Exclusive Remedies
What are Exclusive Remedies? Buyers and sellers usually spend significant time agreeing on an indemnification scheme, so they tend to want most claims for breaches of the Agreement to be governed by indemnification. This section identifies the claims that must be pursued through indemnification and those that are exempt from that limitation.
The Middle Ground: Subject to the equitable remedies provided for in the Agreement, this provision limits the parties’ available remedies in the event one of them breaches the Agreement, except for situations involving fraud, criminal activity, or intentional misconduct. More specifically, if a breach occurs that is not due to one of the three listed exceptions and for which an equitable remedy is not available, the non-breaching party’s only option is to make an indemnification claim (if the parties have chosen to make all covenants and other terms subject to indemnification in addition to the representations and warranties).
Purpose: This restriction is intended to limit the parties’ risk by making indemnification the sole avenue for resolving most claims related to the Agreement. In fact, this term is necessary if indemnification is intended to be the Agreement’s main enforcement mechanism, because without it the parties could simply bypass the indemnification process by filing a lawsuit.
Buyer Preference: Being a fairly standard provision, most buyers accept it as part of the Agreement and, consequently, spend a considerable amount of time negotiating their indemnification rights. However, more aggressive buyers may argue for an alternate provision that allows for indemnification in addition to the usual legal and equitable remedies.
Seller Preference: The Seller wants the exceptions included in this provision to be as narrow as possible since it is typically the party against whom a complaint is being made. In particular, the definition of fraud varies from state to state and may not be as limiting as the Seller intends it to be. To prevent an unwelcome surprise, the Seller (and/or its attorney) must be aware of the legal bounds of fraud, criminal activity, and intentional misconduct in the state whose law governs the Agreement.
Differences in a Stock Sale Transaction Structure: None.
Effect of Investigation
What is the Effect of Investigation section? The Buyer and Seller may view the role and consequences of due diligence differently, so this section is used clarify how knowledge gained during due diligence affects the parties’ rights under the Agreement.
The Middle Ground: This clause states that the parties’ indemnification rights are not affected by its pre-Closing knowledge (or that of its Representatives) or by the waiver of any of the Conditions to Closing. It is often referred to as a “sandbagging” provision because the non-breaching party can claim indemnification after Closing even if it knew or should have known prior to Closing that a representation or warranty was inaccurate.
Purpose: This provision is included to fortify the parties’ indemnification rights in situations where one party knew or should have known prior to the Closing that one or more of the other party’s representations was false. Because the Buyer is typically the one conducting an investigation and gathering information, it is most helpful to the Buyer. It lessens the Buyer’s transaction risk, helps it protect the value it receives from the deal, and makes for a much quicker transaction process for both sides.
Without this provision, the Buyer would need to either (i) investigate every time a Seller’s statement doesn’t match up to the Buyer’s information and make an indemnification claim before the deal is even done, or (ii) complete no investigation whatsoever. Both of those options are detrimental to the Buyer and may cause headaches for the Seller (or blow up the deal), so most parties will turn to this provision to allow the Buyer to conduct a thorough but measured due diligence investigation.
Buyer Preference: Because knowledge of a breach may not equate to knowledge of its consequences, and because it is the Seller’s duty to provide accurate representations, most buyers insist that a sandbagging provision be included in the Agreement. The Buyer wants to include this provision even in states that, as a default rule, allow for sandbagging. State statutes may require the Buyer to prove additional elements beyond the falsity of the representation or warranty, so including the provision in the Agreement simplifies the process for making an indemnification claim.
Seller Preference: The Seller will likely try to exclude this provision or add an anti-sandbagging provision that explicitly removes the Buyer’s indemnification rights if it has knowledge of the breach prior to Closing. Alternatively, if the Seller learns that the Buyer knows of a breach prior to the Closing, the Seller may seek to obtain a waiver from the Buyer for that specific breach rather than fighting to have the entire sandbagging provision thrown out. In terms of time allocation, most sellers will prefer to spend time making sure their representations are accurate rather than using up time and negotiating leverage to avoid the cost of a misrepresentation (and buyers will prefer that too, making for a smoother negotiation).
Differences in a Stock Sale Transaction Structure: None.
Tax Treatment of Indemnification Payments
What is Tax Treatment of Indemnification Payments? The parties use this section to address how indemnification payments will be treated for tax purposes.
The Middle Ground: This provision states that indemnification payments made under the Agreement are to be treated as an adjustment to the Purchase Price for tax purposes, so long as such treatment is allowed by law.
Purpose: This is a technical term that allows the Indemnified Party to avoid paying tax on indemnification payments. It provides a benefit to one party without harming the other, and either party could be in the beneficial position at some point, so neither side will object to its inclusion and it likely won’t even be explicitly discussed.
Buyer Preference: None.
Seller Preference: None.
Differences in a Stock Sale Transaction Structure: None.
Payments
What are Payments? Here, the parties focus on the specific issue of when payments must be made following a valid indemnification claim.
The Middle Ground: This section provides a deadline for when indemnification payments must be made, how they must be made (e.g. by wire transfer), and dictates that interest is to accrue if the payment deadline is missed.
Purpose: This section is purely procedural and, standing alone, has little effect on deal value (and no effect on the other two classification factors). The parties may devote a small amount of negotiation time to determining the payment window and the interest rate that applies if that window is missed. However, those issues will typically be agreed upon quickly given the fact that they may never come into play and, even if they do, they don’t present a particular hardship to either side so long as the terms are reasonable. Furthermore, since either side could end up as the Indemnifying Party it is in both their best interests to institute reasonable and impartial payment terms.
Buyer Preference: The Buyer typically prefers a shorter payment period and a higher interest rate, but that preference will be tempered by the fact that it may end up making a payment subject to those terms.
Seller Preference: The Seller favors a longer payment period and a lower interest rate, but it will also want the terms to be reasonable since it could wind up on the receiving end of indemnification payments.
Differences in a Stock Sale Transaction Structure: None.
Indemnification Procedures
What are Indemnification Procedures? While previous indemnification-related sections focus on the circumstances under which a claim can be made, this section details the procedural rights and requirements of both sides once a claim is made. Essentially, it provides the rules that must be followed once the indemnification process has been initiated.
The Middle Ground: The Indemnifying Party’s rights typically include (but are not limited to) receiving prompt notice of the claim and its details, the right to assume and control the defense of the claim (except in a few limited circumstances), and the right to the Indemnified Party’s cooperation in investigating claims. The Indemnified Party’s rights usually include controlling legal proceedings when the Indemnified Party is the Buyer and the claim is brought by a customer or supplier of the Business or when an equitable remedy is sought, as well as participating in the defense of claims when such defense is controlled by the Indemnifying Party.
Purpose: Indemnification is an essential tool used to enforce the terms of the Agreement, and this section lays out the steps that must be taken and the rights of each party involved when an indemnification claim is made. It has a moderate impact on risk for both parties (more so for the Seller, who is typically the Indemnifying Party), yet its main purpose is to give effect to more substantive indemnification provisions. It is important for the parties to strike the right balance between implementing enough procedures and rules to allow the Indemnifying Party to mitigate its risk as much as possible, while not employing so many hurdles that they interfere with the Indemnified Party’s ability to actually receive indemnification.
Buyer Preference: The Buyer generally favors terms that benefit the Indemnified Party such as including a specific but generous notice period, allowing the Indemnified Party to control all claims against it once the Cap is met (if a Cap is included), and giving the Indemnified Party the option whether to control defense of all claims. The Indemnified Party may also want a say over who the Indemnifying Party enlists as counsel to defend against a claim and/or the ability to control the defense when the Indemnified Party has defenses available to it that are not available to the Indemnified Party.
Seller Preference: The Seller’s preferences will usually be those of the Indemnifying Party. Those preferences typically include the desire for a flexible notice standard (e.g. “reasonably prompt notice”) and the ability to control the defense of all third-party claims and settlements. The Seller may also want to insert an arbitration provision so that disputes over direct claims can be resolved quickly and less expensively than would be the case with litigation.
Differences in a Stock Sale Transaction Structure: If the Stock Purchase Agreement contains a tax-specific indemnification provision tax issues will need to be carved out of this section so there is no question they are governed solely by the tax indemnification provisions.
Certain Limitations
What is the Certain Limitations section? If no limits are set on the right to indemnification it is a tool that can be abused by the parties, especially in situations where there is not a working relationship between the Buyer and Seller after the Closing. Here, the parties implement boundaries around indemnification to avoid the problems caused by abuse of indemnification rights.
The Middle Ground: This provision limits the indemnification claims that can be brought by setting “Caps” and “Baskets” around the right to indemnification. A Basket sets a minimum amount of damages that must be incurred before an indemnification claim can be brought, and it is typically limited to claims based on breaches of the representations and warranties in the Agreement. Typically, the Basket sets a minimum threshold for making a claim and once that threshold is reached the injured party is eligible to receive 100% of the damages it suffered. A Cap may also be included, and it serves as an upper limit on the amount that will be paid in the event of a claim or the aggregate amount that will be paid out for all indemnification claims of a party.
Purpose: The purpose of a Basket is to prevent one party from trying to recapture some of the value given up in the deal by making numerous “nickel and dime” claims against the other side. In other words, it prevents the parties from abusing their indemnification rights. By doing so, the provision protects the parties’ expectations regarding their risk exposure and the value received from the transaction. Caps are also used as a tool to manage overall risk exposure, and they are especially important in situations where there is a reasonable potential for one of the parties to make a large indemnification claim. In addition to their risk management function, Caps and Baskets also increase the chances that the transaction will be completed by encouraging the parties to provide expansive indemnification rights since they know those rights are not subject to abuse and will not create unlimited liability.
Buyer Preference: The Buyer is the party most likely to bring an indemnification claim, which has a number of implications for how it wants to structure this provision. At the most basic level, it wants the Basket to be small (to allow for the payment of moderate claims) and the Cap to either be large or nonexistent. It may also want to tailor the Cap to its specific concerns; if the potential Losses based on one representation are much greater than for the other representations, the Buyer may be better off negotiating for a significantly higher Cap (or no Cap at all) in that area and a smaller Cap in the other areas than for a moderate Cap applicable to every representation. It certainly wants no Cap regarding any liabilities kept by the Seller, as it has no control over those liabilities. It also wants to carve out certain fundamental representations from the Basket and Cap, such as the Organization and Authority representations.
The Buyer wants to resist additional limitations on indemnification payouts, such as a Duty to Mitigate or a requirement to subtract from such payouts any tax or insurance amounts. However, when a Basket is included in the Agreement the Buyer is more likely to seek a “materiality scrape,” which is a provision that removes any materiality qualifiers from the representations and warranties for indemnification purposes. When a materiality scrape is used, the materiality qualifiers used in the representations and warranties still apply to limit what the Seller must disclose in the Agreement, but they do not apply for purposes of determining whether an indemnification claim can be brought and what the damages for the claim will be. The reasoning underlying the use of a materiality scrape in this context is that the Basket already screens out any non-material claims, so including an additional materiality requirement will likely complicate the indemnification process and lead to needless disputes.
Seller Preference: Since the Seller is going to be paying out an indemnification claim in most cases, it will typically seek a high Basket and a low Cap. In addition to this basic position, the Seller will also prefer a “deductible” Basket rather than a “dollar one” or “tipping” Basket. The distinguishing factor about deductible Baskets is that the Basket amount is more than just a threshold, it is also the amount deducted from the total damages to determine the required payment. To put it another way, with a deductible Basket the side making the claim is only entitled to the amount of damages exceeding the Basket amount. In lieu of a deductible Basket, the parties could settle on a hybrid approach, in which the amount deducted from the payout is less than the threshold amount but more than zero. Another beneficial option for the Seller is to include one or more “mini-baskets” that require damages from a particular representation to reach a certain amount before they are counted toward the overall Basket.
Over and above changing how the Basket functions, the Seller could also try to have the Basket apply to all representations, warranties, covenants, and obligations contained in the Agreement, not just the selected representations and warranties. Similarly, the Seller can try to negotiate for the Cap to extend to all indemnification claims. If unsuccessful on that front, the Seller can argue that some Cap (e.g. the Purchase Price amount) should be placed on payments for breach of fundamental representations and warranties, as well as the remaining covenants and obligations in the Agreement, even if that Cap is higher than the Cap applied to the non-fundamental representations and warranties.
Furthermore, the Seller can avoid a “double recovery” situation by including language reducing any indemnification payments by the amount of any insurance money paid to the Buyer for the claim, and it can make the language more effective by requiring the Buyer to use its reasonable best efforts to pursue any viable insurance claim. Another way to avoid double recovery is to reduce the amount of any indemnification claims that result in a tax benefit to the Buyer by the amount of the tax benefit. For instance, if the Seller breaches a representation and the Loss from that breach causes the Business to sustain a net operating loss (NOL) for the year, the amount of the indemnification claim would be reduced by the tax value of the NOL. One final way to limit double recovery applies in situations where the Agreement allows for a Purchase Price Adjustment, and the goal is to ensure that any such adjustment is subtracted from the Losses payable based on an indemnification claim. The Seller could also seek to impose on the Buyer a “Duty to Mitigate,” meaning the indemnified party would be required to try to reduce its damages from a breach by taking some sort of corrective action.
Finally, if the Agreement contains an escrow provision, the Seller can negotiate for its money held in escrow to be paid out to satisfy a claim for indemnification before it is required to pay money out of its own pocket to do so.
Differences in a Stock Sale Transaction Structure: None.
Indemnification by Buyer
What is Indemnification by Buyer? Indemnification is used to enforce representations, warranties and covenants made in the Agreement. Here, the parties list out which breaches by the Buyer are subject to the Seller’s right to indemnification.
The Middle Ground: Much like the previous provision, this one requires the Buyer to indemnify the Seller, its Affiliates, and its Representatives for any Losses caused by an inaccuracy or breach of the Buyer’s representations, warranties, covenants, and other Buyer obligations that the parties agree will be covered by indemnification. The provision is meant to mirror the “Indemnification by Seller” section, with the only difference being the list of items for which indemnification is available.
Purpose: While the Buyer is usually the party most concerned with managing the risk that accompanies the transaction, there are significant areas of risk that the Seller has to deal with as well. Often, that risk is allocated to the Buyer through other pieces of the Agreement because the Buyer is in the best position to control it. This clause gives effect to the risk allocation agreed upon by the parties by providing the Seller with a relatively quick and simple method of recouping damages caused by a Buyer’s breach or misrepresentation.
Buyer Preference: Ideally, the Buyer wants this list to be as short as possible. In practice, the categories listed above will likely all be included because they all represent issues associated with potential liabilities, and they are the areas within the Buyer’s control. Furthermore, if there are any additional issues listed in the Seller’s indemnification section for which the Buyer has a reciprocal responsibility, the Buyer can expect for those issues to be included here since this provision is meant to mirror the Indemnification by Seller provision.
Seller Preference: The Seller wants the Buyer’s responsibilities to extend to any situation where the Seller could lose money due to the actions of the Buyer. For example, if the Seller leases a piece of land from a third party and the landowner requires the Buyer to sublease that land from the Seller rather than take it by assignment (perhaps because the landowner knows the Seller but not the Buyer), the Seller could end up being responsible for unpaid rent if the Buyer fails to live up to its obligations. Typically, the Buyer’s duty to pay rent will be established elsewhere in the Agreement, so it need not be listed separately here, but the Seller would want it listed here if not previously addressed.
Differences in a Stock Sale Transaction Structure: None.
Indemnification by Seller
What is Indemnification by Seller? Indemnification is used to enforce representations, warranties and covenants made in the Agreement. Here, the parties list out which breaches by the Seller are subject to the Buyer’s right to indemnification.
The Middle Ground: This provision requires the Seller to reimburse the Buyer, its Affiliates, and their Representatives for any Losses arising out of: (1) the inaccuracy or breach of any representation or warranty contained in the Agreement or other Transaction Documents, if the representation or warranty was inaccurate or breached when made or at the Closing; (2) non-fulfillment of any covenant, agreement, or obligation undertaken by the Seller pursuant to the transaction; (3) any of the Excluded Assets or Excluded Liabilities; and (4) any Third Party Claim resulting from the Seller’s (or its Affiliates) operation or handling of the Business or Assets prior to the Closing Date.
Purpose: The indemnification aspect of the Agreement is the most efficient tool available for motivating the parties to stand by their agreed-upon obligations. As such, it is the main way for the parties to enforce the risk allocation scheme created throughout the Agreement.
Buyer Preference: If the Buyer is particularly worried about exposure from certain liabilities, it can specifically include those liabilities in this section so there is no debate whether they fall under the Seller’s indemnification obligation. Examples of the liabilities the Buyer may want to specify include retained employee liabilities, product liability claims, environmental issues concerning any assets or property transferred as part of the deal, and noncompliance with any applicable bulk sales laws. The Buyer also wants to carefully evaluate the definitions of “Affiliates” and “Representatives” to ensure the terms cover all those who may have an indemnification claim against the Seller in the future.
Seller Preference: The Seller wants to limit the matters eligible for indemnification as much as possible. Particularly, the Seller will be looking out for issues it cannot control to avoid being held responsible for problems caused by third parties.
Differences in a Stock Sale Transaction Structure: In a stock sale, there are no Excluded Assets or Excluded Liabilities, so it is even more essential for the Buyer to specifically list the liabilities for which the Seller has indemnification obligations. An often-used alternative to including a specific list in this section is to address those concerns in the representations and warranties since they are incorporated here by reference.
Survival
What is the Survival section? This section allows the parties to use indemnification to resolve post-Closing disputes. But what is indemnification? In short, it is a built-in enforcement mechanism that allows the parties to be made whole following a breach of the Agreement without going through the costly and time-consuming legal system. Rather than enforcing the representations and warranties (and, potentially, other areas of the Agreement) through litigation, the parties agree that certain breaches will be handled between the parties without going to court. For example, if the Buyer breaches a portion of the Agreement that is subject to indemnification, the Seller calculates the damage suffered because of the breach and makes a claim to the Buyer for payment. The Buyer can accept the claim and make the payment, or object and it is resolved by an agreed upon dispute resolution process (one that is meant to be faster and cheaper than litigation).
The Middle Ground: The Survival provision states that the representations and warranties (and any other provisions) subject to indemnification under the Agreement will survive after the Closing, and provides an explanation of when each representation is no longer applicable. Typically, the general survival period is anywhere between one and two years, with certain specified representations lasting for a longer period of time. The portions of the Agreement that tend to last longer than the baseline survival period include representations regarding fundamental corporate matters (i.e. organization and authority of both parties), Title to Purchased Assets, the Condition and Sufficiency of Assets, Taxes, Environmental Matters, and Employment Matters.
Purpose: Since most purchase agreements terminate at the Closing, certain portions must be identified for “survival” in order to remain effective after Closing. The indemnification provisions are some of the most important to survive termination of the Agreement. Without this survival clause, any cause for indemnification would have to be discovered prior to Closing, and that is simply not a reasonable expectation, especially for the Buyer who won’t take control of the Business until after the Closing. So, the Survival section is used to show how long claims for indemnification are available and ensures that those claims can be made after the ownership transition has taken place.
Buyer Preference: Ideally, the Buyer would be able to negotiate for indefinite survival of all representations, warranties, and covenants made by the Seller. In practice, that’s probably not going to happen since the Seller does not want to perpetually plan for the possibility of a claim, and because some states do not allow for contractual extension of a statute of limitations. To address the second concern, the Buyer has a couple options: (1) it can negotiate to change the governing law provision to a state with a longer statute of limitations or to a state that allows for contractual extension of the statute of limitations, or (2) state explicitly in the Agreement that a claim for indemnification does not accrue until the wrongdoing is discovered or should have been discovered. In addition to these general strategies, the Buyer wants to assess which representations, covenants, etc. present the greatest loss potential down the road and negotiate for the extended survival of those provisions. For example, whether companies are properly collecting sales tax has arisen as a major issue for buyers of e-commerce businesses, so the Buyer in that situation wants the representation relating to sales tax to survive for as long as it could be exposed to pre-Closing sales tax liability.
Seller Preference: Other than the payment provisions that favor the Seller and extend past the Closing, the Seller will prefer a short survival period for the representations, warranties, and covenants contained in the Agreement. That is because, by the nature of the transaction, the Buyer is more likely to bring a claim for indemnification than the Seller. In some jurisdictions, simply limiting the survival period is not enough to prevent an indemnification claim during that period; the survival language must actually limit the time in which a claim can be brought for a breach. Unlike the Buyer, the Seller should have intimate knowledge of where its risk lies regarding the Purchased Assets, so its top priority on this point is to attempt to limit the survival periods in those areas.
Differences in a Stock Sale Transaction Structure: None.