“When Two Consenting Parties Cannot Consent: Indemnification for Future Wrongful Conduct”

by William G. Benz | Partner

Indemnification provisions are so common that one would be hard-pressed to find a contract that lacks one.  While an indemnification provision may be hidden in an agreement as boilerplate fine print, it is often of critical importance long after the contract is signed.  But, indemnification can only be pushed so far.  Once it becomes so onerous that it encourages bad faith, California public policy will void the indemnification provision and someone who thought she was protected may find herself left holding the bag.

Let us step back.  What is indemnification?  In its simplest form, indemnification is an agreement by one party to bear the monetary costs, either directly or by reimbursement, for losses incurred by a second party.  For example, if Buying Company purchases the assets of Selling Company, the purchase agreement may contain a provision that Selling Company has to indemnify Buying Company for any claims that Selling Company’s product caused injury prior to the sale.  In this example, if Buying Company were sued after the sale on the grounds that a purchased product injured someone before the sale, Selling Company would be forced to pay for Buying Company’s losses related to that claim.  The scope of indemnification is broad, and may include attorneys’ fees, an adverse judgment, and loss of business profits.

There are, however, limits to indemnification. Civil Code section 2773 prohibits an agreement to indemnify a person against an act later done that is known by the person doing the act to be unlawful.

Practically speaking, this means that any indemnification provision that seeks to indemnify a party for losses related to that party’s willful injury to another or violation of law is completely unenforceable.  For example, if Party A agrees to indemnify Party B for any losses Party B incurs for Party B’s infringement of Party C’s intellectual property rights, that indemnification provision will be held void as a matter of law.

While there is a wide ability of parties to bind one another through contract, California’s public policy aims at restricting this discretion when it would cause a harmful result overall. When stepping back, this limitation in section 2773 makes sense.  Taking the example above, if the indemnification provision is enforceable, Party B knows it bears no risk when it infringes Party C’s intellectual property.  After all, if Party B infringes and Party C sues, Party A will have to bear the costs of Party B’s losses, whether that is attorneys’ fees, adverse judgment, or penalties.  Logically, Party B is more likely to infringe because Party B stands to benefit from its wrongful infringing conduct – increased sales and revenue – while Party A bears the risk of loss.

What is the lesson to be learned from this?  It is that while the power of contract may be great, the state-recognized public policy is greater.  Anyone who prepares or signs contracts should be not only acutely attuned to the specific language in the agreement, but must also be aware of any overriding prohibitions created by statute or case law.

Two parties can contract to do anything, except for the things they cannot.

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