Classification: Deal Driver
Negotiation Time: Moderate to Substantial
Transaction Costs: Intermediate
Major Impact: Deal Value, Risk Management, and Transaction Completion
What is This? If no limits are set on the right to indemnification it is a tool that can be abused by the parties, especially in situations where there is not a working relationship between the Buyer and Seller after the Closing. Here, the parties implement boundaries around indemnification to avoid the problems caused by abuse of indemnification rights.
The Middle Ground: This provision limits the indemnification claims that can be brought by setting “Caps” and “Baskets” around the right to indemnification. A Basket sets a minimum amount of damages that must be incurred before an indemnification claim can be brought, and it is typically limited to claims based on breaches of the representations and warranties in the Agreement. Typically, the Basket sets a minimum threshold for making a claim and once that threshold is reached the injured party is eligible to receive 100% of the damages it suffered. A Cap may also be included, and it serves as an upper limit on the amount that will be paid in the event of a claim or the aggregate amount that will be paid out for all indemnification claims of a party.
Purpose: The purpose of a Basket is to prevent one party from trying to recapture some of the value given up in the deal by making numerous “nickel and dime” claims against the other side. In other words, it prevents the parties from abusing their indemnification rights. By doing so, the provision protects the parties’ expectations regarding their risk exposure and the value received from the transaction. Caps are also used as a tool to manage overall risk exposure, and they are especially important in situations where there is a reasonable potential for one of the parties to make a large indemnification claim. In addition to their risk management function, Caps and Baskets also increase the chances that the transaction will be completed by encouraging the parties to provide expansive indemnification rights since they know those rights are not subject to abuse and will not create unlimited liability.
Buyer Preference: The Buyer is the party most likely to bring an indemnification claim, which has a number of implications for how it wants to structure this provision. At the most basic level, it wants the Basket to be small (to allow for the payment of moderate claims) and the Cap to either be large or nonexistent. It may also want to tailor the Cap to its specific concerns; if the potential Losses based on one representation are much greater than for the other representations, the Buyer may be better off negotiating for a significantly higher Cap (or no Cap at all) in that area and a smaller Cap in the other areas than for a moderate Cap applicable to every representation. It certainly wants no Cap regarding any liabilities kept by the Seller, as it has no control over those liabilities. It also wants to carve out certain fundamental representations from the Basket and Cap, such as the Organization and Authority representations.
The Buyer wants to resist additional limitations on indemnification payouts, such as a Duty to Mitigate or a requirement to subtract from such payouts any tax or insurance amounts. However, when a Basket is included in the Agreement the Buyer is more likely to seek a “materiality scrape,” which is a provision that removes any materiality qualifiers from the representations and warranties for indemnification purposes. When a materiality scrape is used, the materiality qualifiers used in the representations and warranties still apply to limit what the Seller must disclose in the Agreement, but they do not apply for purposes of determining whether an indemnification claim can be brought and what the damages for the claim will be. The reasoning underlying the use of a materiality scrape in this context is that the Basket already screens out any non-material claims, so including an additional materiality requirement will likely complicate the indemnification process and lead to needless disputes.
Seller Preference: Since the Seller is going to be paying out an indemnification claim in most cases, it will typically seek a high Basket and a low Cap. In addition to this basic position, the Seller will also prefer a “deductible” Basket rather than a “dollar one” or “tipping” Basket. The distinguishing factor about deductible Baskets is that the Basket amount is more than just a threshold, it is also the amount deducted from the total damages to determine the required payment. To put it another way, with a deductible Basket the side making the claim is only entitled to the amount of damages exceeding the Basket amount. In lieu of a deductible Basket, the parties could settle on a hybrid approach, in which the amount deducted from the payout is less than the threshold amount but more than zero. Another beneficial option for the Seller is to include one or more “mini-baskets” that require damages from a particular representation to reach a certain amount before they are counted toward the overall Basket.
Over and above changing how the Basket functions, the Seller could also try to have the Basket apply to all representations, warranties, covenants, and obligations contained in the Agreement, not just the selected representations and warranties. Similarly, the Seller can try to negotiate for the Cap to extend to all indemnification claims. If unsuccessful on that front, the Seller can argue that some Cap (e.g. the Purchase Price amount) should be placed on payments for breach of fundamental representations and warranties, as well as the remaining covenants and obligations in the Agreement, even if that Cap is higher than the Cap applied to the non-fundamental representations and warranties.
Furthermore, the Seller can avoid a “double recovery” situation by including language reducing any indemnification payments by the amount of any insurance money paid to the Buyer for the claim, and it can make the language more effective by requiring the Buyer to use its reasonable best efforts to pursue any viable insurance claim. Another way to avoid double recovery is to reduce the amount of any indemnification claims that result in a tax benefit to the Buyer by the amount of the tax benefit. For instance, if the Seller breaches a representation and the Loss from that breach causes the Business to sustain a net operating loss (NOL) for the year, the amount of the indemnification claim would be reduced by the tax value of the NOL. One final way to limit double recovery applies in situations where the Agreement allows for a Purchase Price Adjustment, and the goal is to ensure that any such adjustment is subtracted from the Losses payable based on an indemnification claim. The Seller could also seek to impose on the Buyer a “Duty to Mitigate,” meaning the indemnified party would be required to try to reduce its damages from a breach by taking some sort of corrective action.
Finally, if the Agreement contains an escrow provision, the Seller can negotiate for its money held in escrow to be paid out to satisfy a claim for indemnification before it is required to pay money out of its own pocket to do so.
Differences in a Stock Sale Transaction Structure: None.
We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.