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Double Checking those Indemnification Agreements

Dispatches from the Trenches

This issue of Dispatches from the Trenches discusses a pro-lessor case relating to the benefits that the Uniform Commercial Code grants to "financing leases." It might also prompt you to double-check your indemnification agreements.

Cannon Financial Services v. Medico Stationery Service, 2002 WL 31750234 (N.Y.A.D. 1 Dept.)

This case is a great example of the way courts are supposed to treat Uniform Commercial Code "finance leases." Lessee was unhappy with the equipment and stopped paying the lessor. The lessor sued and the court granted lessor summary judgment, requiring the lessee to make payments regardless of whether the equipment was satisfactory. The court cited provisions in the lease which explicitly provided: (1) that the lessor made no representations or warranties of any kind with respect to the equipment; (2) that all warranties were made by the supplier, dealer or manufacturer; and (3) that the lessee was required to make payments no matter what might happen. The court also noted that "[t]hese provisions were typical of a finance lease as defined in U.C.C. 2-A-103(g) and [that] the subject agreement states that it was intended as such."

Other helpful holdings of the court include: (1) a dismissal of the lessee's complaint that the lessor and the supplier of the equipment were wholly owned subsidiaries of the manufacturer (the court noted that "no basis exists for piercing these corporate veils"); and (2) a dismissal of the lessee's complaint that the lease only provided the lessee with ten days to inspect the equipment before the hell or high water clause kicked in. Because of the court's strong understanding of Uniform Commercial Code finance leases, its opinion took less than a single page.

The terminology "finance lease" is sometimes a source of confusion. Many people in the leasing industry use that term to refer to a transaction which, although called a "lease", is actually a loan from the lessor to the lessee with the "leased property" serving as collateral for the loan—such as a lease with a one dollar purchase option or a lease with a mandatory purchase option. Those people distinguish these sorts of finance or financing leases from “true leases” which are also called "tax leases" or "operating leases."

Under Article 2A of the Uniform Commercial Code (the "UCC"), the term "finance lease" is defined to be a special kind of true lease which involves three parties--the lessor, the lessee and the supplier of the leased equipment. In such transactions: (1) the lessor does not select, manufacture, or supply the goods; (2) the lessor does not own the goods before the lease was arranged; and (3) the lessee either approves the purchase contract or receives specified warranty and supplier information before signing the lease agreement. Due to the limited role that a lessor plays in a finance lease and the important role that such transactions play in our economy, Article 2A of the UCC offers special statutory protection to lessors who lease goods in this manner.

As noted in the comments to the UCC, the various sections of Article 2A operate to "substitute the supplier of the goods for the lessor as the party responsible for warranties and the like." UCC §2A-101. For example §2A-209 automatically extends the seller’s warranties (and their exclusions) to the lessee and automatically excludes any implied warranties of fitness or merchantability by the lessor. In addition, §2A-516 and §2A-517 state that, once the lessee has accepted the property, it has no right to revoke that acceptance. Most importantly, §2A-407 and §2A-508 create a statutory "hell or high water" clause by making the lessee’s obligations (including payment obligations) irrevocable and independent of the lessor’s or supplier’ s obligations. In other words, once the lessee accepts property under a finance lease, the lessee is obligated by statute to perform its obligations under that lease "come hell or high water."

All of the aforementioned protections afforded lessors under Finance Leases can be obtained through contractual provisions. See UCC §7-2A-103, comment (g). Well respected authorities therefore encourage lessors to include express "hell or high water" clauses if for no other reason than to avoid arguments about whether a "finance lease" is involved. See e.g. Ian Shrank and Arnold G. Gough, Equipment Leasing-Leveraged Leasing (PLI 4th ed. 1999), Vol. 1, §3:1.5[D].

Cincinnati Insurance Company v. Torke Coffee Roasting Company, 2002 WL 31416104 (Wis. App.) and McNally & Nimergood v. Neumann – Kiewit Constructors, Inc., 648 N.W.2d 564 (Iowa 2002).

Any party that desires to be indemnified with respect to losses that result from its own negligence would be wise to make sure their contracts explicitly say so.

Cincinnati v. Torke: Torke Coffee Roasting Company ("Torke") entered into an agreement with Heinemann’s Candy Company ("Heinemann’s") pursuant to which Torke provided Heinemann’s with a coffee machine at no cost so long as Heinemann’s agreed to purchase all of its products from Torke. The agreement: (1) required Torke to check and service the machine at periodic intervals to insure the safe operation of the equipment; and (2) required Heinemann’s to indemnify and save Torke harmless from any and all claims or damages arising out of the use of such equipment by Heinemann’s or its employees or patrons.

A water supply line that was attached to equipment broke and resulted in damage to Heinemann's property. Heinemann’s collected from its insurance provider ("Cincinnati") who stepped into Heinemann's shoes with respect to all of Heinemann's rights against Torke. Cincinnati brought suit against Torke, alleging that Torke breached its duty to service and maintain the equipment. The trial court dismissed the suit, holding that: (1) Cincinnati's claim (which derived from Heinemann's claim) could only be brought if Heinemann's itself could bring the claim; and (2) since Heinemann's was obligated to indemnify Torke for any losses resulting from the suit, it was barred from bringing the suit in the first place.

On appeal, the Wisconsin Appellate Court reversed, noting that a contractual agreement to indemnify a party against the consequences of its own negligence is not against public policy but that the general rule is that an indemnification agreement will not be construed to cover an indemnified party for its own negligent acts absent a specific and express statement in the agreement to that effect. According to the court, the underlying rationale is that the indemnifying party: (1) is unlikely to have good information about the likelihood of the indemnified party behaving negligently; and (2) is not in a position to prevent such behavior. Therefore, it is unlikely that the indemnifying party will have agreed to insure the other party against the consequences of that party's negligence. Accordingly, indemnification agreements will generally only be interpreted to insure a party for its own negligent acts if the agreement expressly states so. In the instant case, there was no express provision and Heinemann’s therefore had no obligation to indemnify Torke for any damages.

McNally & Nimergood v. Neumann: McNally & Nimergood ("Lessor") leased a construction crane to Neumann – Kiewit Constructors ("Lessee") pursuant to a lease which was a "bare rental"-- meaning that the crane was leased without an operator. The agreement required Lessee to maintain the crane in good working order and to repair it as necessary.

When one of Lessee’s employees was seriously injured by the crane, the employee sued Lessee for negligence, alleging that it failed to inspect the crane, failed to maintain and service the crane, and failed to properly operate the crane. The employee also sued Lessor for negligence, alleging that it failed to inspect and maintain the crane prior to its delivery. The employee's recovery against Lessee was limited by workers compensation laws and Lessee was quickly dismissed from the suit. Lessor subsequently settled the claim for $500,000 and immediately began demanding indemnification from Lessee pursuant to the terms of the lease agreement.

The court noted that indemnification agreements are generally subject to the same rules of formation, validity and construction as other contracts. However, the court articulated a special rule of construction that applied to indemnification contracts when the contract is claimed to relieve the indemnified party from liability resulting from its own negligence. In the instant case, Lessor's settlement was of claims that alleged negligence on the part of Lessor and this rule of strict construction was therefore applicable.

In some past cases, the court permitted a party to be indemnified for losses resulting from its own negligence when such negligence was explicitly addressed in the indemnification agreement. In other past cases, where the language was general and did not specifically mention the indemnified party's negligence, the court held that the agreement did not require indemnification for losses resulting from such negligence. The court erased any confusion that might have resulted from such past holdings by noting that such cases were not intended to create a fixed limitation on the court’s rule of construction and that the key issue remains the clear intent of the parties. As such, Iowa courts are allowed to discern the intent of the parties even if the contract does not mention the negligence of the indemnified party. That flexibility did not help Lessor in this particular case and the court still held that the language did not manifest an intention for Lessee to indemnify Lessor for losses resulting from Lessor's own negligence.

Article appeared in the March, 2003 issue of the Monitor.
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