Co authored by Vitor Silva Clark Nunes
The indemnity clause is one of the most negotiated provisions in M&A transactions. Under a basic indemnity provision, the seller agrees to indemnify the buyer for the breach of her representations and warranties. Known liabilities of the target assumed by the buyer will usually entail an adjustment in the price. Price adjustment, however, will probably not be a proper solution to deal with a contingency in relation to which there is no consensus on its value or chances of materialization. In this case, a customary alternative is to establish a special indemnity by which the risk of the contingency is assumed by the seller. The negotiation of the indemnity provision will often also involve discussions on certain limitations of the seller's responsibilities, such as caps, deductibles, de minimis exclusions and time limitations.
The negotiation of a fair indemnity provision does not put an end to the buyer's worries: a committed buyer will be concerned if the seller will be able to pay an indemnity up and until the end of the period that they agreed she is to be held accountable. A portion of the purchase price paid to the seller will usually be more than enough to pay such indemnities. But how is the buyer to know that the seller will diligently set aside such portion of the purchase price to cover potential future indemnities?
There are a variety of contractual solutions to guarantee post-closing indemnification. If the purchase price is to be fully paid at closing, but the buyer fears that it will flow directly to the seller's shareholders rather than increasing the seller's financial position, the buyer may request a parent company guarantee from the seller. Still, the buyer would be required to bring an action against a third-party to be fully indemnified for his losses. The creditworthiness of the parent company may also be an issue.
Alternatively, the buyer could hold back part of the purchase price to secure payment of the indemnities. In this case, the seller is the one who bears the risk of default and that would have to carry out enforcement proceedings if the buyer fails to pay the holdback when due.
A solution to such quandary is to place the holdback in an escrow account opened with a third-party financial institution (the escrow agent). The amount to be set aside in escrow will usually depend on the value of the liabilities and contingencies being guaranteed and the likelihood that they will actually become losses (and, of course, each party's negotiating leverage). The period of duration of the escrow account will also vary from one transaction to the other, depending, among other factors, on the statute of limitations of the liabilities and contingencies or the survival period of the representations and warranties. It is typically agreed that, if a claim is brought during such period, the amount necessary to cover the claim will be kept in escrow until a final decision on the matter.
The clearest advantage of the escrow account is that it secures resources to indemnify the buyer or to pay the balance of the purchase price to the seller. Since the escrow account is set up by an agreement, the parties have great flexibility in negotiating how the amount in escrow will be invested and when it will be released to the buyer (in case an indemnification is due) or to the seller (as payment of a portion of the purchase price). A common stipulation is that the funds deposited in escrow will be released by the agent upon receipt of a notice signed by both the buyer and the seller.
In spite of these benefits, there are some disadvantages. Setting up an escrow account has costs. Although the escrow account solution mitigates the risk of default, it does not prevent the parties from disputing whether indemnification for a certain liability is actually due. If such a dispute arises, the corresponding amount is normally only released after a final decision or a settlement on the matter. Moreover, the funds deposited in escrow may not be protected from being seized to secure obligations of the account holder towards third parties.
A point of concern is the taxation of the amount deposited in escrow and the risk of tax authorities considering such amount to be part of the purchase price already paid and attempting to immediately tax the seller for capital gain, even if it is later used to indemnify the buyer. Trying to mitigate such risk, sometimes the parties choose to open the escrow account in the buyer's name. Recently, however, the Brazilian Administrative Council of Tax Appeals (Conselho Administrativo de Recursos Fiscais - CARF) issued a decision1 in a case where the seller was an individual, stating that the seller must collect and pay the income tax on amounts held in escrow only when they become either economically or legally available – that is, when they are transferred to the seller or the seller is entitled to receive such amounts. Thus, the seller would not have to pay income tax on capital gain over the amounts deposited in escrow that are eventually used to pay an indemnity.
1 Acórdão number 2202002.859 issued by the 2nd Chamber of the Brazilian Administrative Council of Tax Appeals (Proceeding 19515.720697/201128).
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