When one company buys another, or two companies merge, each has expectations regarding the potential success of the future company, the quality of the assets being purchased, the level of risk they’re assuming, and many other issues. Because mergers and acquisitions (M&A) are complicated transactions, involving multiple parties and assets, these expectations are expressed as representations, warranties, and covenants within the M&A agreement. The agreement also details the terms of the deal, the parties’ legal rights and obligations, and their assumption of risk.
Indemnification clauses are the typical means by which businesses seek to protect themselves from excessive risk in M&A deals. Simply put, an indemnification clause lays out in legal language how one company (usually the buyer) will be compensated by another for losses they suffer after a merger or acquisition takes place. While it’s not unusual for these to be some of the most heavily negotiated terms of any deal, in the current uncertain economic environment the focus on mitigating risk is more intense than ever.
To craft indemnification clauses appropriate to the transaction, sellers, buyers, and their legal counsel should all have a thorough understanding of the risks involved, especially those inherent in the businesses being purchased or the assets being exchanged. The risks to be indemnified should also be balanced against the economics of the transaction, to ensure that the scope of potential indemnification obligations is appropriate to the benefits of the deal to each party.
Understanding Indemnification Clauses
Indemnification clauses can be created to cover any claim parties believe is appropriate, given the terms and scope of the transaction in question. Common types of risk covered by such clauses include financial risk (such as if the seller had undisclosed financial liabilities), operational risk (if the equipment or property transferred were inoperable or unusable), or legal risk (if the buyer didn’t comply with federal or state law or failed to get necessary regulatory approval for the deal). The clauses included in a deal specify who pays when a loss occurs and how much those payments will be. They generally cover losses that result from breaches of warranties, representations, or covenants—in other words, if the facts of the deal were not as represented, or a party fails to live up to the terms they agreed upon.
Indemnification provisions usually consist of two separate obligations:
- Obligation to indemnify: The breaching party is required to reimburse the indemnified party for costs and expenses resulting from the breach.
- Obligation to defend: The breaching party must reimburse the indemnified party for past and future losses related to third-party claims or other litigation.
The terms of the clause will not only specify the type, amount, and recipient of any payments to be made, but also limits on the scope of the clause.
- While indemnification clauses can be drafted in many ways, these provisions will generally include the following to clearly define the rights and obligations of each party:
- Limitations on time: Specifying the length of time the indemnified party can seek compensation from the indemnifying party after the deal has closed. Twelve to eighteen months is a common time frame.
- Limitations on damages: Specifying the liability of the indemnifying party as a total dollar limit, as well as the amount of damages they’re responsible for paying on any given claim. This may be structured as a cap; a common cap is 50% of the total value of the transaction. There may be exceptions to caps for certain types of claims, such as fraud or willful misconduct.
- Deductibles: Setting a deductible by which damages must reach a certain threshold before the indemnified party can seek compensation. For instance, a basket, a typical M&A provision, is a true deductible, in which the indemnifying party is only legally liable for losses that exceed the basket threshold. These can also be subject to exclusions, such as for environmental liabilities and labor issues.
- Limitations on litigation: Prohibiting the indemnified party for suing over any issues they had prior knowledge of before the agreement or that were disclosed through due diligence.
The complexity of these provisions can make them a potential minefield in an M&A deal; without experienced legal counsel to provide guidance, a company could take on more risk than intended, opening themselves up to considerable financial losses or reputational damage.
Protecting Your Interests in M&A
If you’re contemplating a merger, acquisition, or disposition of your company, Bridge Law LLP can help negotiate and draft an agreement that protects your legal and financial rights throughout the M&A process. Our expert team provides the highest quality legal services in the M&A market, with experience in both domestic and international transactions. To learn more about how we can assist your business at every stage, contact us here to schedule a consultation.