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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   April 2010

What Indemnification Means to You

Loan contracts often contain provisions to allocate lender and borrower risk

Risk is inherent in any business, including commercial mortgage lending. In fact, an important function of a commercial loan contract is to allocate risk among the parties. This accounts for factors that may include each party's ability to prevent or mitigate loss, each party's relative fault and each party's respective risk tolerance..

Commercial contracts contain various, often-independent provisions designed to allocate certain risks.

One such provision is indemnification. According to Black's Law Dictionary, indemnification is the act of one person -- referred to as the indemnitor -- to compensate or reimburse another person -- the indemnitee -- for losses or damages that the indemnitee suffered because of the indemnitor's act or fault.

Commercial loan agreements often contain indemnification provisions. In these cases, the mortgage borrower typically is the indemnitor, and the mortgage lender is typically the indemnitee. In these contracts, the borrower agrees to indemnify the lender against certain enumerated, outlined risks.

Most often, the responsibility of negotiating a commercial loan agreement's indemnification provisions falls to the lenders' and the borrowers' respective attorneys. But it is important for commercial mortgage brokers to understand the concept of indemnification to better serve clients. For example, depending on the nature of a borrower's business, the mortgage contract may contain specific indemnification provisions relating to hazardous waste, other environmental issues or other specific provisions designed to address a specific lender risk for this borrower.

Goal of indemnification

Indemnification's basic goal is to shift the burden of loss or damage to the party whose acts or negligence caused it.

Despite the technical definition of indemnification, many courts have narrowed the scope to only circumstances that involve third-party claims against the indemnitee because of the indemnitor's acts. Thus, if the contracting parties intend, it becomes important that parties specifically state that the scope of indemnification includes direct liability as well as third-party liability in their contracts.

As the law evolves and courts become more reluctant to impose extra-contractual obligations upon commercial transactions and the parties involved, it is important that the documents include the nature and extent of the indemnification they seek, as well as its limitations.

Indemnification is not a one-size-fits-all proposition. Agreements to indemnify can be crafted in a number of different combinations to fit almost any type and size of transaction and the parties' relative risk appetites.

When negotiating and drafting indemnification provisions, it is important to keep the following items in mind, each of which can potentially affect the transaction's underlying economics.

Scope

Indemnification provisions can be written as broadly or narrowly as needed. The scope often depends on the transaction size and type.

When negotiating and drafting indemnification provisions for a commercial loan agreement, lenders and borrowers should carefully define:

  • Who is expressly obligated to indemnify;
  • Who is entitled to be indemnified; and
  • The types of claims, losses or liabilities eligible for indemnification.

One additional consideration is whether borrowers as indemnitors are obligated to indemnify for losses, liabilities or both. It is important that the document expressly show the intent of the parties so that they are not litigating whether use of the word "loss" mandates an actual payment before the right of indemnity, as opposed to the use of the word "liability," which may trigger indemnity at the time a claim is made.

If the agreement states that the indemnitor will indemnify for any loss, the lender as the indemnitee generally may not bring a claim against the borrower until it has actually incurred loss. In other words, it cannot bring a claim until the time of payment of the underlying third-party claim, the payment of a judgment on the underlying third-party claim or a payment in settlement of the underlying third-party claim.

On the other hand, if the agreement states that the borrower will indemnify for any liability, the lender may bring an action as soon as it incurs an indemnifiable liability. This distinction may be irrelevant, however, in agreements where the borrower agrees to indemnify against losses and liabilities.

As the indemnitors, borrowers would be obligated to compensate the lender for losses and damages that arise out of certain enumerated items in the credit agreement. It is important to note that the scope of borrowers' indemnification obligations in a commercial loan agreement often is broad. It usually requires borrowers to indemnify the lender and many of its affiliates from and against any and all liabilities, obligations, losses and damages with respect to any aspect of the loan agreement or any transaction it covers.

Further, in commercial transactions, in addition to the lender, the indemnified parties typically include its officers, directors, affiliates, employees, agents, representatives and other parties whose liability for third-party claims could come from their relationship with the lender.

As a general rule, the broader the definition of indemnified parties, the greater the potential indemnification obligations of the borrower. With respect to indemnifying parties, however, the borrower typically will be the only party obligated to indemnify unless there are other shareholders, directors or guarantors that are party to the transaction. 

Therefore, it is important for a lender to understand the borrower's financial strength when drafting the agreement and in the future. The lender also should protect against the possibility that the borrower will not or cannot satisfy its promise to indemnify.

Notice requirements

A well-drafted indemnification agreement in a commercial loan contract also should set forth the procedure for notifying borrowers of potential claims and for handling claims.

As a general rule, borrowers will benefit from specific notice and procedure requirements in the agreement. The lender and other indemnified parties also can benefit from these requirements, which can provide certainty to the indemnification process and unambiguously set forth the process by which they will be indemnified against losses and liabilities.

Notice and procedure requirements also can limit a borrower's obligations under the loan agreement.

To limit the scope of a borrower's liability, a notice provision could make proper notice a prerequisite to the borrower's obligations to indemnify.

Further, the agreement could require the lender to make indemnification claims within a defined period of time or provide the borrower the ability to cure a liability or default before triggering an obligation to indemnify.

Dispute resolution

The duty to indemnify often is coupled with the duty to defend. In terms of a commercial loan contract, this is the borrower's obligation to assume the lender's defense if the lender is sued for losses or damages arising from the borrower's acts. In some instances, borrowers may wish to control the dispute-resolution process because they ultimately will be financially responsible for any losses or damages.

A right to defend also could give borrowers more control over the dispute-resolution process and the subsequent litigation. On the other hand, the duty to defend generally would require borrowers to assume control of the dispute-resolution process, to fund all expenses associated with the process at the outset and to assume primary responsibility for the adjudication of third-party claims.

The decision of whether to agree to defend the lender against claims will depend on the written provisions and each case's facts and circumstances. As a general rule, however, the larger the borrower's potential liability, the greater the incentive to control the claim-adjudication process.

Some indemnification agreements provide for a joint defense against third-party claims. In these cases, agreements should clearly designate how the defense will be conducted, which party will control the litigation, which party has the right to select or approve attorneys, and whether each party has a right to its own attorney.

Associated risks

Before agreeing to indemnify or be indemnified, mortgage lenders and borrowers should attempt to understand the scope of their potential obligations, the losses or damages against which they will be protected, and the party or parties obligated to indemnify for losses or damages.

An indemnification agreement is only as strong as the people obligated to indemnify. Will the borrowing entity exist after the transaction closes? What resources will a borrower have to compensate the lender for any losses or damages? Lenders can spend valuable time and money negotiating an airtight indemnification agreement, but they will be no better off if they cannot rely upon borrowers to satisfy their promise to indemnify.

Lenders should take steps to better ensure they get the benefit of their bargain. Before entering the transaction, a lender could review the borrower's financial statements and perform other due-diligence activities. It also could insist on representations, warranties and covenants in the transaction document that address the borrowing entity's continued existence, solvency and the like.

Practically speaking, however, borrowers' representation that they are solvent essentially will be worthless if they are insolvent, unless there are other parties on the hook to provide indemnification.

A potentially better way for a lender to protect its interests is to require certain funds be set aside in an escrow account to cover potential indemnification claims. With an escrow account, a lender may feel more comfortable knowing that cash is available to satisfy indemnification claims, should any arise. An insurance bond or policy also may be available.

From the borrower's perspective, there also are risks associated with agreeing to indemnify lenders against third-party claims. Borrowers should understand the duration, scope and breadth of the indemnification agreement and attempt to limit their liability as much as possible. Ideally, borrowers should insist on an aggregate cap, survival period or both for their indemnification obligations to quantify them.

Early on, mortgage borrowers and lenders should retain competent advisers and attorneys before they enter any indemnification agreement as part of the lending process. These advisers can help assess and evaluate the risks associated with indemnification agreements and can help draft the provisions to protect against and potentially limit the risks inherent in the indemnification process.


 


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