Indemnity Provisions

A risk of any engagement is being named or joined in civil or administrative proceedings. Claims relating to the accuracy of an accounting professional’s work can arise in connection with the performance of any service, from the preparation of a simple tax return to the audit of a complex financial statement. Often these claims result from inaccurate or incomplete information being provided by the client or a misconception as to the scope of the accounting professional’s services.

The potential exposure to accounting professionals from such claims far exceeds the compensation for such services. Legal costs may be defrayed by insurance, but such claims still result in expenses in the form of deductibles, lost time, and potentially increased premiums. While there is nothing to prevent the assertion of a claim, one potential means to limit the likelihood or effect of such claims recognized by the courts is to include an indemnity provision in your engagement letters.

“In practical terms, an indemnity provision in an agreement requires that one party pay the expenses incurred by, and potentially the damages awarded against, the other resulting from a claim arising out of the performance of services.”

What Is Indemnity?

Indemnity is defined as “[a] duty to make good any loss, damage, or liability incurred by another.” In practical terms, an indemnity provision in an agreement requires that one party pay the expenses incurred by, and potentially the damages awarded against, the other resulting from a claim arising out of the performance of services. As applied to accounting professionals, the questions which arise are who can be indemnified and for what.

Can Accountants Be Indemnified?

Engagement letters are contracts, meaning that they are governed by the same rules as other contractual arrangements. Indemnity provisions are typically considered to be a normally accepted means for parties to contractually agree to the apportionment of risk. Accordingly, as long as the particular indemnity provision is not deemed to violate public policy, it is likely to be enforceable.

It is worth noting that not every professional is permitted to use indemnity agreements. Professionals who are deemed to have fiduciary obligations, such as attorneys, are precluded from transferring the risks of liability to their clients. However, the law treats the relationship between accountants and their clients differently. As a result, courts that have considered the issue have held that accountants performing traditional accounting services are free to utilize risk allocation provisions, such as indemnity clauses.

What Do These Provisions Cover?

Indemnity provisions are as varied as the clients and professionals using them. Some are narrowly limited to the requirement to pay the costs and fees associated with defending a professional liability claim. Others are so broad as to obligate the client to pay damages awarded against the accountant. Similarly, indemnity provisions can also be tied to an accountant’s liability. Some provisions apply only when the accountant is adjudged not negligent. Others impose obligations even if the accountant has been found to be at fault.

Another consideration in the drafting of indemnity provisions is whose claims are being covered. Traditionally, indemnity provisions were thought to apply only to claims brought by a third party. However, many states have held that indemnity provisions are not required to be so limited. That means that depending on the language, an indemnity provision can be drafted broadly enough to require that a client pay the costs and fees associated with claims brought against an accounting professional even by the client itself. Whether or not such a provision will be enforced is dependent on the laws of the particular state where the issue is being addressed.

What Practical Considerations Are There?

One of the biggest concerns in seeking indemnity from a client is whether that provision truly has any value. While it is always good to have such a provision in an engagement letter, it may not be practical to count on them to defray expenses. That is because indemnity is only as good as the client’s ability to pay the incurred expenses and damages.

Even if a client can provide indemnity, depending on the nature of the claims they may not be required to do so. While parties are generally free to decide for themselves the measure of risk they are willing to assume and apportion, there are instances in which restrictions are placed on indemnity provisions for public policy reasons. For public policy reasons, most states will not enforce a provision which requires indemnity for intentional acts, willful misconduct, or gross negligence. Additionally some states have statutes which address the enforceability of certain indemnity provisions.

Finally, if a client declines to provide indemnity there may be issues as to when to seek enforcement of your agreement. This is dependent on both the language of the indemnity provision and the type of claim for which indemnity is sought. In some instances, claims may need to be brought immediately, even while another action is pending. In other cases, the claim may not be said to be “ripe” until there has been a determination in another action.

Conclusion

Use of indemnity provisions are just one more potential means of practice risk management. Like any other contractual requirement, they need to be properly tailored to your jurisdiction. And like any other part of your engagement letter, they need to reasonably reflect the nature of your services. While they are generally recognized as both legal and enforceable (not against public policy), because they transfer risk from one party to another, courts generally limit their reach to circumstances reasonably contemplated by the parties. So documenting a discussion about this provision with your client is advisable, and having them initial it separately is even better. Consider their use as part of an appropriate apportionment of risk.

Commentary provided by Steven J. Bolotin, Senior Partner, Morrison Mahoney, LLP, Boston, MA. Reprinted with the permission of Travelers.