Indemnity Clauses, Claims & Controversies

This article is part of a continuing series by Frank Jones outlining recurring issues of critical importance to sellers in private company M&A. Previous topics include Equity Rolls and Net Working Capital Purchase Price Adjustments.

Indemnification is a key component in virtually every M&A deal, serving as a detailed and nuanced contractual risk allocation device between the Buyer and Seller. Though drafted in a two-way fashion, indemnity operates in the real world to provide the Buyer with post-Closing protection against losses arising from breaches of Seller’s representations, warranties and covenants set forth in the purchase agreement, as well as responsibility for certain other liabilities that the Buyer may otherwise inherit post-Closing.

Indemnification provisions are often heavily negotiated by the parties and specific terms can vary widely based on the structure of the transaction, the nature of the risks involved and the relative bargaining power and sophistication of the parties, among other factors. Sellers often argue that every operating business experiences some claims and losses in the ordinary course and that Buyers should not expect to acquire a “perfect” company but instead be prepared to absorb some ordinary level of claims and liabilities. Buyers predictably counter that the deal was “fully and fairly priced” at the outset and is being pursued on the express expectation that a “clean” business is to be acquired, as reflected in the Seller’s negotiated representations, warranties and covenants. Typically appearing near the end of an already long purchase agreement, indemnification provisions should not be viewed as boilerplate or technical legal language. The stakes in negotiation and drafting are indeed high, as recent studies have found that 30% of private M&A deals resulted in post-Closing indemnification claims and that the size and resolution times for such claims are increasing as well.

Below is a summary of certain key indemnification issues a Seller will need to navigate during M&A negotiations.

Types of Indemnification (defines the distinct categories triggering indemnification coverage)

• Breaches of purchase agreement reps and warranties
  • Reps and warranties are statements of existing fact (e.g., a list of material contracts)
• Breaches of purchase agreement covenants
• Covenants are promises made by one party to the other, either pre-Closing (e.g., operating the business only in the ordinary course) or post-Closing (e.g., non-compete agreements)

• Other specifically negotiated indemnities
  • Typically a “hotspot” outgrowth of the Buyer’s due diligence of the business

Different Types of Reps & Warranties Typically Covered by Indemnification Provisions (typically includes (i) fundamental reps, (ii) special reps and (iii) “garden variety” or general reps)

• “Fundamental” reps typically include organization/good standing, authority and enforceability, equity ownership/capitalization, title to assets, brokers, tax and other matters crucial to a Buyer which go to the heart of its desire to do the deal
• “Special” reps often cover deal-specific issues or liabilities that are uncovered during the Buyer’s due diligence such as employment/benefits, IP, environmental and other identified potentially high-risk liabilities
• “General” reps cover a broad array of other, largely operational, matters. All reps other than Fundamental and Special reps are General reps by default

Survival Period (the time period during which indemnity claims may be asserted)

• Typical survival periods for breaches of General reps range from 12 to 24 months (15 months is both the average and the median)
• Fundamental reps will have significantly longer negotiated survival periods, sometimes indefinitely
• Special reps often steer a middle course and will likely survive until the expiration of the statute of limitations period applicable to the underlying claim (typically 3 to 7 years) or some other longer negotiated survival period
• Fraud-based indemnity claims usually survive indefinitely and may be asserted at anytime

Deductibles/”Baskets” (dollar threshold that must be met before indemnification claims can be asserted)

Baskets are commonly used to avoid the parties “nickel-and-diming” each other with small, insignificant claims. In negotiating baskets, a Seller will clearly seek the highest basket possible, while a Buyer will seek the lowest basket, or no basket at all. Baskets are often determined as a percentage of the purchase price; practices vary widely, but for other than small deals 0.5% to 1% is typical. A variety of approaches are used, but most common are:

• True Deductible (or “non-tippling”) Basket: Claims must exceed a certain dollar amount before indemnification kicks in; then recovery is limited to only the excess amount. Akin to the classic auto policy deductible, this is the most common approach, utilized approximately 70% of the time for other than small deals. Greatly preferred by Sellers over a tipping basket.
• Tipping (or “first dollar”) Basket: Once the dollar threshold is met, the indemnifying party is liable for all associated damages from the very first dollar. More common in small deals
• “Mini-baskets”: A sub-threshold within the (true deductible or tipping) main basket that sets a minimum per claim amount. Individual claims (or related claims) below this amount are disregarded and not aggregated or counted at all towards the main basket amount. Often used (for approximately 30% of deals) with tipping baskets
• Hybrid Baskets: A compromise approach, using a partially-tipping basket. Once the basket “tips,” an amount less than the first dollar is recoverable
• Special Baskets: Separate and special baskets for particular types of claims, meriting different thresholds, approaches and handling

Baskets typically are limited to providing Seller protection only for claims involving breaches of its reps and warranties; rarely (less than 5% of deals) do they apply to covenant breaches. Baskets are often lower in amount for deals where Representation & Warranty Insurance (“RWI”) is used

Caps (the maximum amount of the indemnifying party’s liability for successful indemnification claims)

In negotiating caps, a Seller will obviously seek the lowest cap possible, while a Buyer will seek a high cap or no cap at all. Common approaches include the following features:

• Often expressed (or at least calculated) as a percentage of the overall transaction value
• Like survival periods, caps will inevitably vary based on the type of claim (General rep vs. Fundamental rep vs. Special rep) and the “Fraud” definition
  • For General reps, the cap is often set at approximately 10% of the total Purchase Price
  • For Special reps, the cap is often set between 25% and 50% or more of the Purchase Price
  • For Fundamental reps, the cap is often set between 50% and 100% of the Purchase Price
  • Breaches of reps involving Fraud are typically uncapped
• Caps typically operate to limit claims only for breaches of Seller’s reps and warranties; rarely (less than 10% of deals) do they apply to covenant breaches
• Caps are typically lower in amount for deals in which RWI is used
• Per shareholder caps (typically tied to the amount of purchase price each receives) are also common, depending upon the size and makeup of the Seller’s shareholder base

Escrows & Holdbacks (segregated funds set or held aside from the purchase price for a period of time as security for Buyer’s potential indemnification claims)

• Typically held by a third-party bank independent of both Buyer and Seller
• Amounts and duration typically aligned with those of the general indemnification cap
• May be negotiated to serve as the sole source of recovery for certain claims
• Other common security devices available to protect the Buyer’s indemnification rights may include personal guaranties and set-off rights against future earnout, deferred purchase price or any other post-Closing payments to Sellers

Importance of Qualifiers in Agreeing to Reps and Warranties (qualifiers and limitations set forth within Seller's actual reps and warranties)

• Can operate to head indemnification claims off at the pass by excluding matters otherwise constituting a “breach” of a rep. The most common of these qualifications are:
  • Knowledge
  • General materiality
  • Material adverse effect
  • "Look-back” and other time periods
  • Dollar thresholds

“Sandbagging” Permitted? (whether the Buyer can assert indemnification claims for breaches of which it was aware before Closing)

• Pro-sandbagging provisions allow claims regardless of the Buyer's knowledge
• Anti-sandbagging provisions prevent claims if the Buyer was aware of the breach at the time of Closing
• Though a bit counter-intuitive, parties often strategically choose to remain silent on this point in the purchase agreement and instead rely by default on case law and other laws of the agreed-to controlling state law set forth in the purchase agreement

“Materiality Scrapes” (a provision that disregards materiality qualifiers in reps and warranties for certain negotiated indemnification purposes)

• Can be applied to determine whether a breach has occurred (a “breach scrape”) and/or to calculate damages for which indemnification may be sought (a “damage scrape”)
• The decidedly pro-Buyer “double materiality” scrape is both a breach and a damage scrape, ensuring that even minor breaches (otherwise considered immaterial) are taken into account and Buyer can claim damages for all breaches, again regardless of their materiality
• The more middle ground “single scrape” approach typically is a damage scrape, thus allowing the Buyer to claim a breach for any deviation from the reps and warranties
• A single scrape could theoretically be only a breach scrape, though this is quite rare in practice

Third-Party Claims (procedures for the handling of claims made by third parties)

• Includes notice requirements and right to control (or approve) of the defense and attorneys
• May allow the indemnifying party to elect to assume defense of the claim
• Typically, the purchase agreement sets forth limits on the settlement of third-party claims:
  • Right of the indemnified party to consent to settle a claim, particularly if the settlement involves any admission of liability or imposes any material obligations on the indemnified party
  • Right of the indemnifying party to settle claims freely without the indemnified party's consent, particularly if the settlement involves only the payment of money and includes a full liability release of the indemnified party

“Fraud” & “Knowledge” Definitions (the impact of these definitions on indemnification provisions is significant, particularly for caps, baskets and survival)

• The “Fraud” definition is important because Fraud-based claims typically enjoy no basket, cap or survival period protection for Sellers. Sellers usually accept this, but only if the “Fraud” definition used is appropriate:
  • “Fraud” may be defined narrowly or broadly (or not at all) depending on the purchase agreement
  • Typically includes actual fraud and intentional misrepresentation; may include negligent misrepresentations and intentional, constructive or negligent fraud, or other constructs
  • Apart from what is deemed “Fraud,” the type and scope of statements for which Fraud can be alleged is key and often negotiated
  • Determination of the existence of “Fraud” can also vary widely depending on the case law and other laws of the controlling state law
• The “Knowledge” definition is important because it either limits or expands a Buyer's ability to make a claim against a Seller for a rep breach
  • The definition of “Knowledge” can include actual knowledge, constructive knowledge, implied knowledge or all three or something else. Constructive knowledge is the most common (meaning what an individual should have known about a subject after inquiry)
  • The associated “Knowledge Group” definition determines those individuals captured by the Knowledge definition. In other words, what group of people is considered in determining if a Knowledge-qualified rep has been breached?
  • The definition of “Knowledge” is also key to anti-sandbagging provisions, which prevent the Buyer from claiming indemnification if it had pre-Closing knowledge of the Seller’s breach of a rep

“Damages” & “Losses” Definitions (limits/expands the type of damages which an indemnified party can recover)

• May exclude consequential, incidental, special and punitive damages, unless Fraud involved
• Increasingly differentiates between direct damages between the parties and damages arising out of third-party claims

Exclusivity & Exclusions (specific issues or liabilities that are expressly excluded from operation of the indemnification provisions in the purchase agreement and can be pursued separately)

• For 90% + of transactions, the purchase agreement indemnification is the exclusive remedy
• Common exclusions to exclusivity include Fraud and injunctive actions and equitable remedies
• Other exclusions:
  • Intentional misrepresentations
    • Willful or intentional breach of covenants (e.g., a breach of a non-compete agreement)
• Indemnity obligations typically set forth in a stand-alone, dedicated section of the purchase agreement. Other short-form indemnification obligations may be sprinkled about in other provisions of Agreement
  • harmonize the operation of these other indemnification obligations to avoid double-dipping

RWI (Representation and Warranty Insurance)

• RWI is specialty insurance that can be purchased for M&A deals which provides, at a premium cost of 2.25% – 4% of the insured amount, third-party coverage for certain breaches of the Seller’s reps and warranties
• Often a powerful and valuable tool for Sellers which limits post-Closing indemnification claims and, depending upon the costs, retention and other terms of the specific RWI policy employed, can approach -- if not achieve -- a “zero liability” deal for Seller

Tax Treatment of Indemnity Payments Received (how are indemnification payments taxed?)

• So that the indemnified party avoids paying tax on indemnification payments, the purchase agreement typically provides that such payments are treated as a purchase price adjustment for all tax purposes, to the extent permitted by law
• Tax treatment for RWI proceeds paid to the indemnified party may be different

Indemnification provisions are often among the most hotly negotiated aspects of an M&A agreement due to both their complexity and their significant financial implications for both Buyers and Sellers. While deal studies abound that can assist in getting at what is “market” or typical, the terms are still deal-specific and highly variable. The above is only a summary of some of the key points which Sellers and their advisors need to carefully consider and negotiate to ensure adequate post-Closing protection and that Sellers receive the actual benefit of the deal they bargained for.