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Basics in M&A: Indemnification Provisions

March 23, 2016

Appeared in Law360 on March 18, 2016. Originally appeared in Kaye Scholer's Spring 2016 M&A and Corporate Governance Newsletter. 

—by Danielle Rosato and Tracy Belton

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.

»  Click here to read more articles from our latest M&A and Corporate Governance Newsletter.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 diverging objectives of the parties, and the potential effect that indemnification could have on the economics of the deal as a whole, frequently cause indemnification provisions to be some of the most heavily negotiated provisions in an acquisition agreement.

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.

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.

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.

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.

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.

A “materiality scrape” is a provision that “scrapes” or deletes all materiality qualifications from the representations and warranties in the acquisition agreement for indemnification purposes. For example, presume an acquisition agreement included a representation that the company had authority to do business in all states where such authority was material to the conduct of its business. Post-closing, the buyer learned that the company should have been authorized to do business in Virginia, but it was not. Under these facts, the parties would have to determine whether the company’s failure to obtain authorization to do business in Virginia was material to the company’s business. To avoid this debate, buyers frequently seek to include a materiality scrape so that materiality is “read out” of the representation. Sellers are more inclined to agree to a materiality scrape if they have successfully negotiated a “mini-basket.” By incorporating a materiality scrape, the parties will only need to agree on whether the claim’s dollar amount exceeds the “mini-basket” in order to determine which party has the obligation to pay the fee.

Materiality scrapes, coupled with a mini-basket, have become rather common. An example materiality scrape might read as follows:

“For purposes of determining failure of any representations or warranties to be true and correct, the breach of any covenants and agreements, and calculating Indemnification Losses under this Article VII, any “materiality,” or “Material Adverse Effect” qualifications in the representations, warranties, covenants and agreements shall be disregarded.”

The above provision is an example of a “double” materiality scrape. A “double” materiality scrape requires the parties to ignore all materiality qualifications for determining both (1) whether or not a breach occurred and (2) the amount of indemnifiable losses resulting from the breach. While “double” materiality scrapes are more common, parties may instead choose to include a “single” materiality scrape. In the case of a “single” materiality scrape, materiality is read out of the relevant provisions for purposes of determining the amount of indemnifiable losses, but materiality qualifications continue to apply for purposes of determining whether or not a breach occurred.

A Note on Knowledge Scrapes

Similar to a “materiality scrape,” some buyers may seek to include a “knowledge scrape,” which effectively removes all knowledge qualifications from the representations and warranties in the acquisition agreement for indemnification purposes. A “knowledge scrape” is much less common in acquisition agreements than a “materiality scrape.”

Sellers may also seek to limit the dollar amount of their indemnification obligations by including provisions requiring the buyer to mitigate its damages and to pursue payments from third parties.

A mitigation provision requires the buyer to take efforts to minimize its indemnifiable damages and, if the buyer fails to take such efforts, provides that the sellers will not be liable for any avoidable damages. As an example, let’s assume the acquisition included the sale of a building and the sellers made a representation that the building was in reasonably good repair at the time of the sale. After the closing, a water pipe which was in horrible condition prior to closing, bursts. The buyer does not turn off the water or do anything to mitigate the damage caused by the pipe bursting. If the sellers successfully negotiated a mitigation provision, they would not be liable for the damages that could have been avoided if the buyer had turned off the water or taken other efforts to minimize the resulting damage. Buyers are generally agreeable to some form of a mitigation obligation, but the standard of effort required to be used by the buyer (e.g., best efforts, commercially reasonable efforts, etc.) will often be negotiated.

Sellers also favor provisions requiring the buyer to seek payments from third parties, which would be deducted from the amount of damages that the Sellers are required to pay. Returning to our water pipe example, if such a provision was incorporated and the company had insurance in place that covered the incident, the buyer would be required to cause the company to make an insurance claim, and any money that it received as a consequence of such claim would reduce the total damages owed by the sellers. Let’s now assume that, instead of owning the building, the building was leased to the company, and in lieu of, or in addition to, any insurance held by the company, the landlord agreed to indemnify the company for water damage. Under these facts, the company would be required to take efforts to recover damages from its landlord and any money it received as a consequence of such efforts would reduce the total damages owed by the sellers. Buyers are often amenable to agreeing to pursue insurance claims but will often specify that the amount of damages owed by the sellers can only be offset by the amount of money actually received by the buyer, less any increase in its insurance premium resulting therefrom. Alternatively, the offset can be narrowed to any proceeds under insurance policies that have been paid for by the seller prior to closing. A buyer may also agree to pursue third-party sources of recovery, but because third-party claims can be more difficult to pursue and have the potential of negatively impacting an ongoing business relationship (i.e., the buyer may not want to sue an important customer or supplier), a buyer is more likely to push back on this type of provision. If such a provision was included, a buyer will often specify that any decrease in the damages owed by the sellers will be net of the costs and expenses incurred in seeking recovery from the third party.

In addition to limiting the scope, duration and dollar amount of indemnification damages, sellers may also try to limit the circumstances in which the buyer may bring a claim. A specific question that often arises during the negotiation of the indemnification provisions is: if the buyer knew about a claim before the closing, should it be able to wait until after the closing to bring a claim for damages against the sellers? Sellers will argue that the buyer should not be able to bring the claim in this instance; that the purpose of indemnification is to protect the buyer against unknown losses. Because the buyer knew about the losses and decided to close the transaction anyway, the seller’s position will be that the buyer should bear the burden of that loss.

Buyers will take the position that the acquisition agreement was heavily negotiated to include certain representations and warranties and that the parties should be entitled to rely on those representations and warranties. If there is a breach of a representation and warranty, the buyer does not want the sellers to be able to allege that the buyer “knew” about the breach by, for example, pointing to one of the thousands of documents in the data room and alleging that such document gave the buyer notice of the breach. From the buyer’s perspective, the point of the indemnity is to set forth clear rules of the road for post-closing breaches. Granting the seller an affirmative defense that the buyer knew about a claim prior to closing makes these rules murky and can lead to more litigation over claims.

The type of provision that addresses the parties’ debate above is referred to as an “anti-sandbagging” provision. An “anti-sandbagging” provision prevents a buyer from bringing an indemnification claim for breaches of representations and warranties that the buyer knew of prior to closing. An anti-sandbagging provision might read as follows:

“Notwithstanding anything in this Agreement to the contrary, no Buyer Indemnified Party shall be indemnified or reimbursed for any Damages resulting from the breach or inaccuracy of any representation, warranty, covenant or agreement in this Agreement if the party seeking indemnification for such Damages had actual knowledge of such breach or of any facts or circumstances rendering such representation or warranty inaccurate prior to the Closing.”

Funding the Indemnity

Another aspect of indemnification provisions that requires significant negotiation is how the indemnity will be funded. If an acquisition agreement is silent, the buyer would have to proceed directly against the individual sellers for its damages. Buyers generally dislike this recourse because there is no guarantee that the sellers will have the money to satisfy their indemnification obligations post-closing and proceeding directly against the sellers can be a lengthy process. In an effort to ensure that the Buyer will be able to collect on its indemnifiable damages in a time-efficient manner, it will often pre-negotiate from where the funds to pay for identifiable claims will come. The three most common approaches to funding an indemnity are: (1) an indemnification escrow account, (2) set-offs against future payments, and (3) a holdback of the purchase price.

An indemnification escrow account is a separate fund that the parties can establish at the closing of a transaction for the payment of indemnification obligations. The indemnification escrow is funded from the buyer’s purchase price. In other words, instead of the buyer paying the entire purchase price to the sellers, it will deposit a portion of the purchase price into an escrow account (generally held by a neutral third-party bank) to cover the sellers’ indemnification obligations. Buyers generally favor an indemnification escrow account because it provides security that there will be resources to pay for the sellers’ post-closing obligations and because it eliminates the chore of tracking down multiple sellers to recover its damages. Conversely, sellers dislike having a portion of their proceeds from the sale tied up and inaccessible. The escrow amount is generally a percentage of the purchase price and is held by the escrow agent for a certain time period to cover claims asserted during such period. If certain fundamental representations and warranties or “special” indemnity items survive beyond the escrow period, the indemnitee should consider what their alternative source of recovery will be after the escrow expires.

Sellers may also seek for the escrow account to be the sole source of recovery for the buyer, meaning that the buyer will only be permitted to seek money from the escrow account and will not be able to go after the individual sellers post-closing. In these instances, the escrow works like a cap on the sellers’ damages.

If the purchase price includes certain future or milestone payments, the parties may consider setoff as a mechanism for funding the indemnity. Setoff is the reduction of future payments by the amount owed under the party’s indemnification obligations. Setoff, however, may be precarious if the future payments are conditional or uncertain to occur.

An alternative source of funding the indemnity is the holding back of a portion of the purchase price. This mechanism is similar to an escrow account except that the buyer will maintain the held back funds until an agreed upon future date. When considering the use of a holdback, sellers may prefer the use of an escrow account because it reduces the amount of control the buyer has over the funds and increases the likelihood that any funds remaining after payment of indemnification claims will be promptly paid over to sellers upon the applicable release date.

A Note on Representation and Warranty Insurance

Another potential source of recovery, the use of which has increased significantly during the last five years, is representation and warranty insurance. If a buyer or the sellers purchase representation and warranty insurance, the insurer will cover a certain portion of the indemnifiable damages for certain claims. The amount and coverage of the insurance is negotiated by the party purchasing it.[3] The presence of representation and warranty insurance greatly impacts the negotiation of the acquisition agreement. For example, a buyer will likely agree to a substantially lower indemnification escrow amount if it has the ability to recover directly from its representation and warranty insurer. Sellers may also agree to make a more fulsome set of representations and warranties if a portion of their indemnification obligations are covered by insurance. In an auction process, a buyer may choose to purchase representation and warranty insurance in lieu of seeking a fulsome indemnification package from the seller so that its bid is more attractive.

Sole Recourse

If the sellers have successfully negotiated any of the above limitations to their indemnification obligations, it is likely that they will argue that indemnification should be the parties’ sole recourse. Providing for indemnification as the parties’ sole recourse protects the sellers’ benefit of the negotiation process and provides predictability. The buyer, however, will seek cumulative remedies if the limitations on the sellers’ indemnification obligations cause indemnification to be an inadequate remedy in light of potential post-closing issues and liabilities. Sometimes parties will compromise and agree to indemnification as the sole recourse for non-fundamental representations and warranties but allow for cumulative remedies for fundamental representations and warranties or breaches of covenants.

Fraud Exception

Buyers often try to negotiate in a fraud exception to all of the indemnification limitation provisions. Buyers will take the position that the sellers should not get the benefit of the limitation provisions if they engage in fraud. Returning to our government investigation example, let’s say that the sellers fraudulently hid the government investigation from the buyer and represented that there were no ongoing investigations. Post-closing, the buyer discovered that there was an ongoing investigation at the time of the closing and the investigation resulted in a claim against the company for substantial damages. Consequently, the buyer would like to bring a claim against the seller for its breach of a representation and warranty, but unfortunately for the buyer, the parties had agreed that breaches of non-fundamental representations and warranties would be subject to a cap and the cap is much lower than the buyer’s damages. Had the buyer known about the investigation, it would have tried to negotiate in a “special” indemnity, or an exception from the cap for damages relating to the investigation. Buyers will argue that in fraudulent cases such as this, the sellers should not get the benefit of the limitations on their indemnification obligations.

Sellers are generally amenable to the concept of a fraud carveout, but the parties may get into a debate over what “fraud” means. “Fraud” is defined differently under state law and may be defined to have a much broader scope than what one typically thinks of as being “fraud.” Drafters should be cognizant of the various definitions of fraud and should ensure that the acquisition agreement clearly sets forth the parties’ intended definition.

Who May Bring an Indemnification Claim?

Because indemnification is a contractual remedy, the parties have the ability to negotiate who will be entitled to recover under the indemnification provisions and from whom they may recover. This allows the parties to allocate certain rights and responsibilities to individuals or entities that may not otherwise be party to the acquisition agreement. For example, the buyer may desire to give its equity holders, employees, officer and directors the ability to recover against the sellers’ equity holders, while the buyer and the sellers are the only parties signing the agreement. Therefore, it is important that an explicit exception is made in the agreement’s third-party beneficiary clause to allow the non-party indemnitees to benefit from the indemnification provisions. It is also critical that indemnitees confirm that the person or entity making a representation, warranty or covenant is included as an indemnifying party.

Drafting Tip: Beware of the Dreaded Cross-Reference

Indemnification provisions are often littered with internal cross-references. For example, let’s say an agreement provides for indemnification for the following items:

  • Section 10.2(a) breaches of non-fundamental representations and warranties;
  • Section 10.2(b) breaches of fundamental representations and warranties;
  • Section 10.2(c) breaches of covenants;
  • Section 10.2(d) damages for pre-closing taxes; and
  • Section 10.2(e) damages arising from a specified litigation.

The agreement contains a mini-basket, basket and cap, but only for breaches of non-fundamental representations and warranties. The drafter addressed this by stating that “The foregoing limitations shall not apply to damages arising from the matters set forth in Sections 10.2(b) through 10.2(d).”At the last minute, the parties negotiate for another indemnification item—damages for a certain environmental matter. The drafter adds this as a new “10.2(f).” This claim was not supposed to be subject to the mini-basket, basket and cap. Unfortunately for the buyer, no one remembered to update the cross-references in the limitations section and now the limitations do indeed apply to this environmental matter.

Many times drafters will use the cross-reference function of Microsoft Word to set a cross-reference that auto-updates if the section references change. For example, if a new section was inserted before Section 10.2, the feature in Word would update all Section 10.2 cross-references to refer correctly to Section 10.3. Sounds great, right? The problem is that drafters rely too much on this function and are less careful with checking cross-references manually. The cross-reference function is faulty for a few reasons. First, it would not catch the error set forth in our above example because it would not know that the new 10.2(f) was supposed to be cross-referenced in the limitation section. Second, multiple people will be touching the acquisition agreement, and not all of those people will know how to use the cross-reference function. Those people may try to update the cross-reference manually by typing in the correct cross-reference. The problem with this fix is that if the cross-reference field is still there despite the manual change, the cross-reference will automatically revert to the original cross-reference when the document re-updates all of its fields (which often happens when the document is printed). Third, since not all drafters know how to use the cross-reference function, when drafting new provisions they may manually type in section reference. The other drafters may assume all cross-references are being automatically updated and may not realize in their 100-page agreement that the cross-reference on page 60 was manually inserted and will never auto-update.

Because of the severe impact that an incorrect cross-reference can have on the deal, it is important for multiple deal team members to be able to double-check these cross-references. It is also of critical importance that the entire deal team understands the indemnification “package” being served up or finalized so that everyone is capable of double-checking the cross-references in the indemnification provisions.

What’s Market?

Clients will often look to their lawyers to advise them on “what’s market” for the various aspects of the indemnification section (i.e., the length of the survival period, the size of the basket, cap, etc.). In addition to using a lawyer’s own personal deal experience to advise as to what is market, lawyers may look to many third-party organizations, such as the American Bar Association, which conduct deal surveys and publish what is market in certain industries or for certain deal sizes. It is important that lawyers keep educated on these deal surveys so they can effectively advise their clients. Of course, each deal is different and just because something is not “market” does not mean your client should not fight for it.

Parting Comments

The indemnification provisions in an acquisition agreement are extremely important to buyers and sellers but often are very difficult to read and to understand. It is important that all attorneys assisting in the acquisition agreement, no matter their level, take the time to understand the business deal in order to ensure that the acquisition agreement properly reflects such deal. A small mistake in an acquisition agreement’s indemnification could have a large dollar impact for your client.

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[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.

[3] Representation and warranty insurance can cover more than just breaches of representations and warranties; it can also cover certain special indemnities. The scope of coverage will be negotiated with the insurer and affect the price for the insurance.

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