By Stanley D. Sterna, J.D., and Sarah Beckett Ference, CPA
This article originally appeared in the April 2017 issue of the Journal of Accountancy. Minor updates have been made to supplement previously provided advice. Advice provided in this article has been reviewed and remains current.
Have you ever faced this situation? Your firm is excited about a new client opportunity. The firm sends its standard engagement letter and terms and conditions to the new client for its review and signature. You receive the client’s feedback; 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 internal or external attorney may also suggest such a provision while reviewing the firms’ 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.
How should a CPA Firm Respond to these Demands?
Some CPA firms conclude that these client-requested provisions are not negotiable, and accept the risk. This conclusion is further buttressed by gatekeepers, such as a client’s procurement group or general counsel that limit further queries by the CPA firm.
However, there are alternatives when responding to the client's request.
Educate the client
Suggest alternative provisions
- 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 the client’s legal obligations to defend third-party claims made against the client. If a third party is damaged by the firm’s services, they can bring a claim against the firm directly.
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.
Modify the client’s suggested indemnification provision
- 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.
- 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 allay the majority of clients' concerns regarding future legal bills.
If a client insists upon an indemnification clause and the firm has determined that the benefit of the engagement and the 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 firm’s indemnification obligation may be triggered.
Stand firm and move on
- Limit the firm’s indemnification obligation to claims caused by the firm’s fraud or gross negligence in the performance of the specified 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.
- Limit the 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.
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 engagement letter process does not foreshadow cooperation during the engagement.
CPA firms often seek indemnification from clients for any claims made 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 called mutual indemnification), further education for 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.
Stan Sterna is a vice president of claims at Aon Insurance Services. Sarah Beckett Ference is a risk control director at CNA. For more information about this article, contact firstname.lastname@example.org.
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