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Basics In M&A: Indemnification Provisions

Last Updated: Jun 15, 2016

Article by Danielle Rosato and Tracy A. Belton

Kaye Scholer LLP

 

Given the recent postings about mergers & acquisitions for CPA firms, I thought this was a very good article about a crucial component of such transactions (Rickard Jorgensen).

In an M&A transaction, once the money has changed hands and the deal has closed, who should bear the burden when an unexpected liability occurs? Generally, the sellers desire to walk away from the transaction with the full benefit of the negotiated purchase price and minimal future liabilities related to the business or the asset that they sold. The buyer, by contrast, would like to minimize its liability for issues that arose under the watch of the previous owners and for damages arising from inaccuracies in how the business or asset was described during the negotiation.

Absent a contractual provision that addresses these concerns, buyers and sellers are left with general claims for breach of contract as their sole recourse. To give both parties more certainty as to who bears the burden of liabilities discovered after closing, parties can include provisions in the acquisition agreement, called indemnification provisions, that set forth the rules of the road. Indemnification is a contractual remedy and risk allocation mechanism that the parties to an M&A transaction negotiate to address certain post-closing issues and losses.1

The negotiation of the indemnification provisions is also often the most difficult section for non-M&A lawyers and junior lawyers to navigate. Deal lawyers use terms of art when discussing indemnification (such as “mini-baskets,” “baskets,” “materiality scrapes,” and “anti-sandbagging”) and the provisions themselves are littered with cross-references making them difficult to read and to understand. To assist with this minefield, this article sets forth general information about indemnification provisions, including the various terms of art used, and certain considerations of parties when drafting them. The purpose of this article is to serve as an introductory guide, to assist individuals unfamiliar with indemnification provisions, as well as to provide tips to deal lawyers negotiating them.

Indemnification Parties

Both the sellers and the buyer may desire to negotiate indemnification protections in an acquisition agreement. Generally, the person likely to recover damages in the event of an indemnifiable loss (the indemnitee) will negotiate for broad indemnification rights while the person likely to pay damages to the indemnitee for such loss (the indemnitor) will seek to limit the number of indemnifiable claims and the total damages associated therewith (see the section on Limitations below). After a closing, the buyer (as the new owner and operator of the asset or business that was sold) is most likely to be subject to the risk of post-closing losses and will often be the party to seek broader indemnification. Thus, this article will focus on the buyer as the indemnitee.

Indemnification Limitations

In negotiating indemnification provisions, the law permits great flexibility. The parties may choose to include indemnification as a remedy for any post-closing claim that they deem to be significant given the specific facts and circumstances of the deal. The parties may also choose to expand the scope of recoverable losses beyond what is typically available in litigation (e.g., include attorney’s fees, incidental, special, or consequential damages).

Because of this great flexibility to cover any and all claims, for any and all damages associated therewith, a key objective of an indemnitor is to limit the scope, the duration and the dollar amount of its indemnification obligations. Some of the most common mechanisms for such limitation are discussed below.

Scope

At the most basic level, the goal of indemnification is to provide the parties to a transaction with a streamlined means of seeking damages for issues that arise after the closing. Generally, indemnification provisions address damages arising from breaches of representations, warranties and covenants. However, the buyer will often want to expand the scope of its indemnification protection to address losses that could arise from certain liabilities identified by the buyer during the negotiation or the due diligence process and that would not otherwise be covered under customary indemnification for breaches of the representation and warranties. For example, assume the sellers made a representation that the company is not the subject of any ongoing governmental investigation, except for one specific ongoing investigation. If, after the closing, the government brought a claim against the company based on that investigation, the buyer would not have recourse against the sellers for a breach of the sellers’ representation, because the sellers disclosed the investigation. If the buyer would like to be indemnified for any damages arising from the disclosed investigation, it would need to include a specific indemnification provision addressing this point. Sellers generally resist these “special” indemnification items because sellers take the position that there are risks associated with any business and that the buyer, as the new owner of the business, should assume those risks.

Survival Period

The survival period sets forth the time during which the parties may bring an indemnification claim. Generally, buyers prefer long survival periods to ensure recourse regardless of when an issue arises. Conversely, sellers prefer short survival periods so that at some point the deal is “done” and they can use the proceeds from the sale without consideration of possible indemnification obligations.

Survival periods are often customized based on claim type. Survival periods for breaches of representations and warranties tend to range from between six months and two years after the closing; however, the survival period for certain “fundamental” representations and warranties will often be longer and sometimes indefinite. A “fundamental” representation is a representation that, at its core, is so basic and so important to the transaction that the buyer would not have agreed to the deal if it knew that the representation was false. For example, in a stock sale, the representation that the sellers own the stock that they are selling is often considered a fundamental representation. If the buyer knew that this representation was not true, it almost certainly would not have agreed to acquire such stock from the sellers, and regardless of when a claim relating to this fact arises, the buyer will want to be made whole. Sellers are generally amenable to longer survival periods for fundamental claims, but a hot button for negotiations is determining which of the representations and warranties are “fundamental.” Buyers often will try to include breaches of tax and environmental representations as “fundamental” because breaches of these representations can have such a high dollar impact on the buyer and, because of the nature of tax and environmental claims, can arise long after the closing.

Survival periods for breaches of post-closing covenants are also often indefinite. A post-closing covenant imposes an obligation on the parties to take certain actions after the closing. For example, the sellers may be required to make a post-closing regulatory filing, or perhaps the parties negotiated a post-closing obligation of the sellers to assist with transitioning the business to the buyer. Generally, sellers are amenable to longer periods of survival on their post-closing covenants because they have control over when the covenant is completed.

Survival periods for certain “special” indemnification items are negotiated on a case-by-case basis. Going back to our government investigation example, if a company is subject to a government investigation, it may take some time before the government formerly files suit against the company for a claim associated therewith (and the government may decide not to file suit at all). Consequently, the buyer will advocate that the survival period for a related claim should be quite long, if not indefinite, while the sellers will want to limit this period. Parties heavily negotiate the survival period for similar “special” indemnification claims.

Cap

In addition to limiting the scope of its indemnification obligations and the time period during which indemnification claims may be brought, the sellers will want to cap their damages for such claims. Caps are quite common for breaches of non-fundamental representations and warranties, and are often expressed as a percentage of the purchase price. Once again, buyers will often seek to have the fundamental representations treated differently and will argue that the cap for such claims should be unlimited. Sellers often agree to higher caps for fundamental representations but frequently only agree to cap their damages at the total amount of consideration they received in the transaction. Parties also heavily negotiate whether “special” indemnification claims should be capped and, if so, at how much.

Mini-Baskets and Baskets

Sellers also negotiate for other dollar amount limitations on their indemnification liability, specifically “mini-baskets” and “baskets.”

  • A “mini-basket” is the minimum amount an indemnitee’s losses must exceed for a single claim before it may bring such a claim.
  • A “basket” is the minimum amount an indemnitee’s total losses must exceed before it may bring any claim for indemnification.2
  • A basket that is a true “deductible” means that the indemnitor will only be liable for losses that exceed the threshold amount. Think of this like your health insurance deductible. Your health insurance only picks up the tab after you pay for the first $x amount of the claim.
  • A “tipping” basket means that the indemnitor will be liable for the entire amount of losses, from dollar one, once the threshold is exceeded (i.e., the basket “tips” and the indemnitor is liable for the full amount of any losses).

What is the purpose of these baskets? The purpose of a “mini-basket” is to delineate between material and immaterial claims. Sellers do not want to be bothered with every claim that arises after the closing. For example, presume an acquisition agreement included a representation that the company had the authority to do business in all states where such authority was required. Post-closing, the buyer learned that the company should have been authorized to do business in Virginia, but it was not, and that the buyer will have to pay $1,000 to obtain such qualification. No other losses occurred because of the lack of qualification. Under these facts, the sellers would argue that, because the fee is so small, the buyer’s losses are immaterial and the buyer should bear the cost. Buyers are more inclined to agree to a “mini-basket” when paired with a “materiality scrape,” discussed below.

The rationale for including a “tipping” basket is very similar to that of including a “mini-basket”: the sellers would like the buyer to be prevented from making claims under the indemnity until the buyer’s cumulative losses exceed a certain threshold (if they ever do). A “deductible” also prevents the buyer from bringing “immaterial” claims, but also acts as a risk allocation mechanism. By incorporating a “deductible,” the sellers are requiring the buyer to bear the burden of the first tranche of their losses. Note, this is a purely economic business point and the buyer will consider the effect of the deductible when agreeing upon a purchase price.

To view the full article in the Kaye Scholar Newsletter please click here.

Footnotes

1 Indemnification provisions most often arise in private M&A transactions (i.e., where the company being acquired is a private company). Indemnification provisions are less common in public M&A transactions both through convention and due to the added complexity of recovering from a larger group of stockholders. Indemnification can sometimes be given by a controlling shareholder in a public deal. Contingent value rights can also function as a type of indemnification mechanism in public deals.

2 “Mini-baskets” and “baskets” often only apply to indemnification for breaches of non-fundamental representations and warranties

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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