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Indemnification provisions in client engagement letters: Old tool given new life for limiting liability of accountants

January 2009

As we have repeatedly advised, carefully tailored engagement letters are of growing importance in reducing accountants' liability exposure.  There are numerous provisions incorporated in an engagement letter, some of which can protect the accountant from liability, both from the client and third parties.  However, until recently, it was unclear if one of the most important contractual provisions would be enforced if placed in an accountant's engagement letter: an indemnification and hold harmless provision.

 

An indemnity provision shifts the cost of liability from one contractual party to the other.  In the context of an accountant/client relationship, it can shift the accountant's potential liability to third parties, such as the client's bank, from the accountant to the client.  A hold harmless provision is essentially an anticipatory release in that it contractually waives one party's right to sue the other under certain circumstances.

 

There have been few cases in New York interpreting these provisions as they apply to accounting firm engagement letters.  However, late last year, the Appellate Division of the Supreme Court of the State of New York issued a decision specifically upholding the propriety of such a provision in an accountant's engagement letter.  In Kimber Mfg., Inc. v. Marcum & Kliegman LLP (Index No. 20559/04, Nov. 18, 2008), the court upheld an indemnification and hold harmless provision contained within an engagement letter.

 

In Kimber Mfg., Inc. v. Marcum & Kliegman LLP, the engagement letter included a provision by which the client would indemnify the accounting firm and the firm's partners, principals, and employees, and hold them harmless from all claims, liabilities, losses, and costs arising in circumstances where there has been a known misrepresentation by a member of the Company's management, regardless of whether such person was acting in the Company's interest.1  The appellate court held that under the specific circumstances presented by the facts of the case, the clause was both valid and applicable.  Unfortunately, the appellate court was silent as to whether a generally worded indemnification and hold harmless clause would survive judicial scrutiny.

 

Although the scope of the indemnification clause in Kimber is relatively narrow, applying only to known misrepresentation by a member of the Company's management, broader clauses have been upheld in other situations.  The court cited such cases, in which parties contracted to indemnify and hold harmless for ordinary negligence, in support of its conclusion in the Kimber case.2 3  Thus, although it is yet to be conclusively established that a generally worded indemnification clause and hold harmless agreement would be enforceable in the context of a professional accounting engagement, the law seems to be leaning in that direction.

 

Using the guidance provided by the Kimber case, a carefully worded and specifically tailored indemnification and hold harmless clause should be considered in almost every engagement letter.  Indeed, this type of clause will permit claims against the accountant to be extinguished at the onset of the litigation rather than at the end of lengthy and expensive discovery, as is often the case.  However, because of the uncertainty of whether a generally worded or vaguely worded clause would be upheld by a court in New York, it is critical for the provision to be both carefully worded and tailored to the particular engagement.  Tailoring the engagement letter provision takes on additional importance where attest functions requiring independence are involved.

 


 

1) The engagement letter in the Kimber case was dated October 15, 1998, and concerned review of financial statements for the year ended December 31, 1998.  Accordingly, the provision in this engagement letter pre-dated the discussions and issues raised by Proposed Ethics Interpretation 101-16.  Interpretation 101-16, as respects indemnification and limitation of liability provisions, was not adopted, but still warrants some consideration in this context.

 

2) Levine v. Shell Oil Co., 28 N.Y.2d 205, 211-212 (N.Y. 1971).

 

3) 237 W. 230 Street Realty Corp. v. Castle Oil Corp., 35 AD3d 847, 847 (N.Y. 2006). (Where Appellate Division upheld an agreement that unambiguously required the indemnification for negligence.)

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