Indemnification or hold harmless clauses typically provide that a client will indemnify or hold the CPA firm harmless in the event the firm sustains a loss resulting from claims arising from the CPA’s work. Indemnification clauses are typically intended to limit liability when client management knowingly makes misrepresentations to the CPA, causes or participates in fraud, conceals information from the CPA, or otherwise misleads the CPA.

Where permitted and enforceable, indemnification and hold harmless clauses can provide valuable protection to CPAs. They not only serve as a deterrent against a client considering a potential claim against a CPA, but also can be used to require the client to indemnify the CPA for attorney fees and costs, as well as the costs of any judgments or awards arising from claims made against the CPA by third parties. In addition to indemnification or hold harmless clauses, some CPAs use limitation of liability clauses, which typically limit the CPA’s liability to a portion of their fee or a defined dollar value.

Can You Use Them in Your Engagement Letters?

The answer is yes, except when prohibited by applicable law, regulation, or ethics rules.  The SEC, federal banking regulators and many state insurance departments prohibit indemnification or limitation of liability arrangements between the regulated entities and CPA firms performing audit or other attest services.  According to AICPA Ethics Interpretation 501-8¹, use of indemnification and liability limitation clauses disregarding the rules and requirements of regulators would be considered an ethics violation.

As a result, when considering the use of indemnification and liability limitation clauses in an audit or other attest engagement letter, if the client is in a regulated industry, check for regulatory rules prohibiting the use of these clauses.  AICPA ethics rules also apply.  With respect to indemnification and limitation of liability clauses, an AICPA Ethics Ruling indicates that clauses which limit liability resulting from knowing misrepresentations by client management do not impair independence.²  Accordingly, if indemnification clauses are limited in this manner and are not prohibited by regulation, they are permissible in engagement letters for attest services.  

For non-attest services, there are typically no restrictions on the use of indemnification and liability limitation clauses in engagement letters.  The terms in those clauses are subject to negotiation between the CPA and client.  While CPAs usually prefer the use of such clauses, they often face resistance from their clients.  So, it’s necessary to explain the rationale for using those clauses to clients.  For example, in engagements to prepare a compilation report for management use only, you can explain that because your work product is intended solely for their use, your firm should not be responsible for claims arising from use by others.  

Additionally, many states that have adopted a strict privity standard that prohibits third party lawsuits against a CPA firm unless there is evidence to show that the firm was aware that its work product would be provided to that third party³.  In the non-attest engagement letter, you can both restrict the use and distribution of work product and include an indemnification clause applicable to claims made by third parties.  If the client gives your work product to a third party without your consent and the third party later files a claim against you, you will have afforded your firm a valuable defense and in addition, the client will be required to indemnify you in connection with any expenses and costs associated with the claim. 

Are They Legally Enforceable?

In addition to ensuring that you can use indemnification and liability limitation clauses in an engagement letter without violating applicable law, regulations, or ethics rules, you need to know whether such clauses are enforceable in the applicable jurisdiction. 

The enforceability of such clauses is often a question of equity and public policy, subject to the dictates of the controlling legal jurisdiction. In many jurisdictions, an important enforceability factor is the ability to show that such clauses were negotiated between two parties with relatively equal bargaining power, and that the clauses were clearly set forth in the engagement letter, and understood and consented to by both parties to the agreement. 

Engage the client in a frank upfront discussion about the concept of equitable risk allocation, and document it in your client and engagement acceptance file. You may point out to the client that without indemnification, hold harmless and liability limitation clauses, your fees will be higher to compensate for the elevated risks.  Consult with your attorney about both the extent and wording of such clauses prior to presenting them to clients.  Depending on the advice of your attorney, you may be able to offer your services for different fees with and without such clauses.  Providing the client with the option may serve as evidence that the clauses were negotiated and not forced upon the client.

Can You Indemnify Your Client?

Another question often raised by CPAs is whether they can indemnify or defend their client for damages, losses or costs incurred by the client relating to their services, if requested by the client.  This typically occurs when a governmental entity presents a contract to the CPA firm covering proposed services. Under AICPA Ethics Ruling 102, Indemnification of a Client⁴, indemnifying the client for damages, losses, or costs arising from lawsuits, claims, or settlements that relate, directly or indirectly, to client acts impairs independence.  If a client requests such provision in connection with non-attest engagements, consult your professional liability insurance agent prior to entering into the agreement, as most professional liability policies exclude coverage for liability assumed when entering into a professional services agreement. Additionally, always consult your attorney prior to entering into any agreement to indemnify, defend or hold harmless another party in connection with your professional services. 

Summary

Where permissible, CPAs should consider using indemnification, hold harmless and limitation of liability clauses in engagement letters to limit their liability to clients and third parties. No single clause or wording is appropriate in all situations. Instead, clauses should be tailored to fit individual client situations and the assessed risks. As noted above, the enforceability of indemnification and limitation of liability clauses differs among legal jurisdictions. In certain locales, specific wording may be needed for the clause to be legally binding.  CPAs contemplating the use of such clauses in engagement letters should consult with their attorney regarding both the wording to be used and enforceability under applicable law.

August 2008

CNA, Accountants Professional Liability Risk Control, 333 S. Wabash Ave., Chicago, IL 60604

 The purpose of this article is to provide information, rather than advice or opinion. It is accurate to the best of the authors’ knowledge as of the date of the article. Accordingly, this article should not be viewed as a substitute for the guidance and recommendations of a retained professional. In addition, CNA does not endorse any coverages, systems, processes or protocols addressed herein unless they are produced or created by CNA.

Any references to non-CNA Web sites are provided solely for convenience, and CNA disclaims any responsibility with respect to such Web sites.

To the extent this article contains any examples, please note that they are for illustrative purposes only and any similarity to actual individuals, entities, places or situations is unintentional and purely coincidental.  In addition, any examples are not intended to establish any standards of care, to serve as legal advice appropriate for any particular factual situations, or to provide an acknowledgement that any given factual situation is covered under any CNA insurance policy.  Please remember that only the relevant insurance policy can provide the actual terms, coverages, amounts, conditions and exclusions for an insured.  All CNA products and services may not be available in all states and may be subject to change without notice.

Continental Casualty Company, one of the CNA insurance companies, is the underwriter of the AICPA Professional Liability Insurance Program.

 

CNA is a service mark registered with the United States Patent and Trademark Office.
Copyright © 2008 CNA.  All rights reserved.