For What Did You Intend To Indemnify? Choose Your Words Carefully!

Today, we’re going to discuss two legal issues, one old and one new. The old one has to do with the use of extrinsic evidence, but with an interesting twist. “Extrinsic” means information coming from the “outside,” in our business (agreements, such as a lease), that means information from what was said or what was written before or at the same time the document was signed, but didn’t show up in the document itself.

The second, and the one that has generated a little bit of “buzz,” has to do with the scope of a promise to indemnify someone.

For those readers who like “primary” material, take a look at the California Court of Appeal Order published on December 7, 2015 in the case of Hot Rods, LLC v. Northrop Grumman Systems Corporation. It can be seen by clicking HERE.

[Early warning: Today’s posting is a “two cup of coffee” one. If you print it out and set it aside, you won’t read it. So, if the topic intrigues you, settle in.]

Here’s a story to give readers some context for today’s Ruminating. We’re dealing with the sale of an “environmentally compromised” property. It had been used to make aircraft floor beams. When that manufacturing was discontinued, the building became vacant. Its owner had some environmental investigations conducted and the end result was that contaminated soil was removed but no ground water remediation was conducted. Only monitoring was indicated and the state’s environmental agency “signed off” on that work plan.

The property owner’s corporate policy was to complete soil remediation at its buildings before offering a property for sale, but not to await the completion of ground water monitoring. So, with the contaminated soil seemingly removed and no ground water remediation called for, it offered its building for sale. Along came an automobile parts distributor, one that was leery of buying a contaminated property. Its concerns were overcome by a contractual provision that made the (financially strong) seller responsible for cleanup costs, if any. We’ll see that provision a little further down this blog posting, but first for the “extrinsic” part of today’s posting.

Here’s a refresher on the law of when extrinsic evidence can or cannot be used by a court. The rule followed by courts is called the “parol evidence rule,” though that would ordinarily mean “oral” evidence. Parol means: “Expressed or evidenced by an oral statement as opposed to a written document.” We might say, “By word of mouth.”

Here is the explanation given by the California court:

Under the parol evidence rule, when a contract is integrated [i.e., has an integration or merger provision], extrinsic evidence cannot be used to vary or contradict the instrument’s express terms. … This rule is based on sound logic and policy; when a contract is reduced to writing, it is presumed to contain all of the material terms, and it cannot reasonably be presumed that the parties would intend two contradictory terms to be part of the same agreement.

Ordinarily, even in an integrated contract, extrinsic evidence can be admitted to explain the meaning of the contractual language at issue, although it cannot be used to contradict it or offer an inconsistent meaning. The language, in such a case, must be “‘reasonably susceptible’” to the proposed meaning.

Re-read the second paragraph above. It is what is often used to allow a court to consider extrinsic evidence even if an agreement has an integration clause. Some courts use that exception to run a freight train through the eye of a needle.

The purchase agreement for the sale of this property had (what we see as) an unusual provision in what is usually a humdrum “integration” clause. It stated:

The Parties further intend that this Agreement constitutes the complete and exclusive statement of its terms and that no extrinsic evidence whatsoever may be introduced in any judicial proceedings involving this Agreement.

The buyer tried its best to get extrinsic evidence into its case and almost succeeded. The “trial” judge abided by the “it can be used to interpret provisions that need to be interpreted” general rule. And, in fact, even in its appeal, the seller didn’t “catch” that. But, the appellate court did without help of either litigant. That court took careful note of the purchase agreement’s language of “no extrinsic evidence whatsoever may be introduced in any judicial proceedings,” and saw that the buyer had tried “to do an end run around the integration clause itself.” Succinctly, the court ruled that the “no extrinsic evidence whatsoever may be introduced in any judicial proceedings involving this Agreement” provision permitted no other interpretation.

Here’s a drafting lesson for today, again using the court’s own words:

The expressed intent of the parties was to bypass the general rule that consistent extrinsic evidence is admissible to explain the meaning of a contractual provision. Contracts must mean what they say, or the entire exercise of negotiating and executing them defeats the purpose of contract law – predictability and stability.

As every reader might expect, the buyer wasn’t real pleased with this outcome and even argued that the “no extrinsic evidence whatsoever may be introduced” was unenforceable because it violated public policy. Fortunately for Ruminations and its readers, this gives us an opportunity to take a quick look at this “public policy” thing.

The parol evidence rule is NOT a rule of procedure; it is a rule of the substantive law. Some rules of substantive law cannot be waived or overridden because of this animal named: “public policy.” Which substantive rules are those? That’s hard to answer as the following words from the Opinion explain the difficulty of figuring out what “public policy” might be in any given circumstance and whether it should be applied in those circumstances.

It has been well said that public policy is an unruly horse, astride of which you are carried into unknown and uncertain paths. . . . While contracts opposed to morality or law should not be allowed to show themselves in courts of justice, yet public policy requires and encourages the making of contracts by competent parties upon all valid and lawful considerations, and courts so recognizing have allowed parties the widest latitude in this regard; and, unless it is entirely plain that a contract is violative of sound public policy, a court will never so declare.

That’s a pretty “high bar” that the buyer failed to clear. This particular “contract only govern[ed] the relationship between [the buyer and the seller], and ha[d] no implications for public policy.”

The buyer also tried the “unequal bargaining strength” argument and, as is almost always the case in commercial transactions, it didn’t work. Oh, yes, the purchase agreement had that covered as well, even though that wasn’t a dispositive factor in the court’s decision. What the agreement said was that it had been entered into under “the normal and reasonable expectations of a sophisticated Seller and Buyer.” If you want to see the little else the court had to say about this, you’ll need to retrieve the actual Opinion.

Now, we are finally getting to the “what is the scope of the indemnification provision” part of today’s droning on.

To understand the context within which the court had to confront the purchase agreement’s environmental indemnification, we need to continue the “story.” It turns out that, despite a representation to the contrary, there was an underground tank at the property. Meanwhile, based on newly discovered facts “on (under?) the ground,” the state’s environmental board ordered groundwater remediation. Under the purchase agreement, the seller was required to remove the tank and conduct the remediation, and it did. At the time of trial, portions of the property had been completely remediated and the rest of the remediation was in progress. Over the course of 13 years, the seller had reimbursed the buyer for about 30 environmentally related expenses. It was only then that the seller cautioned that it didn’t have an “open pocket” policy and that it would only reimburse the buyer for certain expense, notably not “first party” ones.

Though not entirely clear, this “reservation of rights” appears to have been related to the buyer’s assertion of “you aren’t doing enough.” The buyer started to complain about “substantial inconvenience as a result of the remediation procedures, including the presence of monitoring wells, odors, parking spots taken up with equipment, blocked access, pollution generated by equipment, and similar matters. Damage to the building also occurred and evacuation for several days was required at one point.” In addition, the buyer leased the property to a church and the environmental situation caused a delay in the church’s occupancy and hence a loss of rental income. Lastly (for today’s discussion), the buyer claimed the value of the property was diminished by the environmental issues.

Finally, we get to the issue of “the scope of an indemnity obligation.” More narrowly, does a duty to indemnify someone mean only with regard to claims by others against the indemnified party (“third party claims”) or does it also cover direct losses to the indemnified party (“first party claims”)? Well, here’s a spoiler: “It depends.”

Judging from what we (of Ruminations) have already read, most who have commented on the Hot Rods Opinion were struck by the court ruling that the following indemnification provision covered first party claims. We disagree about the “surprise” factor. Those brave readers who continue on will see why. First, here’s the agreement’s indemnity provision:

With respect to the Seller’s ownership and/or operation of the Real Property including the acts or omissions of Seller’s employees, agents, or contractors before or after the Closing, Seller hereby agrees to indemnify, defend by legal counsel selected and retained by Seller, and reasonably approved by Buyer, and hold the Buyer and Buyer’s lenders . . . harmless from and against any claims, demands, penalties, fees, fines, liability, damages, costs, losses, or other expenses including, without limitation, reasonable environmental consulting fees and reasonable attorney fees arising out of (a)[: Environmental Stuff] …; and (b) any personal injury (including wrongful death) or property damage (real or personal) arising out of Hazardous Materials… .

So, let’s rephrase the issue. The seller, as the indemnifying party, argued that “the indemnity provision applied only to third party claims and [did] not permit the [buyer, as the indemnified party] to sue for its own damages.” That’s a common misunderstanding because, “[a]lthough indemnity generally relates to third party claims, ‘this general rule does not apply if the parties to a contract use the term ‘indemnity’ to include direct liability as well as third party liability.” That statement allows Ruminations to revisit a frequent haunt, the one in which “contract interpretation” resides. As is our wont, we like to pick up “thought threads” from courts around the country. That allows us to hammer home that we may write the agreements, but when the parties disagree enough so as to litigate, it is the courts that decide what we “meant.” Here are some of the “contract interpretation” thoughts expressed by this particular California appellate court using the agreement’s “indemnity” provision to teach us a lesson. They aren’t different from what all other courts say, but use different words to explain the same process.

Each indemnity agreement is “interpreted according to the language and contents of the contract as well as the intention of the parties as indicated by the contract.”

When indemnity is expressly provided by contract, the extent of the duty to indemnify must be determined from the contract itself.

The question whether an indemnity agreement covers a given case turns primarily on contractual interpretation, and it is the intent of the parties as expressed in the agreement that should control.

When the parties knowingly bargain for the protection at issue, the protection should be afforded. This requires an inquiry into the circumstances of the damage or injury and the language of the contract; of necessity, each case will turn on its own facts.

The indemnity provisions of a contract are to be construed under the same rules for interpreting contracts, ‘“with a view to determining the actual intent of the parties.”

You get the point: to interpret the scope of any particular agreement to indemnify, to open the lock so to say, the “key” is “intent.” That being the case, readers can correctly predict how this court responded to the indemnifying seller’s argument that there needs to “be ‘express language’ in an indemnity clause before it is interpreted to encompass first party claims.” Why not? Because, “it is the intent of the provision, and the agreement as a whole, that governs.”

California, a civil law jurisdiction, has a statute that defines “indemnity” to mean “a contract by which one engages to save another from a legal consequence of the conduct of one of the parties, or of some other person.” It has case law saying this definition “plainly states that indemnity may apply to either direct or third party claims.”

Note the use of the underlined word, “may.” [We did the underlining.] The “may” means that sometimes it will include direct (first party) claims and sometimes not. [Interestingly, we think it always includes third party claims unless expressly saying otherwise, but that may be because the “market” provides the “intent” that this is the way an indemnity works.]

So, what were the factors this court used to reach its conclusion that first party claims were covered? What can we, when drafting agreements, learn from the court?

One factor was the use of “any and all” in the formulation. That’s not to say the presence of these words alone is dispositive, only that they open the door to reading the indemnity provision as being “broadly worded.” “Read in . . . [the given] context . . . the word ‘indemnify’ makes better sense when read to mean ‘make good,’ ‘reimburse,’ or ‘compensate.’”

The indemnity provision in the Hot Rods case covered: “any claims, demands, penalties, fees, fines, liability, damages, costs, losses, or other expenses including, without limitation, reasonable environmental consulting fees and reasonable attorney fees.” “Claim” was defined as “any claim or demand by any Person for any alleged liabilities, whether based in contract, tort, implied or express warranty, strict liability, criminal or civil statute, Permit, ordinance, regulation, common law, equity or otherwise.” “Person” meant “any person, employee, individual, corporation, unincorporated association, partnership, trust, federal, state or local governmental agency, authority or other private or public entity.”

Thus, according to the court, when “the parties expressly adopted a broad definition of ‘claim’ and ‘person,’ that encompasse[d] ‘any alleged liabilities,’ and cover[ed] both first and third party claims.” It didn’t matter that the word “claim” was not capitalized. The court interpreted it as if it had been.

The court also honed in on the phrase “damages, costs, losses,” one that all of us “toss in” for good measure. Think about it (as the court did), “if the language [of the indemnity provision] was meant only to cover third party claims, there seems little point in including the phrase “damages, costs, losses” when those would all have been covered already. … That language seems entirely duplicative of ‘any claims, demands, penalties, fees, fines, liability,’ if the provision is intended to apply only to third party claims.”

“Surplusage” is a troublesome issue for agreement-writers. [We’ll probably do an entire rant on “surplusage” in a future blog posting.] The problem is that courts “try to interpret contracts to avoid surplusage.” Consequently, in the court’s words: “The extremely broad language here, such as ‘any claims, damages, costs, losses’ [did] not suggest the parties intended to limit the provision to third party claims.”

Another “flag” for the court was the different ways in which the purchase agreement dealt with the two indemnified categories: (a) “environmental stuff” (actually, “Environmental Action(s) and/or Remediation”); and (b) personal injury arising out of “Hazardous Material used.” A section of the purchase agreement required the buyer to give the seller prompt notice of any “Environmental Action” and gave the seller the right to contest or defend such actions. On the other hand, the buyer wasn’t obligated to give prompt notice of personal injury claims and the seller reserved no right to defend against those claims. Perhaps only as a “moreover,” the court mused why, if the seller intended to indemnify only for third party claims, it wouldn’t want prompt notice of personal injury claims or it wouldn’t want to be able to control the defense of such claims. To the court, this was another indication that first party claims were to be covered because a “property damage” type of claim made directly by the buyer (for its own property) wouldn’t be the kind of claim that the seller would take over the “defense” or need to know of immediately.

Lastly, the court (correctly) contemplated the entire purchase agreement, concluding from the document’s many environmental provisions and representations that the buyer wanted to be completely insulated from economic harm resulting from a contaminated property.

Basically, this court, relying heavily on the actual words used in the indemnity provision and in the overall agreement, concluded that the intent of the indemnification provision was for the buyer to be placed in the same position as if there was no environmental problem or injury from hazardous materials in the first place.

Now, honestly, how many of us representing an indemnifying party previously thought that making long lists such as, “demands, penalties, fees, fines, liability, damages, costs, losses, or other expenses including, without limitation, reasonable environmental consulting fees and reasonable attorney fees,” would make the difference as to whether first party claims were covered?

Yes, as has been said very often in this forum: “Words matter.” Will we now be adding, to our agreements, sentences like: “The duty to indemnify covers only third party claims”? Or, are we afraid to do so because we’d prefer to negotiate the issue when it comes to court instead of when the agreement is being born?