One of the most important issues for a buyer in an acquisition is the handling of legal claims following the closing. It is very common for issues to arise after the closing of a purchase of a business that can result in burdensome and expensive lawsuits. The parties tend to focus on negotiating indemnification provisions in the contract late in the negotiation process, and these provisions are often the last significant issue agreed upon by the parties. These provisions generally provide that the seller will indemnify (or hold harmless) the buyer from any and all liabilities incurred after the closing to the extent such liabilities arise in connection with a breach of the representations and warranties made by the seller in the definitive agreement, a breach of the post-closing agreements made by the seller or as a result of the actions of the seller prior to the closing.
As the post-closing liabilities incurred by the buyer can significantly undermine the value of the acquired business, and many of the seller’s liabilities can be difficult to discover in the due diligence process, it is important for buyers to understand the post-closing indemnification provisions and make sure that the indemnification provisions are clear and understandable. In that regard, below are some key considerations with which all buyers should be familiar before negotiating the post-closing indemnification provisions.
No. 1: Require the seller’s principals stand behind representations and warranties.
Sellers will typically prefer that representations and warranties that are subject to indemnification be made solely by the selling entity. As the overall liability of the selling entity will often be limited to any amounts held back or placed in escrow, the incentive of the selling entity to confirm that all representations and warranties are 100 percent accurate may be limited. To the extent that the seller’s individual principals are required to make the representations and warranties with the selling entity, the risk of personal liability will often not only provide another source of funds to pay indemnification claims, but will cause the seller’s principals to take a much more active role in confirming the accuracy of the representations and warranties and any disclosure schedules.
No. 2: Require adequate credit support.
As the selling entity will likely distribute the sale proceeds to its owners shortly after the closing, it is important that the buyer not rely solely upon the credit of the selling entity for the payment of post-closing indemnification claims. The most common method of credit support is for a portion of the purchase price to be placed in an escrow account with a third-party escrow agent to be used to pay future indemnification claims. Buyers should generally request that amounts be held in escrow for a period of not less than 12 to 18 months, and escrowed amounts should not be released to the seller until any and all potential indemnity claims have been fully and finally resolved. An alternative to setting up a potentially expensive and complicated escrow process is to hold back a portion of the purchase price to be paid over time and allow the amounts of any indemnified claims to be set-off against amounts otherwise due as the deferred purchase price. As sellers will be required to rely upon the credit of the buyer to pay the deferred purchase price, it is likely that a buyer will require security with respect to the amounts owed by the buyer as deferred purchase price.
No. 3: Make sure caps and other limits on indemnification make sense.
One of the most highly negotiated aspects of indemnification arrangements is the liability caps, baskets and other limitations on indemnity. Buyers should typically request that the indemnity cap be as high as possible, but no lower than 20 percent of the overall purchase price. In addition, sellers will often request baskets requiring individual indemnity claims and/or the total amount of indemnity claims to be in excess of a specified amount before claims may be made against the seller. While these types of baskets are generally a reasonable protection against small harassing claims by the buyer, buyers need to make sure that the individual amounts are appropriate given the likely nature of the indemnity claims. For example, to the extent a buyer expects a large number of small claims, a basket based upon the total amount of all indemnity claims would be more appropriate than a basket relating to each individual indemnity claim. In addition, to the extent baskets are used, there is no need for a “materiality” qualifier, because the parties have already agreed to what constitutes material damage.
No. 4: Don’t agree to cap claims relating to fraud.
While it is reasonable for the seller to request certain baskets and caps on indemnification claims, buyers should not agree to allow such limits and caps on any breaches of representations and warranties that are fraudulent or intentionally misleading. These types of breaches should be excluded as the potential damages for such claims could be significant and the seller and its principals should be strongly incentivized to act in an ethical manner.
No. 5: Do your due diligence.
While buyers sometimes believe that strong language in the representations and warranties and indemnification provisions will provide adequate protection for undiscovered liabilities, liabilities that turn up post-closing are typically larger and more material than the parties anticipate. In addition, the caps and other limitations on indemnification provisions, as well as qualifications contained in the representations and warranties, may leave the buyer without an adequate remedy. In addition, indemnification claims can be costly and time consuming to enforce. Accordingly, to the extent feasible, buyers should independently verify all information contained in the representations and warranties during the due diligence process. As we often tell our clients, there is simply no alternative to good due diligence.