Mergers and acquisitions (M&A) are complex transactions that involve multiple parties, multiple assets, and complicated agreements. When one company purchases another company or two companies merge, there are expectations on the part of each party concerning the quality of assets being purchased, the success of the future company, and a myriad of other issues.
The parties typically set forth these expectations in various representations, warranties, and covenants within an M&A Agreement. Representation and warranties are statements of fact made by the parties that are true as of the date of the agreement (i.e., Company A purchased Property X on August 4, 2012). Covenants are legal promises made by each party (i.e., Company A shall pay the $250,000 lien against Property X).
In addition to representations and warranties, and covenants, parties also outline, in an M&A Agreement, the specifics of their deal (i.e., what assets are being purchased), their legal rights and obligations (i.e., the buyer is going to purchase the company for $10 million), and their assumption of risks (i.e., the Seller will pay a termination fee of $5 million if it terminates the deal).
Risk allocation is typically accounted for in various indemnification clauses. In today's uncertain economic environment, companies and lawyers on both sides of the negotiation table are focusing on risk allocation via indemnification. Indemnification provisions can be some of the most heavily negotiated provisions in an M&A agreement.
But what exactly are indemnification clauses, and how can they be used to protect my business?
What are Indemnification Clauses?
Indemnification (or indemnity) clauses appear in nearly all commercial agreements. “To indemnify” means to compensate an individual for a harm or loss. At the most basic level, indemnification clauses are a “risk allocation tool.” Indemnification provisions allow a party to (1) customize the amount of risk it is willing to undertake with respect to its counter-party, as well as third parties; and (2) protect itself from liability and damages that may arise from claims arising out of the transaction(s).
Because indemnification clauses are designed to allocate risk, companies, target companies, and lawyers must have a complete understanding of all of the risks involved in the transaction, particularly those inherent in the assets or businesses being purchased. Additionally, parties should weigh the potential magnitude of the risks to be indemnified versus the economics of the transaction. This way, the scope of each parties' indemnification obligations is appropriate to the benefits to be conferred upon the parties in the deal.
The allocation of risk under indemnification provisions can vary depending on the type of transaction. Common risks covered by indemnification clauses include:
- Financial risk, in the event that, for example, the acquired company has hidden debt or other undisclosed financial liabilities;
- Operational risk, in the event that, for example, the acquired company's machinery is obsolete and inoperable, or properties are unusable because of environmental law violations; and
- Legal risk, in the event that, for example, the acquiring company fails to get necessary regulatory approvals for the deal or fails to comply with other federal and state law mandates.
The indemnification clauses in an M&A agreement will determine who pays when risks become a reality and how much those payments will be. Most indemnification provisions require the indemnifying party to "indemnify and hold harmless" the indemnified party for specified liabilities. The parties can draft an indemnification provision to cover any claim that they believe is appropriate given the scope and terms of the transaction. Moreover, the parties may choose to broaden (or narrow) the scope of the damages that the indemnifying party is responsible for.
Importance of Indemnification Clauses in M&A Agreements
Indemnification clauses serve a fundamental purpose in M&A agreements. An indemnification clause lays out in legal terms how Company A will be compensated by Company B for the losses they suffer after a merger or acquisition occurs. Put another way, if a company does not meet its contractual obligations under an M&A agreement, or subsequent claims arise, the indemnification provision outlines the rights and obligations of the parties.
Indemnification clauses generally cover losses resulting from breaches of representations, warranties, or covenants. For example, suppose Company B finds out that Company A did not pay the $250,000 lien against Property X after the closing of the transaction as it promised to do. In that case, Company A may have to compensate (or indemnify) Company B for any losses in connection with its failure to satisfy the lien.
In many cases, a party may also seek indemnification from the other party for specific liabilities that the buyer did not assume. For example, say Company B is purchasing Company A. When drafting the acquisition agreement, Company A makes a representation that Property X in Colorado has not been found to be in violation of federal and state environmental laws. Following the closing of the transaction, Company B receives a notice about a federal investigation into activities that took place on Property X 3 years ago while Company A was still the owner. An indemnification provision would outline Company B's legal rights in this situation.
Components of a Typical Indemnification Clause
A typical indemnification provision consists of two separate obligations: (1) an obligation to indemnify; and (2) an obligation to defend. The obligation to indemnify requires the indemnifying (or breaching) party to reimburse the indemnified party for any costs and expenses (also known as losses) that result from the breach. In addition, the indemnifying party may also have to advance payments to the indemnified party for any unpaid future losses. The obligation to defend requires the indemnifying party to reimburse the indemnified party for any past and future losses that arise in connection with third-party claims or other litigation.
The indemnification clause will contain specific information on the (1) type of payment, (2) the amount of payment, and (3) how and to whom to make the payment. Indemnification clauses also frequently include the following:
- Baskets: Baskets refer to a threshold for indemnification. Baskets, in this context, are true deductibles. This means Company B is only legally liable for losses that exceed the basket threshold suffered by Company A. There are exclusions to these baskets, such as labor issues or environmental liabilities, as well as retained liabilities for Company A.
- Mini-baskets: Mini-baskets are terms used similarly to baskets and represent the minimum amount of losses Company A must endure before they can seek compensation from Company B. In effect, mini-baskets serve to differentiate between material or immaterial losses. Rather than Company B being subject to every small claim that arises after the deal has been closed, they can only be legally responsible once the claims reach the particular threshold outlined in the indemnification clause.
- Caps: Caps refer to a limit or total amount which Company B is liable to Company A. Caps function as a legal cap or limit on the total amount that is payable to Company A. In most cases, the common cap is 50% of the total value of the transaction, but the parties can negotiate this percentage. Caps may be subject to certain exceptions for specified types of claims, such as fraud, willful misconduct, or breaches of certain representations and warranties.
- Special Indemnities: Special indemnities are a way for sellers to indemnify the buyer from any losses against special indemnities agreed to by the parties at the time an M&A agreement is signed. In this situation, Company B might, for instance, set up a special indemnity that has the backing of an escrow fund in preparation for X liability. In the event that X liability arises, caps or deductibles will not apply because of the special indemnity.
Other Important Considerations?
In the event that Company A acquires Company B, an M&A agreement may include an indemnification clause that impacts Company A prior to the close of the merger or acquisition, at the same time the merger or acquisition occurs, or at some point in time following the merger or acquisition.
Each of these time frames dramatically impacts the legal rights of each company and their ability to seek financial recourse and compensation if there are any contractual breaches or third-party claims. There are several different ways an indemnification clause can be drafted, but typically, these provisions will include one or more of the following terms:
- Limitations on Time: Placing time limits on Company A, such that they can only seek compensation Company B for a set number of years. For instance, the length of time that the contract's representations and warranties, covenants, or other provisions will continue to be in effect after a deal has closed determines how long a party will be potentially liable for any violations. Twelve to eighteen months is "market" for the survival of a deal's reps and warranties. Still, parties can contractually extend the effective period of these provisions, and thus, corresponding indemnification clauses.
- Limitations on Damages: Placing total dollar limits on the liability of Company B, as well as the amount of damages that the indemnifying party is responsible for paying out on any given claim.
- Deductibles: Agreeing to a deductible such that the damages requested by Company A must meet a minimum amount before they seek compensation from Company B.
- Limitations on Litigation: Prohibiting Company A from suing over any previously disclosed item through due diligence or that company A had prior knowledge of previous to the agreement.
Contact a Business Attorney To Help Guide You Through M&A Agreements and Indemnification Clauses
Indemnification clauses are an essential component to both buyers and sellers within an M&A agreement. However, these provisions can be challenging and legally complex. If you are engaging in a merger, acquisition, or disposition, consider reaching out to one of our experienced M&A attorneys to ensure you are not taking on more risk than you intend.
At Newburn Law, we can help you with negotiating and drafting your M&A agreement, understanding your legal rights and obligations, and allocating risks in a way that best protects you and your business. Our team can also help you understand indemnification clauses in your existing contracts better or help you with drafting these provisions in M&A agreements you choose to create. Taking the time to speak with our experienced attorneys can ensure that your legal and financial rights remain protected throughout the merger, acquisition, or disposition process. Even a minor mistake in an M&A agreement as it pertains to the indemnification clauses can result in significant reputational damage or monetary losses.
If you are in a situation where you need help understanding indemnification clauses in M&A agreements or are considering drafting an M&A agreement, our experienced attorneys can prepare you for the next steps and guide you during this time in your business.
Contact Newburn Law for your free consultation today!