Indemnification in Mergers & Acquisitions Explained

BusinessLegal

  • Author Lisa Thorsen
  • Published February 12, 2020
  • Word count 1,048

Seller agrees to indemnify, hold harmless and defend…

Some variation of those words is almost certain to make an appearance in any well drafted purchase agreement. They are boring looking legal words that make your eyes glaze over like a jelly donut. But, to attorneys, they are some of the most hotly contested aspects of negotiating a purchase agreement. So, as a seller or buyer in an acquisition, its best to grab some hot chocolate, settle down and read this post to get cozy with the concepts.

Indemnification

This is when one party agrees to make good a loss, damage or other liability incurred by another.

Hold Harmless

This is when one party agrees not to hold the other liable for a loss, damage, or other liability.

Defend

This is when one party agrees to reimburse or advance costs and expenses of suit, including attorneys’ fees, appeals and counterclaims, incurred by the other in connection with third-party claims. This obligation is broader than an obligation to indemnify because it may apply whether or not a claim has merit. It is the allegation asserted in the suit brought by the third party, not the ultimate merits of the action itself, that give rise to the obligation to defend. The obligation to defend will often be coupled with the defender’s right to assume and control the actual defense of the suit.

The most common scenarios in which one party would have to indemnify, hold harmless or defend the other party in an M&A transaction are:

Breaches of representations and warranties

A statement of fact or promise that the seller made at closing (or otherwise) turns out to be incorrect and the buyer suffers damages as a result. I have written more on the importance of representations and warranties in a prior post.

Breach of covenants

A favorite word of priests and lawyers, a covenant is an agreement to do, or not to do, something. A classic example of a covenant commonly found in a purchase agreement is a non-compete provision or a confidentiality clause.

Third party claims

Claims brought by a person who is not a party to the M&A transaction (a "3rd party") arising from or related to a breach of representations and warranties, a covenant or some other obligation arising under the purchase agreement and/or ancillary documents.

Why you need an M&A attorney?

Like many things in law, the obligations to indemnify, hold harmless and defend come down to how much risk each party is willing to take on.

Taking on more risk than necessary can be a costly mistake so it’s best to have a skilled negotiator negotiate on your behalf.

M&A attorneys know what to look for, what is reasonable to ask and have creative ways to limit or expand the scope and duration of certain risks associated with the M&A process. Some of the ways we accomplish this are as follows:

Limit survival.

A well drafted purchase agreement will have a "survival" period for the representations, warranties, covenants and other obligations. The survival period is how long after closing an aggrieved party may seek indemnification from the other. It is not unusual for attorneys to negotiate different survival periods for different types of obligations. For example, representations related to things like taxes, title to assets or capital structure may be deemed "fundamental" and have a longer survival period (or survive indefinitely) as compared to those designated as general representations and warranties." Some representations and warranties may expire at their statute of limitation or live on to become the last known survivor!

Add a liability floor.

As a seller (and perhaps as a buyer) it helps to have a liability floor, so you don’t get caught up after closing dealing with an endless string of small claims. Liability floors (more commonly referred to as a "basket") are a minimum dollar amount that a certain claim (or set of claims) must rise to before an indemnification claim can be brought. M&A Lawyers have creative ways to structure baskets to accomplish various liability allocations.

Add a liability ceiling.

A liability ceiling or "cap" is the maximum amount that a party with an indemnity obligation can be held liable. A party’s total liability exposure can be capped at a set number (or numbers), the total purchase price or, in the absence of a liability cap, could even be unlimited.

Disclose.

As I stated in my prior post, Disclose, Disclose, Disclose. A seller’s attorney can draft specific language into the representations and warranties that limit their scope through disclosures made on a Seller Disclosure Schedule. A limited scope means a limited liability exposure.

We can’t get you out of everything.

While attorneys are skilled at allocating, limiting and defining risk, we cannot absolve clients of all sins. Claims for fraud, intentional breach and willful misconduct are likely excluded from any of the foregoing limitations. Also, provisions that violate certain public policies may not be upheld.

Paying for indemnification claims.

A purchase agreement will split ultimate responsibility for payment of claims between the parties responsible for indemnification. For example, in a stock purchase agreement where a selling company has multiple shareholders, each shareholder could be liable just for their own breaches and/or be liable for all breaches. They may also be liable for the total cost of all damages or just their pro-rata share of damages. In some cases, minority shareholders may be absolved entirely and certain key players may have excess liability.

If there was some sort of earnout, escrow, instalment payment, seller financed promissory note or other holdback method negotiated, then in many cases the buyer will request the right to set off indemnification claims against any such holdback amounts to ensure that they get paid.

It’s complicated.

Now that you have a basic understanding of what types of liabilities exist, how risk allocation is handled, and what role M&A attorneys play in limiting your liability exposure, it is important to note that the actual practice of drafting and negotiating these terms is complex and nuanced.

If you need someone to help you negotiate indemnification obligations in an M&A transaction, contact the attorneys at Business Lawyer Austin. We’re here to help.

Lisa Thorsen is a business transactional attorney who runs Business Lawyer Austin and San Diego Business Lawyer: https://blaustin.com/ and https://sdblawyer.com/

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