Although every seller would like to sell its business “as is” and walk away from any associated liabilities, few deals get done that way. Instead, subject to negotiated limitations, most buyers expect the seller to be responsible, and make the buyer whole, for certain known and unknown liabilities relating to when the seller owned its business – a concept M&A professionals refer to as indemnification. Indemnification provisions are essential to allocating risk between the parties, are complex, and require careful drafting. The increasing use in recent years of representations and warranties insurance (RWI), either as a supplement to a seller indemnity or as a replacement for a seller indemnity, has heightened the importance of detailed attention to indemnification provisions and to a strong understanding of the constantly changing market.
What is a Seller Liable For?
A seller is generally liable for any breaches of its representations, warranties, and covenants contained in the purchase agreement. Representations and warranties are written statements the seller makes about itself and the business, which may include, among other things, ownership of equity interests and assets, authority to transact, corporate organization, financial statements and liabilities, customers, contracts, intellectual property, compliance with laws, liens, litigation and claims, taxes, employees and benefits. Covenants are promises by the seller to take (or not take) specific actions, which may include, among other things, agreements not to compete with the business after closing (typically for 3-5 years) within a defined geographic area, and not to use or disclose confidential business information. In a typical deal structure, if the seller’s representations and warranties aren’t accurate, or the seller breaches its covenants, it must then indemnify the buyer for any resulting losses the buyer suffers (including attorneys’ fees and litigation costs), subject to certain negotiated limitations.
Asset deals sometimes follow a so-called “our watch / your watch” approach. Under this approach, a seller may be required to indemnify the buyer for all liabilities arising prior to closing of the transaction, whether or not the liabilities would be a breach of any representation or warranty (and, in exchange, the buyer is required to indemnify the seller for all liabilities arising after closing of the transaction).
Limitations on Liability
A seller’s liability is typically limited by negotiated survival periods for claims, caps, baskets, and other limitations on recovery. Survival Periods. “Survival periods” refers to the length of time that a party entitled to indemnification has the right to bring a claim against the other party. Typically, the seller’s indemnification obligations for breaches of most “standard” representations and warranties will last 18-24 months after closing of the transaction. However, certain potential liabilities discovered during the buyer’s due diligence may be subject to separately negotiated and more extended survival periods. Representations and warranties relating to certain “fundamental” matters (such as the seller’s ownership of the equity interests or assets being sold, and its authority to enter into the transaction), and other matters such as taxes, ERISA, and broker’s fees, typically last for more extended periods (which may be as long as the applicable statute of imitations).
Caps and Baskets
Deals Without RWI. A seller’s indemnification obligations in deals without RWI are usually limited to an agreed-upon percentage of the purchase price (cap), which varies based on the value of the transaction and the matter for which indemnification is sought. In smaller transactions, liability for breaches of “standard” representations and warranties is often limited to 15%-20% of the purchase price. In larger transactions, liability for breaches of “standard” representations and warranties usually will not exceed 10% of the purchase price. Indemnification for potential liabilities discovered during the buyer’s due diligence that are subject to separately negotiated survival periods may be subject to separately negotiated liability caps. Indemnification for “fundamental” matters (and other matters for which similarly extended survival periods apply) is typically capped at the purchase price (or sometimes uncapped).
To discourage litigation over matters involving small amounts of money, buyers and sellers typically negotiate thresholds (baskets) to the seller’s indemnity obligations, below which the seller will not be liable (typically, 1/2%-1% of the purchase price, depending on the deal’s value). These thresholds can be in the form of deductibles or what M&A professionals call “first-dollar” or “tipping baskets,” where the buyer can seek indemnification from dollar one for all losses once the threshold has been reached. Indemnification for known liabilities (such as pending or threatened litigation), “fundamental matters,” and other matters for which extended survival periods apply, will typically be excluded from such baskets. However, in asset deals following the “our watch / your watch” approach, claims related to preclosing liabilities and post-closing liabilities may not to be subject to the limitations that are imposed on claims related to breaches of representations and warranties. Deals With RWI. A seller’s indemnification obligations in deals with RWI are usually limited to one-half of the RWI deductible; and subject to agreed-upon caps, certain matters that are excluded from RWI coverage and losses in excess of the RWI coverage amount. In a “no seller indemnity” structure, a seller can have no exposure for breaches of its representations and warranties.
Whether or not there is RWI, the parties usually will state expressly that no limitations of liability for indemnification will apply if the seller has committed fraud (typically, defined in the purchase agreement), and buyers often will seek no limitations of liability for breaches of covenants (in particular, non-compete covenants).
Funding For Indemnification
Buyers frequently seek to fund potential indemnity claims by placing a portion of the purchase price into escrow at closing (frequently, 10% in deals not using RWI) or by deferring payment of a portion of the purchase price and insisting on a right of offset against the deferred payment(s). A buyer may also seek to fund potential indemnity claims by purchasing RWI. However, RWI is currently not available on deals under about $20 million in value, will be subject to an overall coverage limit (usually, 10% of the transaction price), is subject to a deductible (historically, about 1% of the transaction value), will not cover known liabilities, will not cover breaches of covenants, and is subject to certain other limitations.
Conclusion
Understanding what are market standard terms for a seller’s indemnity obligations is essential to both buyers and sellers. Since indemnification is one of the most heavily negotiated, and potentially most significant, provisions of a purchase agreement, either party’s failure to understand what are market standard terms creates the risk of that party insisting on indemnification terms that can kill a deal.
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About the Author:
Paul Pincus, Esq. is a partner at the international law firm Ortoli | Rosenstadt LLP and head of the firm’s Mergers & Acquisitions practice. He can be reached at (212) 829-8931 or php@orllp.legal.
