Coming to Terms: Important Issues and Considerations in Drafting M&A Agreements — Part III: Indemnification

The indemnification provisions are among the most heavily negotiated portions of a purchase agreement, yet business owners may be tempted into thinking they are simply something lawyers like to argue over without realizing their importance.  The indemnification provisions deal with the issue of what rights the acquirer have when it discovers a breach of the representations and warranties.  Much of this depends on when the risk is discovered.

If the definitive agreement is structured such that the closing is scheduled to occur after the signing of the agreement, then a breach of the representations and warranties discovered before closing often allows the acquirer to walk away from the deal without closing.  In that case, the acquirer may walk away or at least use the threat to do so to lower the purchase price.  In most private company deals, the closing occurs at the same time the definitive agreement is signed, so this is usually not an option.  If the breach is discovered post-closing and the acquirer is harmed or damaged in specific ways after the closing, then the seller is liable to compensate the acquirer for that damage or harm.

A very basic seller indemnification provision read as follows:

The seller and each shareholder, jointly and severally, will indemnify and hold harmless the buyer and its shareholders and subsidiaries (collectively, the “Buyer Indemnified Parties”), and will reimburse the Buyer Indemnified Parties for any loss, liability, claim, damage, or expense (including costs of investigation and defense and reasonable attorney’s fees and expenses), whether or not involving a third-party claim, arising from or in connection with . . . [a list of matters].

So what does all this legalese mean?  In simple terms, the duty to indemnify and hold another harmless means to compensate the other for a loss suffered,  In the context of a purchase agreement, the indemnity given by the seller and its shareholders is a contractual agreement by them to compensate the buyer for certain losses the buyer suffers after the closing and which are related in some way to representations, warranties, covenants, or other obligations of the seller and/or its shareholders set form in the purchase agreement.
In short, if the buyer is harmed or damaged in specific ways after the closing, then the seller is contractually agreeing to compensate the buyer for that damage or harm.  From the seller’s perspective then, it’s critical to review and understand the seller’s indemnity obligations and to be sure they are as narrowly drawn as possible.

Some of the matters typically made part of the seller’s indemnification provision are:

  • Breaches of representations and warranties made by the seller or shareholders;
  • Breaches of covenants or other obligations of the seller or shareholders;
  • Any liabilities arising out of the ownership or operation of the company’s assets before the closing;
  • Any product manufactured by or shipped by the seller or any services provided by the seller before the closing;
  • Certain specific matters which may be disclosed in the disclosure schedules; and
  • All liabilities specifically retained by the seller.

The seller’s lawyer should try to minimize the risks by pushing for limits on the indemnification provisions.  Some common things to ask for are:

  • Time limits as to when the acquirer can bring a claim;
  • Total limits to the seller’s liability
  • A deductible, whereby the acquirer’s damages must exceed a certain amount before any liability occurs;
  • Ensuring that if any loss is covered by insurance, the acquirer must file an insurance claim before suing the seller; and
  • Prohibiting the acquirer from suing over anything that was disclosed in due diligence or that the acquirer actually knew about.

Conclusion

The indemnification provisions in an M&A agreement are extremely important to buyers and sellers but often are very difficult to read and to understand.  It is important that all attorneys assisting in the M&A agreement, no matter their level, take the time to understand the business deal in order to ensure that the agreement properly reflects such deal.  A small mistake in an acquisition agreement’s indemnification provision could have a large dollar impact for your client.

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