After navigating the minefield of the representations and warranties, you might be convinced that we have, like Odysseus, reached the shores of Ithaca. Nothing could be further from the truth. We now come to the next heavily negotiated part of the acquisition agreement: the indemnities.
What function do the indemnities serve?
When a contractual clause is breached, the injured party will have a right to bring a legal action against the breaching party, and the court will determine the appropriate quantum of damages to be paid by the breaching party. The problem with letting the court determine the quantum of damages is that it leaves both parties uncertain of what their maximum exposure post-closing will be. Rather than leave the issue to the courts, the parties will negotiate indemnification provisions that specify in exacting detail the types of breaches that will be indemnified, the liability of the respective parties for indemnification, the procedures for claiming indemnification, the time and monetary limits on indemnification, and whether indemnification is the sole remedy for a breach of the acquisition agreement.
As might be expected, all of the above will be negotiated extensively, and a good private equity investor will pay close attention to this section of the acquisition agreement, and to his or her counsel’s advice.
The Components of an Indemnity Provision
An indemnity provision in an acquisition agreement consists of several components:
- The scope of the indemnities
- The parties entitled to indemnification
- The survival period of the indemnities
- The damages covered by the indemnities
- The caps and baskets on the indemnities
- The escrow, holdback, or other method of ensuring payment of indemnities
- The procedures for making an indemnity claim
- The indemnities as exclusive remedy
Scope of the Indemnities
When I say the scope of the indemnities, what I mean is: What kind of breaches of the acquisition agreement are indemnified?
As a general rule, the following matters will be indemnified by the seller(s):
- Breaches of the representations and warranties provided by the seller(s)
- Failure of the seller(s) to perform any of the seller(s) covenants
- Pre-closing taxes and tax related claims of the target company
- Pre-closing environmental liabilities
- Pre-closing product liabilities
- Pre-closing litigation
- Pre-closing employee benefits for employees that were not transferred to the purchaser(s)
- Excluded liabilities1
The purchaser(s) will, in turn, indemnify the seller(s) for the following matters:
- Breaches of the representations and warranties provided by the purchaser(s)
- Failure of the purchaser(s) to perform any of the purchaser(s) covenants
- Liabilities explicitly assumed by the purchaser(s)2
As one might expect, the basic rule for negotiating the scope of the indemnities is simple:
I want the other party to indemnify me for as many things as possible, while I want to indemnify the other party for as little as possible. Unless the market is extremely frothy, the scope of indemnities set out above will tend to be where the parties will end up. If it is extremely frothy, you may see the purchaser(s) giving way on either the scope of the indemnities or on the survial period of the indemnities, or both.
Parties Entitled to Indemnification
At its most basic, the parties entitled to indemnification should be the purchaser(s) and the seller(s), for the seller(s) indemnification obligations and the purchaser(s) indemnification obligations, respectively. The party that is being indemnified will often want to include its affiliates, directors, officers, employees, agents, and representatives. The party subject to the indemnification obligations, on the other hand, would much rather see this limited to just the other party that is executing the acquisition agreement.
One side note. In a transaction with a financial sponsor or an asset sale, the seller(s) may be “shell entities” with no resources post-transaction. In such situations, the shell entities’ ability to indemnify the purchaser(s) will obviously be close to non-existent, and in such situations there may either have to be a substantial escrow account or the parent or controlling stockholder of the seller(s) may have to become a party to the acquisition agreement and be made liable for the indemnification obligations.
The indemnities are not “indefinite” (well, except, possibly, for certain fundamental representations and warranties). Instead, there will be an “expiry date” on them, after which the parties can no longer rely on the indemnification provisions in the agreement. This is what the survival period addresses. Survival periods do differ for different contractual clauses, and we can broadly divide them into representations and warranties and covenants.
- Representations and Warranties: I have previously discussed the survival period of the representations and warranties and will not repeat myself here. As a general rule, the survival period of the indemnities relating to these representations and warranties will mirror the surival period of the representations and warranties and are negotiated at the same time as the representations and warranties.
- Covenants: As a general rule, the survival period of the indemnities relating to the covenants will be specified as being the same as the applicable statute of limitations. This can, of course, be altered by the parties, with the seller(s) preferring a shorter survival period and the purchaser(s) preferring a longer survival period.
To illustrate, I’ve excerpted one example of a survival period provision, drawn from an English law acquisition agreement that I worked on.3
A Seller shall have no liability for a Claim unless it receives from a Purchaser written notice of such Claim (a “Claim Notice”) specifying in reasonable detail the matter giving rise to such Claim, the nature of such Claim and (if practicable) the amount claimed:
(a) within eighteen (18) months of the Completion Date in respect of any Claim other than a Tax Claim or any Fundamental Warranty Claim; or
(b) within seven (7) years of the Completion Date in respect of a Tax Claim or Fundamental Warranty Claim.
As one might expect, the basic rule for negotiating the survival period of the indemnities is simple: the purchaser(s) want the indemnities to survive for as long a period as possible, while the seller(s) want the indemnities to survive for as short a period as possible. If the market is extremely frothy, the purchaser(s) will often have to give way to the seller(s) on the length of the survival periods.
Damages Covered by the Indemnities
The question of what damages is covered by the indemnities is a thorny question, and one that may not always be obvious to private equity investors without a background in law. To understand this, one needs to understand the types of damages that may be available to a party as a result of a breach of contract.
Damages can be classified as:
- Actual damages: Losses that are directly caused by a breach of contract. Almost all acquisition agreements will indemnify parties for direct damages, up to the negotiated cap. These are sometimes referred to as compensatory damages. In essence, actual damages are meant to compensate the non-breaching party by putting that party in the position that he/she would have been in had there been no breach of contract.
- Incidental damages: Costs incurred by the non-breaching party as a result of the breach of contract by the breaching party. These seem small, but can actually add up to significant amounts in some cases. Not every acquisition agreement will indemnify parties for incidental damages, and as a rule the seller(s) will often be the most motivated to exclude incidental damages.
- Consequential damages: Losses arising out of special circumstances not ordinarily predictable.4 This can include diminution of value.
- Punitive damages: Damages that are imposed as a matter of public policy to punish the offending party and as a means of deterring others from engaging in the conduct that gave rise to the punitive damages. They are, as a rule, not available for breaches of contract, but might be available if a tort is committed by a party to the contract, for example, some forms of fraudulent misrepresentation.
The question, for the parties, is what types of damage will be covered by the indemnification obligations? The best rule of thumb is that the seller(s) will seek to limit damages to actual and/or incidental damages, while trying to exclude consequential damages and punitive damages. Purchaser(s), on the other hand, will aim to expand the list to include consequential damages, but rarely punitive damages.
Purchaser(s) and their counsel should, however, be cautious when agreeing to exclude consequential damages: sometimes this can have unintended consequences.
To conclude our section on damages, this is what the U.S. market looked like in 2014:
|Percentage of Deals (%)|
|Actual damages only||5%|
|Diminution in value||Silent||72%|
Caps and Baskets on the Indemnities
The indemnification obligation is limited to a maximum amount, the “cap”. This serves to limit the exposure of the parties post-transaction:
The cap is often a heavily negotiated term, and one that is driven primarily by the private equity investors rather than by counsel. There are many ways to come up with a number that works for a cap. One can do probability weighted analyses of the expected damages that might result from breaches of investment and calculate the expected amount that might be needed to deal with expected breaches, plus a margin of safety. One can also use median caps for comparable private equity transactions, though given that each transaction is unique, that may not always be the most appropriate starting point (though it will often end up being the ending point).
In my experience there are a few good rules of thumb that I have found work well for determining the cap on indemnities:
- A good rule of thumb is that for larger transactions, the cap will end up somewhere around 10% of the purchase price, while for very small transactions one can see the cap end up around 50% of the purchase price.
- As a rule, in frothy markets the cap on indemnifications will tend to fall as purchaser(s) try to make their bids more attractive to seller(s).
- As a rule, target companies operating in certain industries such as industrials will tend to have higher caps on indemnifications to reflect the additional risk of indemnity claims.5
- As a rule, target companies with significant operations in emerging markets will tend to have higher caps on indemnifications to reflect the additional risk from such operations.
In terms of market data for the U.S. (I am not aware of any comparable studies for Asian M&A transactions), in 2014, the distribution of indemnity caps was as follows:
|Percentage of Deals (%)|
|No cap specified||0%|
|Less than 10% of transaction value||50%|
|10% of transaction value||9%|
|10% – 15% of transaction value||22%|
|15% – 25% of transaction value||11%|
|25% – 50% of transaction value||5%|
|50% – 99% of transaction value||0%|
|100% of transaction value||3%|
Seller(s), and to a lesser extent purchaser(s), do not want to be bothered with every small claim that might arise from a minor breach of the covenants or representations and warranties in the acquisition agreement. They will often negotiate what is called a “de minimis” threshold. Essentially, if your claim is below the de minimis threshold, you are not entitled to make a claim under the indemnity obligations, because it’s just too small. See, for example, a $25,000 claim on a transaction with a purchase price of $2 billion, essentially a 0.00125% of purchase price claim.
The relevant clause in the acquisition agreement will often look something like the following:
No Party shall have any indemnification obligation for Claims under… for any individual item, or group of items arising out of the same event, where the Claim relating thereto is less than $25,000…
Apart from the indemnity caps and the de minimis threshold, the other limitation on the indemnity obligations is the “basket”. The basket in essence requires the aggregate claims for indemnification to exceed a defined threshold before the indemnifying party is required to pay. Once this threshold is reached, the basket can take one of two forms:
- A tipping basket: Once the basket amount has been reached, the indemnifying party pays for all claims, back to the first dollar.
- A deductible: Once the basket amount has been reached, the indemnifying party pays for only the excess claims above the basket.
Neeedless to say, the former is preferred by the party being indemnified; the latter is preferred by the indemnifying party.
Before you ask, the difference between the de minimis threshold and the basket is that the former deals with individual claims while the latter deals with claims in the aggregate. The way the two interact can be complex. In the transactions that I have seen, it has usually been the case that only claims that exceed the de minimis threshold are aggregated to determine when the claims exceed the basket. This is, needless to say, more seller friendly, on the assumption that usually it is the seller that is more likely to have to indemnify the purchaser.
To use a simple example to illustrate the basket and the de minimis threshold:
Assume that in the acquisition agreement for Stark Industries there is a basket of $500,000 and a de minimis threshold of $25,000. The purchaser, Loki Odinsson, discovers the following breaches:
- A breach of a representation and warranty that results in a claim for $10,000.
- A breach of a covenant that results in a claim for $25,000.
- A breach of a representation and warranty that results in a claim for $250,000.
- A breach of a representation and warranty that results in a claim for $100,000.
- A breach of a representation and warranty that results in a claim for $400,000.
To determine whether the basket has been reached, the seller, Anthony Stark, would calculate it as follows: Exclude the $10,000 claim as it is below the de minimis threshold, and sum the $25,000 claim, the $250,000 claim, the $100,000 claim, and the $400,000 claim, for a total of $775,000.
The next step depends on whether the acquisition agreement specifies a tipping basket or deductible.
- Tipping basket: Anthony Stark pays Loki Odinsson the full $775,000.
- Deductible: Anthony Stark pays Loki Odinsson $275,000, the excess over the $500,000 basket.
Looking at market data on U.S. private M&A transactions in 2014, the deductible basket remains the prevalent form, as shown in the table below.
|Percentage of Deals (%)|
Escrow, Holdback or Other Method of Ensuring Payment of Indemnities
Once the parties have agreed on scope, survival periods, caps and baskets, the next major question is how to ensure that the seller(s) and purchaser(s) really do have the money to cover the indemnification obligations. This is particularly the case for financial sponsors where the seller(s) will often be a special purpose vehicle incorporated specifically to hold the target company and where the purchase price will be distributed to limited partners of the selling financial sponsor as soon as practicable.
There are a range of options for ensuring that the indemnities can be paid, the ones I have listed below are but a few of them that I have seen in the transactions I’ve done:
- Holdback: The purchaser(s) may withhold a portion of the purchase price until the expiration of a specified period of time (usually the relevant survival period), whereupon it will be paid to the seller(s). This is the most purchaser-friendly approach I have seen, and is—naturally—resisted by most seller(s).
- Escrow: The purchaser(s) may pay a portion of the purchase price to an escrow agent that will administer the escrowed amount and disburse it in accordance with the terms of the escrow agreement, i.e. when valid claims above the de minimis threshold and basket are presented. Given the current low interest rate environment, an escrow account is an unattractive option for most seller(s).
- Parent company guarantee: The seller(s) may offer a guarantee from their parent company for the seller(s) indemnities.
- Representations and warranties insurance: See below.
The choice of method depends on the negotiating power of the parties; it’s most unique to each case and there are no good rules of thumb that I know of for selecting among the options.
Procedures for Making an Indemnification Claim
The procedures for making an indemnification claim can be hotly negotiated, but usually by counsel to the seller(s) and purchaser(s). It does not tend to be an issue that most private equity investors will become heavily involved in. As such, I will not spend too much time discussing this, except to note that as a rule there will be separate procedures for claims directly against the indemnifying party, and claims made by third parties against an indemnified party. There will also be procedures and rules for ensuring that the indemnifying party has access to necessary documents, officers, employees, etc. of the target company in connection with any defense of a third party claim.
Exclusivity of Indemnities as a Remedy
The majority of private equity acquisition agreements will expressly provide that indemnification is the sole remedy available to the parties, in the form of an “exclusive remedy” clause (see example below). The logic behind this is simple: Why would anyone spend the time and energy to negotiate all of these complex provisions if a party could do an “end-run” around these provisions by bringing a claim under some other remedy in contract law or in tort?
Except for Claims arising out of or resulting from actual fraud, from and after the Completion Date, the sole and exclusive remedy for any breach or failure to be true and correct, or alleged breach or failure to be true and correct, of any representation or warranty, or any breach or nonfulfillment, or alleged breach or nonfulfillment, of any covenant or agreement in this Agreement, shall be indemnification in accordance with this section.
I should note that in general, the purchaser(s) are more likely to resist having an exclusive remedy clause in the acquisition agreement. They usually do not get their way, as can be seen by the data from the ABA, which shows a trend towards indemnification being the exclusive remedy in the acquisition agreement:
|Position of Acquisition Agreement on Indemnification (%)||2006||2008||2011|
While indemnities will often be the exclusive remedy, the parties will often negotiate to exempt fraud from the operation of the indemnity clause (see example above). In other words, if there is a claim that one party fraudulently induced the other party to enter the transaction, the claim is not limited by the indemnities provisions in the acquisition agreement, but instead can be brought under relevant tort or contract law principles, with the potential for a court sanctioned unwinding of the transaction (“rescission”) in some cases. While the fraud exception is reasonably common, and its absence can be a signaling mechanism suggesting that further diligence is justified,7 it is my view (and the view of some eminent transactional lawyers) that a fraud exception ought to be carefully drafted, such that it refers to intentional misrepresentations by specified persons relating to the representations and warranties in the acquisition agreement.8
Furthermore, while parties will expressly exclude the availability of other remedies, there are some limits to that, such that the exclusive remedy clause is not “watertight”. Notably, under Delaware law9 and English law10, as a matter of public policy, a party cannot contract out of liability for its own intentional fraud. Some other states and countries, I understand, will not permit parties to contract out of a broader range of liabilities, and this should be carefully considered when determining the appropriate governing law for the acquisition agreement.11
Representations and Warranties Insurance
Before I end this post, I would like to—briefly—mention representations and warranties insurance, which is something that I have seen used in all the Asian buyout transactions I did at Partners Group.12 Representations and warranties insurance is an insurance policy that provides an insured party—usually the purchaser(s)—with protection from unintentional and unknown breaches of representations and warranties given by another party to the acquisition agreement. It was introduced around 20 years ago, and has gradually become more common in private equity transactions. There are two broad classes of representations and warranties insurance, a buy-side policy that covers the purchaser(s) and a sell-side policy that covers the seller(s). Buy-side policies are more common and more expensive than sell-side policies.13
At its best, representations and warranties insurance can be a useful tool for preserving deal value and/or enhancing a purchaser(s)’ bid. In my experience, if either party is planning to use representations and warranties insurance, it is best to start the discussion early; the insurer(s) will want to understand the nature of the risks they are insuring. Most insurers will exclude certain classes of risks from their general representations and warranties insurance, and if so the parties to the acquisition agreement will have to address such gaps separately.14
Indemnities are probably almost as convoluted a topic as representations and warranties, and with good reason. The best advice I can give to most private equity investors is: Be very careful and listen to your counsel when negotiating indemnities. This, together with the representations and warranties, is still Scylla and Charybdis territory.
Other Posts in the SPA Series
- Stock Purchase Agreement Series — Overview
- Stock Purchase Agreement Series — Purchase Price
- Stock Purchase Agreement Series — Representations and Warranties
- Stock Purchase Agreement Series — Indemnities
- Stock Purchase Agreement Series — Closing Conditions
- Stock Purchase Agreement Series — Covenants
- Excluded liabilities are more common in asset sales or carve-out transactions where there may be certain liabilities that are explicitly retained by the seller(s), so that the purchaser(s) are not responsible for such liabilities or are entitled to indemnification from the seller(s) if there is a claim for such liabilities. ↑
- This is more common in asset sales or carve-out transactions where the purchaser(s) may explicitly agree to assume certain liabilities in connection with the transaction. These might include warranty liabilities for products sold prior to the transaction closing in order to retain control over the customer experience. ↑
- I have found that very often English and Australian law documents tend to be drafted in a more readable form than equivalent U.S. law documents, reflecting the success of the “Plain English movements” in England and Australia. One is tempted, sometimes, to remind U.S. lawyers that they are no longer paid by the length of their agreements. ↑
- My fellow lawyers should still, I hope, recall our infamous case of Hadley v Baxendale (1854) 156 ER 145. ↑
- Yes, it is a fact that there will often be exclusions or separate caps for big ticket items like environmental liabilities and tax liabilities. Nevertheless, certain industries do have heightened risks that purchaser(s) will want coverage for, which are not purely related to environmental or tax liabilities, hence the rule of thumb that there are some industries where you will want to negotiate for a higher cap. ↑
- A combination basket is, as its name implied, some combination of a tipping basket and a deductible basket, which might reflect different allocations of risk among the parties for different liabilities. ↑
- Let’s face it, if someone sitting across the table objects strenuously to a carve-out for fraud, it is a signaling mechanism, intended or not. This is thus one of the “easy wins” that purchaser(s) counsel will often go for at the start of negotiations, knowing that it is hard for seller(s)’ counsel to object, and that most seller(s)—unless they are versed in the common law and the myriad ways that fraud can be defined at common law—will not understand. ↑
- Glenn D. West, “That Pesky Little Thing Called Fraud: An Examination of Buyers’ Insistence Upon (and Sellers’ Too Ready Acceptance of) Undefined “Fraud Carve-Outs” in Acquisition Agreements”, The Business Lawyer, vol. 69, August 2014, 1049 – 1079. ↑
- ABRY Partners V, L.P. v. F&W Acquisition LLC 891 A.2d 1032, 1062 (Del. Ch. 2006). ↑
- HIH Casualty & General Insurance Ltd. v. Chase Manhattan Bank  UKHL 6. ↑
- Don’t laugh. I’ve had some fairly intense discussions with seller(s) in emerging markets over which country’s laws should govern the acquisition agreement, keeping in mind that not every country has a fully functioning legal system and impartial judiciary, and that the length of time it takes for a court case to move through the system in some countries can be measured in years or even a decade. It is an issue outside of the U.S. and Western Europe. ↑
- I should note that these buyouts were secondary buyouts where the seller(s) were financial sponsors. Accordingly, the sample is not representative of trends in buyout transactions more generally. ↑
- The preference for buy-side policies over sell-side policies has to do with: (1) the fact that purchaser(s) claim directly against the insurer, rather than first claiming against the seller(s) and then having the seller(s) claim against the insurer, and (2) the fact that . ↑
- For example, an insurer may not wish to insure against various forms of tax related liabilities, particularly in certain jurisdictions that have less settled tax laws, as the risk is either not quantifiable or is significantly higher than the insurer is able to underwrite at a particular premium. ↑