Indemnification and Advance Payment

Reimbursed at the End

Indemnification obligations do not arise until there is some determinable amount that a party is obligated to indemnify. The fact that a party has an indemnification right does not mean they will get reimbursed for their expenses or losses (especially defense costs and attorney fees) until after there is an actual out-of-pocket expense that is found to be covered by the contract language. In other words, you do not get reimbursed until the end.

Example in Corporate Setting

An example might be a corporate officer who is sued by a regulatory agency for violation of some law. Company Articles of Incorporation, Bylaws, and/or state statutes generally include indemnification rights for officers for their liabilities incurred while acting in good faith for the company. This usually means that if the officer meets certain criteria, the company has to cover the cost of the defense and any liability imposed on him or her. However, unless there is an advance payment provision in the indemnification provision (or an equivalent state statutory requirement), the company does not have to pay any amount to the officer until after the officer has the expense and proves their entitlement to the indemnification. This means the indemnitee may have to front all of the costs and expenses of a defense, including any liability. This can be a substantial burden.

Application to Commercial Contracts

The same is true with indemnification provisions in commercial contracts. The party who is obligated to indemnify does not have to reimburse the other party until that party has the expense and proves entitlement to the reimbursement – a proceeding that is usually done after the underlying matter is resolved.

Depending on the language, an advance payment provision states that the party obligated to indemnify may also be obligated to provide the funds in advance of the final resolution of the matter. In short, the advance payment is a loan to the indemnitee over the course of the resolution of the dispute that only has to be paid back if it is determined that the party was not actually entitled to be indemnified.

What the Advance Payment Provision Does

The advance payment provision does two things. First, it mitigates the financial burden of the indemnitee during the time that the claim is being addressed. It does this by requiring that the payment of the fees and costs in the defense, and any ultimate liability, be provided while the expenses are being incurred. The provision can be used to place the obligation of the expense on the party best capable of financing the situation.

Second, the provision can shift the risk of whether the claim is covered by the indemnification provision to the indemnitor because the indemnitor might have to front the costs of the defense if there is a possibility the claim is covered. If it is not covered, it is the indemnitor’s obligation to recover the amount paid from the indemnitee.

Conclusion

Depending on the financial conditions of the parties involved, as well as the roles being played and risks involved, an advance payment provision can be essential in appropriately allocating the risks presented to the parties of a third party claim arising out of the relationship.

One of the areas such a provision can be useful is in the single-member LLC environment. We will discuss this in the next post.

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