Indemnification provisions are an essential component of any M&A transaction and, for obvious reasons, buyers and sellers have opposite agendas in drafting the scope and substance of their inclusion in a transaction agreement. Buyers are motivated to protect themselves from post-closing monetary damage, and the type and extent to which they can indemnify themselves is often the subject of extended negotiation in M&A transactions. A review of three related indemnification provisions commonly included in transaction agreements, and their prevalence in 2013, helps to set the stage for the coming year.

Basket clauses

Parties to a transaction agreement will often negotiate a basket amount which serves as a minimum threshold for indemnification claims. For example, the parties might agree that the seller is not liable to indemnify the buyer for losses unless the amount of loss exceeds a certain dollar amount; this amount can either trigger an obligation to pay the entire aggregate amount of the loss (a first dollar basket), or only those amounts that exceed a deductible value (a deductible basket). The American Bar Association’s 2013 Deal Points Study of private mergers and acquisitions (the ABA Study) indicates that last year, 95% of deals included a basket and, of those, 59% had a deductible basket and 32% had a first dollar basket.

Not surprisingly, the dollar amount – whether in a first dollar or deductible basket – is the main point of contention between buyers and sellers. The ABA Study found that of the deals with baskets, 56% of deals set the basket value at 0.5% of the transaction value or less. 32% of deals had baskets between 0.5% to 1% of the transaction value.

Liability caps

While the value of a basket clause is important to both parties to a transaction, sellers may be even more concerned with the inclusion of a liability cap. Liability caps serve to limit contractual indemnification obligations to a certain dollar value, and the ABA Study found that 96% of deals in 2013 included these provisions. The cap was set at 25% of the transaction value or lower in 93% of the deals, with 60% of the deals including a cap of 10% or less of the transaction value.

Buyers want to negotiate a large liability cap to protect themselves as much as possible from future loss. On the other hand, sellers have an inherent interest in limiting their liability to less than what the deal was worth. If the cap exceeds what the transaction was worth, sellers who are liable for losses greater than the transaction value would have been better off to walk away from the company rather than sell it.

Materiality scrapes

Sellers often include materiality qualifiers in their representations and warranties for the purpose of limiting their liability. The purpose of a materiality “scrape” is to effectively exclude those qualifiers from the buyer’s right to post-closing indemnification in the event of loss. An example materiality scrape might be worded as follows: “For the purpose of Article X (Indemnification), the representations and warranties of Target shall not be deemed qualified by any references to materiality or to Material Adverse Effect.”

The ABA Study indicates that in 2013, 28% of agreements with a basket clause included a materiality scrape and, of those, only 41% limited the scrape to the calculation of loss and damages only. Of course, materiality scrapes are buyer-friendly provisions and, interestingly, they are now one of the most regularly negotiated provisions in private M&A transactions. Sellers are motivated to resist materiality scrapes, and may justify their position on the grounds that they need such qualifiers to accurately make representations and warranties, or that they are necessary to create fair risk profiles.

The author wishes to thank Dana Carson, articling student, for her valuable assistance in preparing this legal update.