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Current Developments in the Commercial Divisions of the
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Posted: July 1, 2019

Failure to Give Required Notice Doomed Indemnification Claim

On June 24, 2019, Justice Risi of the Queens County Commercial Division issued a decision in Quantum Servicing Corp. v. First Madison Servs. LLC, 2019 NY Slip Op. 51022(U), holding that the failure to give the required notice doomed a claim for contractual indemnification, explaining:

In Conergics Corp. v. Dearborn Mid-W. Conveyor Co., the seller of a corporation (Conergics) entered into a stock purchase agreement (SPA) with the buyer of the corporation (DMW) on November 3, 2007 and subsequently began an action against the latter for a judgment declaring that that it was not required to indemnify the buyer for certain tax losses. The buyer, alleging that the seller had breached the SPA by refusing to provide indemnification for the tax losses, counterclaimed for a declaratory judgment that the seller was obligated to provide it with indemnification. The dispute concerned a section of the SPA which provided in relevant part that “the Seller [Conergics] shall indemnify the Buyer [DMW] and hold the Buyer harmless from and against… all Taxes of the Company [Dearborn] for all taxable periods, or portions thereof, ending on or before the Closing Date in excess of the amount of Taxes reflected in the determination of Net Working Capital . . .”

In Conergics, Section 8.1(c) of the SPA required a party seeking indemnification with respect to a tax audit to give the other party “‘prompt[ ]’ written notice of the commencement of such an audit, but further provides that ‘a failure to give such notice will not affect’ the asserted indemnification right ‘except to the extent that [the indemnifying party] is actually prejudiced thereby.'” Section 8.5(b) of the SPA provided in substance that the seller would have the “the sole right” to represent the sold company’s interests in any audit, examination, or proceeding “by any Taxing Authority (‘Tax Audit’) with respect to taxable periods or portions thereof ending on or before the Closing Date.” Moreover, the SPA required the parties to “cooperate fully” with each other “in connection with any Tax Audit.”

On April 19, 2012, a Mexican tax authority (SAT) sent a letter to Dearborn announcing its determination to reopen the audit of Dearborn’s 2004 tax year (the second audit). Neither DMW nor Dearborn provided Conergics with written notice of the second audit in the manner specified by section 13.8 of the SPA until January 24, 2014, twenty-one months after the defendants had received notice of the second audit from the SAT in April of 2012. Instead, Dearborn assumed its own defense of the second audit in the proceedings before the SAT and in court by commencing a proceeding in a Mexican federal court to dispute whether the tax authority had the constitutional authority to conduct the second audit. On November 19, 2013, the SAT issued an adverse determination, but DMW waited two months before sending Conergics a letter, dated January 24, 2014, giving notice of the second audit and demanding indemnification pursuant to the SPA. By letter dated January 30, 2014, an attorney for Conergics rejected the indemnification demand and refused to assume the defense of the second audit on the grounds that defendants’ 21-month delay in giving notice had prejudiced Conergics by depriving it of its right to defend the audit under section 8.5(b) of the SPA. DMW continued the defense of the second audit, but without abandoning its claim for indemnification. The indemnification dispute was eventually added to others in a case already pending in the courts of New York State, and the indemnification dispute eventually reached the Appellate Division, First Department.

The Appellate Division stated early in its analysis of the case: “[D]efendants’ failure to notify plaintiffs of the second audit until 21 months after it was commenced—a breach of the SPA’s notice provision that, to reiterate, is not disputed on this appeal—relieves plaintiffs of their indemnity obligations with respect to the second audit only in the event plaintiffs establish that this breach caused them ‘actual[ ] prejudice[ ]’.” (Conergics Corp. v. Dearborn Mid-W. Conveyor Co., supra, 523,) “What we must determine,” the Appellate Court continued,” is the standard that plaintiffs must meet to demonstrate that the untimely notice of the second audit that they received caused them actual prejudice, and whether, on this record, that standard has been met.” (Conergics Corp. v. Dearborn Mid-W. Conveyor Co., supra, 523,) “We agree with plaintiffs” the Appellate Division stated further, “in view of their ‘sole right’ under the SPA to ‘control’ the defense of the second audit (expressly including the rights to choose counsel and to settle), plaintiffs need not establish ‘tangible economic injury’ to show that they have been actually prejudiced by the late notice. Rather, to establish actual prejudice due to late notice, it suffices for an indemnitor afforded the right to control the defense of an indemnifiable claim to show that it was deprived of its right to exercise that right for a material portion of the proceedings on the claim.” (Conergics Corp. v. Dearborn Mid-W. Conveyor Co., supra, 523—24.) “[W]e hold that such late notice actually prejudices the indemnitor when it results in a material deprivation of the indemnitor’s right to control the defense of the claim…” (Conergics Corp. v. Dearborn Mid-W. Conveyor Co., supra, 527,)

As a second reason for its decision, the Appellate Division added: “An additional ground for relieving plaintiffs of their indemnity obligations with respect to the second audit—independent of defendants’ failure to give timely notice—is that the deprivation of plaintiffs’ ‘sole right’ to defend the audit for 21 months, until after the SAT had completed its review and rendered an adverse assessment, constituted a sufficiently material breach of the indemnity provisions of the SPA to excuse plaintiffs’ duty to indemnify with respect to this audit.” (Conergics Corp. v. Dearborn Mid-W. Conveyor Co., supra, 530.)

The court agrees with the parties that Conergics is the controlling case although the wording of the Madison SPA, “except to the extent of any damage or liability caused or arising out of such delay,” is not the wording, “actually prejudiced, ” used in the Conergics SPA. As the attorney for Madison states in his memorandum of law dated August 7, 2018: ” There is no material difference between the ‘actual[ly] prejudice[d]’ language used in the Conergics SPA and the ‘any damage’ language used in the parties’ [to this action] SPA. Under both the Merriam-Webster dictionary and Black’s Law Dictionary, prejudice is defined respectively as ‘injury or damage resulting from judgment or action of another in disregard to one’s rights’ and ‘[d]amage or detriment to one’s legal rights.’ Also, as explained in Black’s Law Dictionary, the singular ‘damage’ (as used in the SPA) “is to be distinguished from its plural ‘damages’ which means a compensation of money.” “Moreover, the court notes that the Madison SPA expresses an intent to include both the impairment of legal rights and the obligation to pay compensation from the use of two words, “damage” and “liability.”

The attorney for Quantum argues that “Conergics while controlling is not dispositive.” This court finds Conergics both controlling and dispositive. It is true that the Appellate Division did not establish a definite, fixed threshold which must be crossed for prejudice to occur, but stated instead we need not define the lower limit of what would constitute a material deprivation of plaintiffs’ ‘sole right’ to control the defense of the second audit. The Appellate Division simply found that the threshold had been crossed under the facts and circumstances of the case. Similarly, this court finds that Quantum crossed the threshold under the facts and circumstances of this case. The court notes in particular that Quantum did not provide the defendants with notice of the claim in the manner required by the SPA until March 5, 2018, thirty-two months after Quantum first learned of the Trauts’ grievance. The Trauts began their federal action on September 21, 2015, and it remained pending until March 9, 2018, however, Quantum did not provide the defendants with notice of the claim in the manner required by the SPA until March 5, 2018, days before the case settled. Due to the long delay in providing Madison with notice of the Trauts’ claim, Quantum deprived Madison of the opportunity to obtain an earlier, possibly more favorable, settlement and left the defendant with the consequences of actions not taken by Quantum, including but not limited to incurring $162,839 in legal fees and costs in defense of the Traut claim. There is no issue of fact in this case concerning whether Madison suffered damage because Madison, an indemnifying party afforded the right to control the defense of an indemnifiable claim, established as a matter of law that it was deprived of its right to exercise that right for a material portion of the proceedings on the claim.

Quantum did not successfully distinguish Conergics and instead relies on cases that are inapposite. For example, CIH Int’l Holdings, LLC v. BT United States, LLC, (821 F. Supp. 2d 604[S.D.NY 2011]) decided approximately five years before Conergics , is inconsistent with the Appellate Division case, because it requires an allegation of tangible economic injury: CIH fails to allege that it suffered any tangible economic injury as a result of the allegedly delayed notice.

There are no issues of fact to be tried in this case, and Madison, not Quantum, successfully demonstrated its entitlement to summary judgment.

(Internal quotations and citations omitted).

We frequently litigate issues relating to the advancement or indemnification of litigation expenses such as attorneys’ fees to corporate officers, directors and employees. Contact Schlam Stone & Dolan partner John Lundin at jlundin@schlamstone.com if you or a client have questions regarding indemnification and advancement claims.

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