Looking Over Your Shoulder: Just How Long Does the Threat of Indemnification Lurk?
When you sell your business, the purchase agreement between you and your buyer will contain a number of promises that you make to your buyer. These promises come in the form of representations, warranties, covenants, and other agreements relating to the business. Many of these provisions are tied to the disclosure schedules that you (or your attorney or both) prepare and attach to the purchase agreement. Still, there are other risks of breach of the purchase agreement that may be outside of your control. In addition, a buyer may also require supplemental indemnification provisions if it has concerns about specific liabilities, including specific environmental conditions; retained employee liabilities; product liability claims; current or pending litigation; and pre-closing taxes.
Generally, indemnification is the buyer’s remedy for a breach of any promises made in the purchase agreement or losses incurred relating to specific liabilities outlined in the purchase agreement. Indemnification allocates the risk of various post-closing losses between buyer and seller. For this reason, the indemnification provisions of your purchase agreement will very likely be among the most heavily negotiated provisions in your purchase agreement. Since the buyer is more likely to incur losses after closing, the buyer will advocate for broad indemnification provisions. Since the seller is the one agreeing to pay for any losses covered by the indemnification provisions, the seller will advocate for narrow indemnification provisions and seek to minimize his or her obligation to pay the buyer for any post-closing losses.
Indemnification allocates the risk of various post-closing losses between buyer and seller.
Indemnification obligations survive closing – meaning the obligations remain in effect even after you close the deal and collect the purchase price. The survival period for the representations and warranties made in the purchase agreement usually ranges from six months to two years. Since the seller is the one agreeing to pay for any losses covered during the survival period, the seller will advocate for a short survival period to minimize the risk of losses springing up in that time frame. Buyers generally will want to ensure the survival period lasts at least through the completion of one audit cycle.
Certain representations have a longer survival period than other provisions. Generally, representations covering corporate organization, authority and capitalization; title to stock; taxes; environmental matters; and ERISA often survive until the expiration of the applicable statute of limitations or indefinitely. Covenants and other agreements usually survive indefinitely.
Limitations to Indemnification
To address the threat of indemnification post-closing, sellers will try to negotiate monetary limits on indemnification. Two common indemnification limitations are baskets and caps.
Baskets require a party to reach a certain amount of losses before any indemnification obligation is triggered. They usually only place limits on indemnification with respect to breaches of representations and warranties. In addition, certain representations and warranties are often excluded from the scope of the limitation. Baskets can be structured as thresholds, where once the threshold amount is exceeded, the indemnifying party is liable for the total amount of losses; or as deductibles, where once the minimum amount is exceeded, the indemnifying party is only liable for any amount over the minimum. A mini-basket may be included within a basket to require the losses from a particular claim to exceed a certain amount before being counted toward the basket.
Caps place a maximum limit on a party’s recovery. The cap is often limited to an amount less than the total purchase price and oftentimes equal to an amount placed in escrow (further explained below). Caps may apply only to breaches of representations and warranties and may exclude certain representations and warranties.
Indemnification as Exclusive Remedy
While some buyers may push back and try to preserve their right to bring other types of claims against the seller, most buyers will concede to indemnification being their sole remedy for breach of any promise in the purchase agreement. If the seller has negotiated monetary limitations on indemnification, such as baskets and caps, it is important that indemnification is the exclusive remedy of the buyer so that the buyer cannot exceed the limitations set by the purchase agreement by bringing other causes of action against the seller.
A buyer will want to ensure that the seller has adequate funds to pay indemnification claims. Buyers will often ask that part of the purchase price be set aside and held in escrow to satisfy the seller’s indemnification obligations should the buyer incur post-closing losses. These funds are often held in escrow during the survival period.
In summary, the indemnification provisions in any purchase agreement are often times the most highly negotiated aspect of the agreement and deal in general. It is also one that is reliant on several other aspects of the agreement, namely the disclosure schedules. It is for this reason, you should pay particular attention to the representations, warranties, covenants and related schedules in any agreement to sell your business in order to manage the “threat” of indemnification post-closing.
This document is intended to provide information of general interest and is not intended to offer any legal advice about specific situations or problems. Neither the author nor Strassburger McKenna Gutnick & Gefsky intend to create an attorney-client relationship by offering this information, and anyone’s review of the information shall not be deemed to create such a relationship. You should consult a lawyer if you have a legal matter requiring attention.