Indemnification in M&A Contracts Part II: Indemnification “Claims”

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Part II of our series on Indemnification in M&A focuses on the types of claims Indemnification covers.[1]

What “Claims” does Indemnification Cover?

The Claims covered under a purchase agreement in an M&A transaction often catch sellers and other parties off guard because they are very wide. Specifically, indemnification is usually the sole remedy if something goes wrong related to the M&A Purchase Agreement. (This “Exclusive Remedy” provision is generally subject to exceptions for fraud, equitable remedies and, in many cases, claims under ancillary documents entered into in connection with the Purchase Agreement, such as employment agreements.)

The clause below lists some representative language used for the types of claims covered in the context of an asset purchase. The indemnification clause for an equity (stock or membership interests) purchase is usually similar to the list below but may omit items such as (3) Excluded Assets and Excluded Liabilities and (4) Third Party Claims.

1.01      Subject to the other terms and conditions of this Article VIII, seller shall indemnify and defend each of Buyer and its Affiliates and their respective Representatives (collectively, the “Buyer Indemnitees”) against, and shall hold each of them harmless from and against, and shall pay and reimburse each of them for, any and all Losses incurred or sustained by, or imposed upon, the Buyer Indemnitees based upon, arising out of, with respect to or by reason of:

  1. any inaccuracy in or breach of any of the representations or warranties of seller contained in this agreement, the ancillary documents, or in any certificate or instrument delivered by or on behalf of the seller pursuant to this agreement, as of the date such representation or warranty was made or as if such representation or warranty was made on and as of the closing date (except for representations and warranties that expressly relate to a specified date, the inaccuracy in or breach of which will be determined with reference to such specified date)
  2. any breach or non-fulfillment of any covenant, agreement, or obligation to be performed by seller pursuant to this agreement, the ancillary documents, or any certificate or instrument delivered by or on behalf of seller pursuant to this agreement
  3. any excluded asset or any excluded liability
  4. any third-party claim based upon, resulting from or arising out of the business, operations, properties, assets, or obligations of seller or any of its affiliates (other than the purchased assets or assumed liabilities) conducted, existing, or arising on or prior to the closing date

In a nutshell, several different types of claims are covered by indemnification in M&A transactions:

Inaccuracy or Breach of the Representations and Warranties

These are claims by one party to the purchase agreement (usually, but not always the buyer) that the representations and warranties of another party to the purchase agreement (usually the seller) were not accurate.

For example, the seller represented that there were no contracts in default.  The buyer finds out post-closing that 20% of the contracts were in default. In this example, the buyer would make a claim against the seller directly stating “X representation/warranty was inaccurate and caused Y amount of damages to me, the buyer.”

Breaches of covenants, agreements, or obligations

Similar to inaccuracy or breach of representations and warranties, this is a claim by one party to the purchase agreement against another party to the purchase agreement. But this subsection involves the failure of one party to take actions or not take actions they promised to complete as part of the purchase agreement.

For example, the buyer may have promised to use its best efforts to obtain Costa Rican anti-trust approval for the transaction, but failed to meet that standard. Failure to meet that standard would be a “breach of the covenants” of the buyer under the purchase agreement.

Pre-Closing Liabilities and Excluded Assets

In a M&A transaction, the buyer and seller agree to allocate responsibility for certain risks (or liabilities) between the parties, generally based on three things:

  1. representations and warranties made by the seller/owners in the purchase agreement
  2. pre-closing versus post-closing
  3. the assets being sold versus retained by the seller

In simple terms, the seller is generally responsible for anything that happened in the business prior to the closing date, while the buyer will be responsible for anything happening in the business after the closing. Generally, in an asset sale, almost all liabilities are retained by the seller (i.e. “Excluded Liabilities”).

If the seller or selling owners elect to keep any assets (i.e. “Excluded Assets”), this section also allocates responsibility for claims that may arise associated with those items. Equity purchases, on the other hand, may be structured differently – a buyer in an equity transaction may assume some or all liabilities of the target company at closing. The risk associated with pre-closing liabilities are allocated between the buyer and seller through the representations and warranties, as well as indemnification, and there often will be no separate indemnification category that covers concepts like Excluded Liabilities or Excluded Assets.

Third-Party Claims

This goes hand and hand with splitting responsibility for certain claims pre-closing and post-closing, specifically third-party claims that relate to events pre-closing versus post-closing – for example, unpaid vendors from the pre-closing period, taxes from pre-closing period, customer suing based on an improperly executed project from pre-closing period, etc. Third party claims may be subsumed into the representations and warranties indemnification requirements in an equity purchase, instead of being separately listed.

Specifically Named Items

Sometimes the buyer and seller will specifically identify additional items in the Indemnification section. These are usually items the buyer is particularly concerned about and wants specifically identified as a responsibility of the seller. Examples of these special provisions might be calling out a sales tax issue, a pending employment claim, etc.

In summary, the scope of potential claims covered by indemnification is very wide in M&A Purchase Agreements. With that in mind, Part III of our series will focus on the Time Periods for Indemnification.

[1] Readers of this series should note that each transaction is different and generalizations herein may not apply to every transaction. This is particularly true where Representations and warranties insurance has been obtained for the transaction.

Posted in: M&A
About the Author
Candace Groth

Candace Groth is a senior attorney at Vela Wood. She focuses her practice in the areas of mergers and acquisitions and commercial contracts.

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Other Posts in this Series
1 of 2 Indemnification in Mergers and Acquisitions Contracts
Indemnification in Mergers and Acquisitions Contracts
2 of 2 Indemnification in Mergers and Acquisitions Contracts
Indemnification in M&A Contracts Part II: Indemnification “Claims”