by Kenneth P. Weinberg & Jennifer L. Howard Jul/Aug 2014
Kenneth P. Weinberg and Jennifer L. Howard collaborate to describe lease and loan indemnity issues by providing a detailed outline to help better identify indemnity clause concerns. They note that a careful review of the indemnity provision in an equipment lessors’ standard documentation can yield big results if an indemnity claim arises later.
Indemnity provisions offer a powerful way to contractually allocate risks related to equipment leasing and financing transactions. Such provisions are particularly near-and-dear to lessors of equipment, as the role of “owner of the equipment” has both positive and negative aspects. In the same way, being the owner of equipment benefits the lessor when it claims depreciation, immunity from the cram-down provisions of a bankrupt lessee or other benefits of ownership, the role of the lessor as owner of the equipment can be detrimental when the local taxing authority claims personal property taxes were not paid when due, when the toll road operator claims the leased equipment has been using toll roads without paying, or when persons or property are injured by the leased equipment. Even if the transaction is not a true lease, the financing company’s familiarity with the equipment, and its close ties to the equipment and sometimes the vendor, can still result in increased risk for the lessor or lender.
A properly drafted indemnification provision operates to shift these risks from the lessor to the lessee. It should be noted, however, that indemnification can be a complex and less-than-certain area, and such provisions should therefore not be viewed as an elixir vitae. This edition of Dispatches from the Trenches provides an outline intended to help identify indemnity issues in leases and loans. Note that tax indemnification related to lost depreciation benefits and similar issues is a specialized area beyond the scope of this article. The remainder of this article therefore addresses indemnity generally but does not focus on special tax-related provisions.
For ease of reference, the remaining text refers to lessors, lessees and leases, although many of the concepts are equally applicable to a lender/borrower relationship.
In the world of equipment leasing and finance, prudent lessors cast a very broad net when describing the types of claims for which its lessees must provide indemnification. Indeed it is generally industry standard to start with a broad indemnity clause and focus negotiations on any exceptions. As lessor counsel, this author further believes that these exceptions should be few and far between. At the end of the day, the lessor is only a money source, and a broad scope of indemnity, consistent with the idea of a triple net lease, is a fundamental basis of its bargain.
When considering the types of claims covered, it is sometime helpful to focus first on the type of legal proceeding that may be brought. For example, are losses from an allegation or threatened suit covered by the indemnity clause or only those related to an actual suit? Is a claim brought through arbitration or mediation covered? What about criminal claims versus civil claims? The remainder of this article will refer to the types of legal claims, allegations, demands, suits or other legal proceedings as the type of “claims.”
Once the type of claims is properly addressed, it is necessary to describe the subject matter of the claims covered by the indemnity. Starting broadly, a lessor would want to cover all claims related to the equipment, the lease or the transactions contemplated by the lease. Many prefer to provide additional examples of the subject matter of certain claims, such as those relating to manufacturing, possession, maintenance or use of the equipment and those relating to patent, trademark or copyright infringement. Care should be taken, however, to make sure that any examples do not limit the scope of the covered events, e.g., all claims incident to, arising out of, or in any way connected with the lease, the equipment or the transactions contemplated by the equipment.
Once the types and subject matters of claims have been properly defined, it is important to describe the types of financial losses and damages covered. For example, parties almost always intend for an indemnity provision to cover attorneys’ fees, but it is important to specifically list them. Other costs of litigation, such as filing fees and court costs, should also be listed. What about non-legal fees, such as those of an appraiser or a consultant with environmental expertise? If the indemnitee settles a claim, is it still covered by the indemnity clause? Again, it is crucial to pay attention to every word in the provision while you envision the parade of horribles that could theoretically result. The language in form documents tends to be best when transactional lawyers seek input from their brethren experienced with litigation.
Special Scope Issue: Lessor’s Negligence
Generally speaking, an indemnity provision does not require the lessee to indemnify the lessor for the lessor’s own negligence unless the form expressly so provides. Even then, the matter is left to the courts as to whether one party can contractually require another to indemnify it for its own negligence — although many courts allow such an indemnity if expressly provided in the lease.
This issue is particularly important in equipment leases, since a third person who is injured by leased equipment may bring a claim directly against the lessor, alleging that it has somehow been negligent. For example, injured parties have argued that a lessor was liable for failing to inspect equipment and discover defects likely to cause injury, for failing to deliver operating manuals to the lessee, or for failing to warn a lessee about equipment defects of which the lessor knew or should have known.
Consider, for example, the case of McNally & Nimergood v. Neumann – Kiewit Constructors, Inc.,1 where McNally & Nimergood (Lessor) leased a construction crane to Neumann – Kiewit Constructors (Lessee) pursuant to a lease that required Lessee to maintain the crane in good working order and to repair it as necessary. When one of Lessee’s employees was seriously injured by the crane, the employee sued both the Lessee and the Lessor for negligence. The claim against the Lessor alleged that it failed to inspect and maintain the crane prior to its delivery to the Lessee. The employee’s recovery against Lessee was limited by workers’ compensation laws, and Lessee was quickly dismissed from the suit. Lessor subsequently settled the claim for $500,000 and immediately began demanding indemnification from Lessee pursuant to the terms of the lease agreement. Because the lease did not expressly provide that the indemnity covered the Lessor’s own negligence, Lessor was not able to recover from Lessee.
Lessees’ counsel will sometimes push back on language indemnifying lessor for its own negligence, but explaining the rationale behind such clauses sometimes solves the issue. Many lessors agree to exclusions for their own gross negligence or willful misconduct. However, that solution raises the same risk, just to a lesser degree. This author prefers to address the issue by specifically stating that even claims of gross negligence are covered if they relate to theories of negligent inspection, entrustment or failing to enforce the lessors’ rights under the documents.
Special Scope Issue: Direct Claims versus Third-Party Claims
Indemnity clauses can cover not only claims brought by third parties against one of the contracting parties, but such clauses can also cover claims brought by one contracting party against the other. In the latter case, the claim is a “direct” claim. Some parties may question the need for indemnity clauses to cover direct claims, since the contracting parties would already have contractual or tort damages available for losses related to the lease. However, an indemnity clause that applies to direct claims can allow an indemnitee to recover additional types of damages — such as attorneys’ fees and specific performance — that may not otherwise be as available under the lease. Generally, the language of an indemnification clause must clearly reflect the parties’ intent to cover direct claims in order to be effective.
Experienced lessee counsel frequently requests that the indemnity specifically cover only third-party claims. After all, it does not seem fair that a lessee can sue the lessor for the lessor’s breach of its obligations and then have the lessor turn around and say, “Fine, now indemnify me for any losses I owe you.” In addition, strong lessor forms should already cover the types of losses for which the indemnity for direct claims could be used, including for example, through a strong further assurances clause and a strong remedies provision.
Obligation to Defend
The duty to indemnify is distinct from the duty to defend. The duty to defend means the duty to hire an attorney and pay for the costs and expenses associated with the legal defense of an asserted claim that is within the scope of the indemnity clause. The distinction is particularly important when a claim has no merit or when it is not clear whether a claim is meritorious, and the claim must be litigated. The duty to defend requires the party with the obligation to indemnify the other, often referred to as the indemnitor or the indemnifying party, to pay for a legal defense even if a court ultimately determines that the claim has no merit.
Equipment leases typically combine an indemnity clause with a defense clause, e.g., the lessee shall defend, indemnify and hold [the indemnified parties] harmless. If the contract provides indemnity for direct claims (see above), parties may wish to expressly state that the duty to defend applies only to third-party claims, so that if there was a dispute between the two contracting parties, one would not be obligated to pay for the other’s legal expenses in that litigation.
It is good practice to spell out certain procedural matters related to the timing and control of indemnity claims. Timing:
In order to avoid prejudice resulting from late claims, some indemnity clauses include a requirement for prompt notice by the party being indemnified, often referred to as the indemnitee or the indemnified party. If notice is late, the parties should address whether that delay entirely cuts off the indemnitor’s liability or merely limits its responsibility to indemnify only for losses (such as legal expenses) incurred after the notice is given. Similarly, an indemnity clause may exclude costs or other damages incurred because of the indemnitee’s delay in providing notice.
The parties should consider whether they wish for the indemnity clause to survive the termination of the lease, thereby allowing indemnity claims to be asserted after such termination. Lessors typically demand that that the indemnity clause survives in order to obtain protection from third-party claims, such as personal injury claims, that arose during the term of the lease but were not asserted until after its termination. State statutes of limitation may allow certain types of claims — such as personal injury claims — to be asserted at any time within a period of years after the claim accrues, and accordingly, a party seeking to be indemnified would want the indemnity provision to survive for a corresponding time period.
If a lawsuit is filed, which party can choose counsel and control the defense of the claim? If the indemnity clause includes a duty to defend, the duty to defend generally includes the right to choose counsel and control the defense, unless the contract states otherwise. The indemnitee may wish to include certain limitations on the right to control the defense, in order to protect its interests. For example, the indemnitee may wish to provide that the indemnitor’s choice of counsel is subject to the indemnitee’s approval. Consider a case against a lessor based on the type of vicarious liability laws addressed by the Graves Amendment. Lessor may want lessor counsel familiar with this area of the law handling the defense.
Another key issue is whether the indemnitee has the right to approve any proposed settlement. Clearly, it will want to make sure settlements state that the lessor does not admit fault or liability.
In the event that the indemnitee is not satisfied with the defense provided by the indemnitor, a contractual right to assume the defense or participate in the defense, with counsel of indemnitee’s own choosing, may allow the indemnitee to better protect its interests.
During the course of litigation, the indemnitor may not have access to all of the witnesses or information needed to properly defend the claim. To address this issue, an indemnity clause may provide that the indemnitee has a duty to reasonably cooperate with the indemnitor and provide any information reasonably requested in connection with the defense of the claim.
Indemnity clauses, which are useful tools for contractually allocating risks, are industry standard in equipment leases. Such clauses also generally remain in, and are useful with respect to, equipment financings as well. Larger transactions, with robust documentation packages, frequently address the various nuances associated with indemnity obligations. However, documentation for smaller transactions is often less thoroughly developed. A careful review of the indemnity provision in equipment lessors’ standard documentation can yield big results if a claim arises later for which indemnity is sought. As the saying goes, an ounce of prevention is worth a pound of cure.
Kenneth P. Weinberg is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.
Jennifer L. Howard is of counsel at Baker, Donelson, Bearman, Caldwell & Berkowitz, P.C., and practices in the areas of equipment leasing, equipment finance and renewable energy project finance.