximum automation will not work in such case. In this case, the customer-relationship function was probably not one that could be automated and outsourced for a fixed price to a for-profit company. Interruptions in Medicaid and Temporary Assistance to Needy Families can impact living conditions.
- Contract Administration and Relationship Governance. Best practices in outsourcing call for the enterprise customer (here, the State’s agency) to exercise supervision and control of the contract terms to verify compliance with milestones, service level agreements, pricing agreements and internal procedures. Relationship governance sets forth a framework for joint decisionmaking and actions to resolve unforeseen implementation problems. Contract administration and relationship governance are essential to avoiding cost overruns, failed service levels and poor administration.