Allocating liability between buyers and sellers for the business and operating risks of a target company in M&A transactions is key to assessing what might be an appropriate purchase price for the transaction. As a result, the indemnification provisions in a purchase agreement are heavily negotiated with buyers seeking to limit their post-closing damages and sellers seeking to limit their liability for uncertain risks.
Recent trends in the use of indemnities are revealed in the 2016 SRS Acquiom M&A Deal Terms Study (the SRS Acquiom Study) which analyzed 735 private-target acquisitions that closed in 2012 through 2015.
Where a specific risk is identified in the course of the purchaser’s due diligence, it is often advisable to specifically address that risk in the form of a separate indemnity in the purchase agreement, as opposed to relying on the standard indemnities for the seller’s breach of representations and warranties and covenants. The SRS Acquiom Study reveals that separate indemnities are most commonly used to protect purchasers from (i) taxation liability (78% of the deals reviewed in 2015), (ii) payments to dissenting shareholders (72%), (iii) the accuracy of closing certificates (69%), (iv) transaction expenses (43%), (v) litigation (35%), (vi) fraud and wilful misrepresentation (33%) and (vii) purchase price adjustments (33%).
There may be circumstances where the purchaser learns of a seller’s breach of a representation, warranty or covenant prior to closing but says nothing about it until the transaction has closed, in order to bring about an indemnity claim at a later stage. The SRS Acquiom Study reveals that “pro-sandbagging provisions”, which permit the purchaser to pursue this course of action, have reduced in prevalence over the course of the past few years, from a high of 64% in 2012 down to 52% in 2015. The prevalence of “anti-sandbagging” provisions, which limit the seller’s liability for such losses, has correspondingly increased from only 34% in 2012 to 45% in 2015, indicating that sellers have improved their bargaining position in this respect. Not surprisingly, very few purchase agreements are silent on the issue.
Sellers often seek to qualify the representations and warranties in a purchase agreement in terms of materiality, in order to limit their liability. Purchasers can reduce the impact of these qualifiers by including an indemnification provision that expressly states that these materiality qualifiers do not apply for the purpose of indemnification. This materiality scrape can apply for the broad purpose of determining whether any breach of representation or warranty has occurred, or it can be reduced in scope to be only relevant for the purpose of calculating losses. The SRS Acquiom Study indicates that in both 2014 and 2015, most ( i.e., 55-58%) materiality scrapes negotiated applied only for the purpose of assessing damages. The remainder were split roughly equally between (i) applying to assess whether there has been a breach and (ii) applying both to assess whether there has been a breach and for the purpose of assessing damages, with the latter use being most advantageous for purchasers.
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