Indemnification: What Exactly Is a Seller Responsible for When Selling Its Business?

What Is a Seller Liable For?

A seller is generally liable for any breaches of its representations, warranties and covenants contained in the purchase agreement. Representations and warranties are written statements the seller makes about itself and the business, which may include ownership of equity interests and assets, authority to transact, corporate organization, financial statements and liabilities, and customers and contracts, among other things. Covenants are promises by the seller to take (or not take) specific actions, which may include agreements not to compete with the business after closing (typically for three to five years) within a defined geographic area and not to disclose confidential business information. In a typical deal structure, if the seller’s representations and warranties aren’t accurate, or the seller breaches its covenants, it must indemnify the buyer for any resulting losses.

Asset deals sometimes follow a so-called “our watch / your watch” approach. Under this approach, a seller may be required to indemnify the buyer for all liabilities arising prior to closing of the transaction, whether or not the liabilities would be a breach of any representation or warranty (and, in exchange, the buyer is required to indemnify the seller for all liabilities arising after closing).

Limitations on Liability

A seller’s liability is typically limited by negotiated survival periods for claims, caps, baskets and other limitations on recovery.

Survival Periods: “Survival periods” refers to the time that a party entitled to indemnification can bring a claim against the other party. Typically, the seller’s indemnification obligations for breaches of most “standard” representations and warranties last 18-24 months after closing. However, potential liabilities discovered during the buyer’s due diligence may be subject to separately negotiated and more extended survival periods. Representations and warranties relating to “fundamental” matters (such as the seller’s ownership of the equity interests or assets being sold, and its authority to enter into the transaction), and other matters such as taxes, ERISA and broker’s fees, typically last longer.

Caps and Baskets – Deals Without RWI: A seller’s indemnification obligations in deals without RWI are usually limited to an agreed-upon percentage of the purchase price (cap), which varies with the deal value and the matter for which indemnification is sought. In smaller transactions, liability for breaches of “standard” representations and warranties is often limited to 15%-20% of the purchase price. In larger transactions, liability for breaches of “standard” representations and warranties usually will not exceed 10% of the purchase price. Indemnification for potential liabilities discovered during the buyer’s due diligence that are subject to separately negotiated survival periods may be subject to separately negotiated liability caps. Indemnification for “fundamental” matters (and other matters for which similarly extended survival periods apply) is typically capped at the purchase price (or sometimes uncapped).

To discourage litigation over matters involving small amounts of money, buyers and sellers typically negotiate thresholds (baskets) to the seller’s indemnity obligations, below which the seller will not be liable (typically, 0.5%-1% of the purchase price, depending on the deal’s value). These thresholds can be in the form of deductibles or what M&A professionals call “first-dollar” or “tipping baskets,” where the buyer can seek indemnification from dollar one for all losses once the threshold has been reached. Indemnification for known liabilities (such as pending or threatened litigation), “fundamental matters” and other matters for which extended survival periods apply, will typically be excluded from such baskets.

However, in asset deals following the “our watch / your watch” approach, claims related to pre-closing liabilities and post-closing liabilities may not to be subject to the limitations that are imposed on claims related to breaches of representations and warranties.

Caps and Baskets – Deals With RWI: A seller’s indemnification obligations in deals with RWI are usually limited to one-half of the RWI deductible; and subject to agreed-upon caps, certain matters that are excluded from RWI coverage and losses in excess of the RWI coverage amount. In a “no seller indemnity” structure, a seller can have no exposure for breaches of its representations and warranties.

Whether or not there is RWI, the parties usually will state expressly that no limitations of liability for indemnification will apply if the seller has committed fraud, and buyers often will seek no limitations of liability for breaches of covenants.

Funding for Indemnification

Buyers frequently seek to fund potential indemnity claims by placing a portion of the purchase price into escrow at closing (frequently, 10% in deals not using RWI) or by deferring payment of a portion of the purchase price and insisting on a right of offset against the deferred payment(s). A buyer may also seek to fund potential indemnity claims by purchasing RWI. However, RWI currently is not available on deals under about $20 million in value, will be subject to an overall coverage limit (usually 10% of the transaction price), is subject to a deductible (historically, about 1% of the transaction value), and will not cover known liabilities or breaches of covenants.

Conclusion

Understanding market standard terms for a seller’s indemnity obligations is essential to both buyers and sellers. Since indemnification is one of the most heavily negotiated provisions of a purchase agreement, either party’s failure to understand market standard terms creates the risk of that party insisting on indemnification terms that can kill a deal.

Paul Pincus, Esq. is a partner at the international law firm Ortoli | Rosenstadt LLP and head of the firm’s Mergers & Acquisitions practice. He can be reached at (212) 829-8931 or php@orllp.legal.