Indemnification
If a Representation or Warranty Is Breached or Inaccurate
The indemnification section requires the parties to indemnify one another for breaches of representations, warranties and covenants, and other types of claims that may arise after the closing, such as those related to tax, environmental, or employee issues. The indemnification clause, which is sometimes called a “hold harmless” clause, functions similarly to an insurance policy and requires the breaching party to reimburse the other party for all expenses resulting from a breach.
The value of the indemnification depends on the financial strength and creditworthiness of the party providing the indemnification. In most M&A transactions, 10% to 20% of the purchase price is withheld by a third party in an escrow account to fulfill any post-closing indemnification obligations, which mitigates the risk of the seller sailing off to the Bahamas.
The indemnification section of the purchase agreement addresses what will happen if a representation or warranty is breached. In most cases, an indemnity offers a party the right to recover losses and legal expenses. Indemnification is a hotly negotiated component of the purchase agreement.
Indemnification rights are much more specific than the general legal rights included in most contracts. The indemnification provisions include specific rules governing the level of involvement the parties may have in defending suits or other claims, and other options that are rarely afforded to the parties under other general legal rights in most purchase agreements.
The indemnification is normally subject to limitations such as the minimum thresholds that must be triggered (i.e., the basket) and the maximum limit of indemnification (i.e., the cap). Indemnification can also be limited by knowledge qualifiers, materiality qualifiers, and survival periods. These collectively serve to limit your exposure level and further serve to allocate risk between the parties beyond the specific language provided in each individual representation.
Reps and warranties work similarly to an insurance policy. There are exclusions or events that the policy doesn’t cover. There’s also a deductible, or basket, and a maximum payout amount, or cap. Your goal is to limit your exposure by doing the following:
- Tighten the Language:
- Limit the language of each representation individually.
- Limit “joint and several” liability.
- Add knowledge qualifiers such as “to the best of Seller’s knowledge.”
- Limit the indemnification to actual losses, as opposed to other types of damages, such as punitive or speculative damages.
- Reduce Financial Exposure – Money:
- Increase the basket or deductible that must be met before a claim is paid.
- Reduce the maximum payout through a cap.
- Reduce the amount of the escrow.
- Limit the Length of Exposure – Time:
- Decrease the survival period.
- Reduce the length of the escrow.
- Other:
- Require the buyer to self-insure against certain risks.
The specifics of how a dispute is handled are addressed in the purchase agreement, usually in a section called “Disputes.” For example, the agreement may require arbitration, or it may require litigation. In some cases, a breach of reps and warranties may be handled differently than any other breach. One of the most common disputes concerns errors in financial statements. Any representations made regarding the condition or accuracy of your financial statements should be carefully reviewed by your CPA. Examples of potential disputes include:
- Inaccurate financial statements
- Violations of post-closing covenants, such as non-competes or non-disclosure agreements
- Tax claims
- Loss of key employees
- Loss of key customers
- Working capital calculations
- Undisclosed pending litigation
- Undisclosed material liabilities, such as unpaid bills
- Undocumented employees
The buyer also normally agrees to indemnify you. Common areas include the buyer’s covenant, or promise, to offer employment and certain benefits to your key people. The buyer may also indemnify you regarding environmental liabilities or accounts payable.
The following remedies are available to the buyer of a mid-sized business:
- Holdback: The primary method involves holding back 10% to 20% of the purchase price. This is when a portion of the purchase price is held in escrow for a period after closing for the sole purpose of being made available to the buyer in the event of a breach of a representation or warranty. Most holdbacks range from 6 to 18 months.
- Right of Setoff: Alternatively, some parties use a right of setoff against any future payments, such as an earnout or a promissory note. In some states, there’s a statutory right of offset for specific claims.
- Litigation: Finally, the parties may litigate.
Nothing in M&A is simple – the parties can negotiate varying baskets and caps for different types of losses, so it’s wise to hire an experienced M&A attorney to review your exposure. Note that losses occurring because of fraud may not be subject to a basket or cap.
When a problem arises after the closing, the parties look to the “Indemnification” and “General” sections of the purchase agreement to determine how the dispute will be handled.
The Indemnification section usually addresses the following questions:
- Parties: Who exactly is providing the indemnification? Is the indemnification solely limited to one shareholder or are all shareholders indemnifying the buyer? If multiple shareholders are indemnifying the buyer, are they jointly and severally responsible? Is the buyer also indemnifying you?
- Scope: What specifically does the indemnification cover? What’s the scope of the indemnification? Most typically cover breaches of reps and warranties, breaches of covenants, non-compliance with laws, liabilities arising from the assets, and the like. Is the indemnification limited to the four corners of the agreement, or are ancillary documents – such as those provided to the buyer during due diligence – subject to indemnification? The precise scope of the indemnification is often subject to intense negotiation. Some agreements also contain separate remedies that aren’t covered by the indemnification section in the purchase agreement. This could include a non-compete agreement, for example, and those agreements will be governed by the provisions outlined within the agreement.
- Remedies: Is the indemnification the parties’ exclusive remedy, or are other remedies available to the parties?
- Survival: How long will the representations, warranties, covenants, and other obligations in the agreement remain in place?
- Limitations: What are the financial limits, such as baskets and caps, of the indemnification obligations?
- Escrow: Will a portion of the purchase price be held in escrow? If so, how much, for how long, and what are the terms of the escrow?
- Right of Offset: Does the buyer have a right of offset against the promissory note, consulting agreement, or other obligations?
- Indemnification Process: How are indemnification claims handled? What role does the indemnifying party have in the role of the defense of the claim?
The indemnification clause should also address the following questions:
- What recovery is available to the party in the event of a breach?
- What’s the process for resolving a dispute? Most agreements require an initial complaint in writing. If the parties can’t resolve the issue, the agreement determines how the parties must resolve the dispute.
- What are the procedural aspects of indemnity claims?
- What are the rights of the parties to take part in any legal proceedings?
- What notice requirements exist?
- Who controls the defense of a claim from third parties?
- How will a party collect on an indemnification claim? Is collection limited to the amount in escrow?
- What rights do both parties have to access information?
- What rights of subrogation do the parties have?
- How do insurance proceeds affect the parties’ indemnification obligations?
- Does a failure to act on a breach constitute a waiver?
- How do the parties choose counsel to defend a claim? Who has control over the defense and the fees?
The General Provisions section of the purchase agreement usually addresses the following:
- Dispute Related
- Jurisdiction: Addresses dispute resolution options, such as litigation, arbitration, mediation, jury trials and forum, selection of mediators or arbitrators, rules for mediation or arbitration, who pays expenses, remedies, and to what extent the decision is final.
- Enforcement: This may provide the parties additional remedies, such as specific performance or injunctive relief.
- Waiver: May state that rights are cumulative, and a failure to exercise a right doesn’t constitute a waiver.
- Governing Law: Specifies which state’s law governs the agreement.
- Non-Dispute Related
- Expenses: How are transaction-related expenses allocated between the parties?
- Notices: Who are notices sent to, and when are they deemed received?
- Entire Agreement: This clause usually states that the purchase agreement constitutes the entire agreement and supersedes all previous written or oral agreements.
- Severability: Severability states that if any provision is determined to be invalid by a court, the remaining provisions will remain in effect.
- Assignment: This prohibits the purchase agreement from being assigned to third parties and provides that the agreement doesn’t create any rights for third parties.
- Time of Essence: A clause explicitly stating that time is of the essence, which enables the parties to enforce deadlines, such as drop-dead and other dates.
- Execution: The agreement can be executed in counterparts or electronically.
Notice that there’s some overlap between the indemnification provisions and the general provisions in the purchase agreement. In some purchase agreements, these sections may be combined. Other times, they remain separate. This underscores the need for you and the buyer to hire experienced attorneys to represent you and the need to rely on their guidance in negotiating the terms of the reps and warranties, related indemnification, and other clauses that govern how disputes will be handled.
Tips for Negotiating Indemnification
Custom-Tailor the Language: The indemnification language should be custom-tailored to the unique characteristics and circumstances of your business and the specific risks identified during due diligence. The relationship between time and dollar limits should also be taken into consideration. Businesses in certain industries may be better served by higher dollar limits and shorter time limits, and vice versa.
Limit Who Provides Indemnification: It’s important to consider who, specifically, is providing the indemnification. If there are multiple shareholders of your company, will all shareholders indemnify the buyer, or only the majority shareholders? Or will your entity indemnify the buyer? In most cases, the majority selling shareholders are required to personally indemnify the buyer. To be obligated under the indemnification clause, a selling shareholder must sign the purchase agreement directly or through a “joinder.” This is often the case because your entity normally ceases to exist after the closing date. If it does exist, the proceeds from the sale are usually distributed to the shareholders, and your entity is left with few assets to fund a potential indemnification claim. It’s difficult for the buyer to have to chase down multiple shareholders, which is why escrows are so prevalent. If there are multiple selling shareholders, they should also attempt to limit their liability to “several” (separate) liability, as opposed to “joint and several” liability.
Conclusion
American baseball legend Yogi Berra coined the phrase, “It ain’t over till it’s over.” To which I would add, “But even then, it may not be over.” That’s certainly the case with reps and warranties, one of the few elements of a purchase agreement that survive the closing and which can come back to bite you if you’re not careful.
The antidote? Be careful. Pay attention.
As a seller, it’s wise to meticulously read the representations before you sign them. Don’t assume anything is boilerplate language. In fact, a breach of a rep or warranty – unwitting or not – can kill a deal at worst or lighten your bank account in less extreme circumstances. Obviously, neither outcome is desirable.
The information in this chapter will help you avoid the snafus that can arise from a lack of preparation when it comes to dealing with reps and warranties – one of the most important and often overlooked aspects of a deal.