In 1996, a licensing manager for Taco Bell attended a trade show and came across a cartoon Chihuahua dog character called “Psycho Chihuahua.” The manager expressed an interest in using the character for its marketing campaigns, but after numerous focus groups and extensive discussions with the creators of the character, Taco Bell decided not to close a deal with the creators of the character.

One year later, Taco Bell signed on TBWA Chiat/Day (TBWA) as its new advertising agency. At one point, someone from the Taco Bell marketing department shipped the agency a box of Psycho Chihuahua materials. When the ad agency presented Taco Bell with a variety of ideas for a new marketing campaign, Taco Bell selected a campaign based on the now-famous Chihuahua dog character. Taco Bell did not execute a license with the creators of the Psycho Chihuahua.

The creators of the Psycho Chihuahua character subsequently filed and won a highly-publicized lawsuit against Taco Bell for a judgment of $42 million. Taco Bell in turn filed a lawsuit against TBWA, claiming that the TBWA breached the agreement by failing to perform due diligence on the Chihuahua campaign (e.g., clearing copy, uncovering an application for a trademark and bringing the risk of liability to Taco Bell’s position). Citing the indemnification clause in the agency agreement, Taco Bell sought to have the agency pay for the full cost of the judgment.

Indemnification clauses are common in services agreements, especially in areas of business where a contractor’s performance of services may expose the client company to risk. The indemnification clause makes one or both parties responsible for liability that results from failure to properly meet the obligations specified in the contract. In TBWA’s agency agreement, Taco Bell would indemnify TBWA for any liability resulting from risks brought to the attention of, discussed with and approved by Taco Bell. Likewise, TBWA agreed to indemnify Taco Bell for any liabilities resulting from materials created, produced or provided by TBWA for Taco Bell. In a separate clause, TBWA also agreed that it would “exercise its best judgment in the preparation and placing of [Taco Bell’s] advertising and publicity, with a view to avoiding any claims, proceedings, or suits.”

Contract language was critical in the case of Taco Bell Corp. v. TBWA Chiat/Day, since court examined the indemnification clause closely to determine whether it was TBWA’s responsibility to clear the rights for use of Psycho Chihuahua. Of special importance was the fact that the indemnification clause did not require TBWA to perform any copy clearance, trademark searches or risk reporting. Likewise, the court noted that the indemnification clause did not mention the need for TBWA to obtain approval of risks from Taco Bell before moving forward. The clause only required Taco Bell to indemnify the ad agency for liability resulting from risks proposed by Taco Bell. TBWA had agreed to exercise its best judgment in preparing the ad campaign, and the court refused to create obligations beyond what was explicitly written into the contract.

Beyond the $42 million judgment and the epic ten-year legal battle that followed, the lawsuit over the Taco Bell Chihuahua campaign is a corporate worst-case scenario that underscores the importance of due diligence. It is important to not only create, review and adhere to internal policies that reduce the risk of litigation, but also to execute agreements with indemnification clauses that fully anticipate risk.

-By Dava Casoni, Annie Lin