Responding to a Client’s Request for Defense and Indemnification
Have you ever faced this situation? Your firm receives a request for proposal (RFP) from a new client. It sounds like a great opportunity, and the firm is excited to respond. The RFP includes the client's standard terms and conditions and a statement indicating respondents must agree to the terms. You review them; nothing seems out of the ordinary until you see a provision titled "Indemnification and Defense Requirements." What is this?
Client requests for defense and indemnity by the CPA firm are on the rise. Defense and indemnification provisions are commonly requested by governmental entities, construction contractors, or entities that use a procurement or purchasing group to manage the bidding and contracting process. These entities may require certain clauses in all contracts with vendors, regardless of the product or service provided. A client's attorney may also suggest such a provision while reviewing the firm’s engagement letter on behalf of the client.
Why the concern? Requests for such clauses are unnecessary and unfair, and, in some cases, they are unenforceable.
What Are Defense and Indemnification Provisions?
A typical engagement letter provision requested by the client may read as follows:
CPA Firm shall indemnify, defend, and hold harmless Client, its officers, directors, members, employees, and agents from and against any and all claims, demands, suits, costs, liabilities, losses, and expenses (including attorneys' fees) arising out of or in connection with (i) the Services provided hereunder; (ii) any negligent or intentional acts or omissions of CPA Firm or any of its officers, directors, employees, or agents; (iii) the inaccuracy or breach of any of the covenants, representations, obligations, and warranties made in this Agreement; and (iv) any action by a third party against Client or its affiliates or representatives relating to the Services, supporting data, or materials.
In plain English, this provision obligates the CPA firm to:
- Pay the client's costs to defend a claim made by third parties against the client that resulted from the CPA firm's negligence;
- Fund any settlement, judgment, or award entered against the CPA firm for a claim resulting from the firm's negligence; and
- Fund any settlement, judgment, or award incurred by the client for a claim made by a third party from the firm's negligence.
Clients include defense and indemnification provisions in engagement letters in an attempt to insulate themselves from exposure and shift responsibility to the CPA firm. More egregious provisions seen by the AICPA Professional Liability Insurance Program have even included requests to reimburse the client's costs upon notification and without evaluation of the firm's liability.
What Are the Risks of Such Provisions?
When enforced, these provisions may lead to significant costs to a CPA firm that may not be covered by professional liability insurance. Most accountants' professional liability policies generally exclude insurance coverage for claims arising out of liability assumed under a contract unless that liability would have been present regardless of the existence of the contract. For example, absent a contractual agreement to do so, a CPA firm is generally not liable to reimburse a client for its legal costs or amounts paid by the client to settle claims made against the client by a third party.
In addition, many states have anti-indemnification statutes, some of which may prohibit the inclusion of additional insured provisions in contracts. The law that applies varies depending on where your firm or the client is located and where the services are rendered. Consultation with the firm's attorney is recommended in order to ensure the relevant state statute is applied.
How Should a CPA Firm Respond to These Demands?
Some CPA firms conclude that these client-requested provisions are not negotiable, and blindly accept the risk or decline to bid on the engagement, leading to a missed business opportunity. This conclusion is further buttressed by RFPs that state the client's terms must be accepted without modification or that use a proposal process that does not allow for further queries by the CPA firm.
However, there are alternatives when responding to the client's request.
Educate the client
- Advise the client that the proposed clauses may jeopardize the CPA firm's coverage, and the client's damages resulting from the firm's negligence in providing professional services may be covered by its professional liability policy anyway.
- Advise the client to consult with an attorney on how applicable state law may affect the defense and indemnification agreements. If statutes prohibit the inclusion of indemnification provisions in engagement letters, explain why these clauses would be unenforceable.
- Finally, appeal to the client's sense of fairness and explain that it is simply not reasonable for a CPA firm to indiscriminately be held liable for legal obligations to defend third-party claims asserted against the client.
Suggest alternative provisions instead of an indemnification provision
Many clients use defense and indemnification clauses in an attempt to control their own litigation costs and ensure their ability to recoup damages. Suggest alternative engagement letter provisions to accomplish the same goals.
- Professional liability insurance: Include a provision in the engagement letter that requires the firm to maintain professional liability insurance for the duration of the engagement and a specified period thereafter. The clause could reference the applicable professional liability policy, terms and limits, and required carrier rating. Attach a certificate of insurance from the carrier so the client may verify that the policy remains in force. A sample provision follows:
“[CPA Firm] shall, during the term of the engagement and for [X] years after termination of same by either you or us, maintain in full force and effect, accountants professional liability insurance coverage from an insurance carrier or carriers licensed to conduct business in the state of [State Name]. As of the policy effective date, such insurance carrier(s) shall be rated A- (Excellent), by A.M. Best with a Financial Size Category of Class VII or greater. Premiums for said insurance policy shall be paid by [CPA Firm]. Upon your written request, [CPA Firm] shall furnish certificates of insurance for the required professional liability insurance coverage. Such certificate of insurance shall indicate the minimum limits of liability per claim and in the aggregate as required by you.”
- Alternative dispute resolution: Suggest alternative dispute resolution (ADR), such as mediation or arbitration, to resolve disputes. ADR is generally less costly and much more efficient than civil litigation. While an ADR provision would not apply to claims made against the client by a third party asserting reliance on the CPA firm's work, this approach should help to allay clients' concerns regarding future legal bills. A sample provision follows:
“If a dispute arises out of or relates to the Agreement including the scope of services contained herein, or the breach thereof, and if the dispute cannot be settled through negotiation, the parties agree first to try to settle the dispute by mediation administered by the American Arbitration Association (“AAA”) under the AAA Professional Accounting and Related Services Dispute Resolution Rules before resorting to arbitration, litigation, or some other dispute resolution procedure. The mediator will be selected by the mutual agreement of the parties. If the parties cannot agree on a mediator, a mediator shall be designated by the AAA. The mediation will be conducted in [State Name]. The mediation will be treated as a settlement discussion and, therefore, all conversations during the mediation will be confidential. The mediator may not testify for either party in any later proceeding related to the dispute. No recording or transcript shall be made of the mediation proceedings. The costs of any mediation proceedings shall be shared equally by all parties. Any costs for legal representation shall be borne by the hiring party.”
Modify the client’s suggested indemnification provision
If a client insists upon an indemnification clause and the firm has determined that the benefit of the engagement and client potentially outweighs the risk, consider modifying the indemnification language suggested by the client. The following changes may help mitigate potential exposure to the firm and may reduce the likelihood that the CPA firm’s obligation to indemnify the client would be triggered.
Limit the firm’s indemnification obligation to claims involving fraud or gross negligence by the firm in the performance of specified professional services. The client’s burden of proof to establish such conduct is typically higher than ordinary negligence. In most instances, the client must demonstrate that the firm acted with reckless disregard or committed an intentional or malicious act in order to deceive. If the engagement is conducted in accordance with applicable professional standards, the risk is further mitigated.
- Define the specific event that would trigger the fraud or gross negligence indemnification obligation. For example, the entry of a judgment or award by a judge, jury or arbitrator or by a confession judgment based upon an admission of such acts by the firm.
- Consider limiting damages required to be paid under a fraud or gross negligence indemnification provision to a mutually agreed upon amount as documented in the engagement letter.
By including an indemnification provision to address fraud or gross negligence by the firm in conjunction with a professional liability insurance provision, the CPA firm can articulate to the client that these provisions, taken as a whole, provide the client with broad recourse for negligent acts (per the applicable professional liability policy) as well as uncovered fraudulent or malicious acts (via the indemnification clause).
Unfortunately, the RFP process at some organizations may not permit dialogue between the CPA firm and the prospective client. If this is the case, include a statement in the proposal response expressing the firm's desire to discuss the client's terms. Do not be reluctant to also include a disclaimer indicating the firm’s proposal is subject to the firm's standard client and engagement acceptance procedures, including the execution of a mutually agreed-upon engagement letter.
Stand firm and move on
If the above approaches are not successful and the client refuses to remove or modify the request for defense and indemnification, do not accept unlimited liability. A client's unwillingness to understand your position or work with you to find common ground during the proposal process does not foreshadow cooperation during the engagement.
CPA firms often seek indemnification from clients for any claims asserted against the firm that arise from management's misrepresentation or intentional withholding of information. If the client balks and does not wish to indemnify the firm without being indemnified itself (commonly referred to as mutual or reciprocal indemnification), further education of the client is required. Explain to the client that the risks and obligations of the firm and client are not the same, and therefore, mutual indemnification should not be expected.
Indemnification provisions are closely tied to a party's representations or warranties. With most CPA firm services, the firm relies on the client's representations or warranties. The firm should not expect to be liable to the client or to a third party in the event the representations or warranties are false. Moreover, the CPA firm does not operate the client's business. If a dispute arises with a third party as a result of the client's products, services, operations, acts, or omissions, the firm has no authority over and should not be held responsible to the third party for the client's acts.
A Final Note
Used effectively, an engagement letter can be a flexible and useful tool that describes and defines the engagement between the CPA firm and the client but also serves to appropriately allocate risk between the parties. A CPA firm should not be disconcerted by a client’s request for indemnification. The techniques suggested in this article represent a means of assuming a lower amount of risk while still addressing the client’s concerns.
Stanley D. Sterna (firstname.lastname@example.org) is a vice president of claims at Aon Insurance Services. Sarah Beckett Ference (email@example.com) is a risk control director at CNA. Aon is the administrator and CNA is the underwriter of the AICPA Professional Liability Insurance Program.
A version of this article first appeared in the April 2017 issue of the Journal of Accountancy. This article provides information, rather than advice or opinion. It is accurate to the best of the authors' knowledge as of the article date. This article should not be viewed as a substitute for recommendations of a retained professional. Such consultation is recommended in applying this material in any particular factual situations.
Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program. Aon Insurance Services, the National Program Administrator for the AICPA Professional Liability Program, is available at 800-221-3023 or visit cpai.com.
Examples are for illustrative purposes only and not intended to establish any standards of care, serve as legal advice, or acknowledge any given factual situation is covered under any CNA insurance policy. The relevant insurance policy provides actual terms, coverages, amounts, conditions, and exclusions for an insured. All products and services may not be available in all states and may be subject to change without notice.