Published: Boston Business Journal
November 1, 2024
Outside of the representations and warranties in a purchase agreement for the purchase and sale of a business, often the other most highly negotiated provisions are the indemnification provisions. Conceptually, these indemnification provisions set forth the terms and conditions under which the buyer or seller needs to pay the other party for any losses they suffered as a result of the other party's breach of the purchase agreement.
Regardless of how the transaction is structured, the indemnification provisions in the purchase agreement will set forth three specific pieces of information: (1) the survival period for the representations and warranties, (2) the basket or deductible amount that triggers a party's indemnification obligations, and (3) the cap on a party's liability for the other party's losses.
1. Survival periods
In most transactions, there are two groups of representations and warranties – (1) fundamental representations and warranties, and (2) non-fundamental representations and warranties. One of the key differences between these groups of representations and warranties is the amount of time each group survives after the closing date of the transaction. Traditionally, fundamental representations and warranties are the core representations of the business the party is expected to affirmatively stand behind. Some examples of fundamental representations and warranties are: organization and authority, no conflicts or consents, no undisclosed liabilities, ownership of assets, ownership of equity, and tax matters. Non-fundamental representations and warranties are all the other representations and warranties in the purchase agreement that are not included in the definition of fundamental representations and warranties, such as employee benefits, material contracts, intellectual property, and employees.
Which representations and warranties are included in the definition of fundamental representations is a negotiated item in the transaction process. It is standard for fundamental representations and warranties to survive the closing longer than non-fundamental representations and warranties. The survival period is the timeframe that a party has to bring an indemnification claim. While these survival periods are independently negotiated in each purchase and sale agreement, the standard or "market" survival period for fundamental representations and warranties is the applicable statute of limitations, and the survival period for non-fundamental representations and warranties is between 12 and 24 months. There is one standard exception to the above survival periods – both periods are not applicable in the case of fraud by any party.
2. Baskets vs. deductibles
In each purchase and sale agreement, one heavily negotiated item is when an indemnifying party's indemnification liability is triggered for the losses the indemnified party incurs. Typically, there is a dollar threshold that must be met in order for an indemnifying party's indemnification obligations to begin. The thought behind this concept is for a party's indemnification obligation to not kick in until the other party incurs a "material" amount of losses resulting from breaches of representations and warranties. This materiality threshold is usually created by the parties agreeing to a "basket" or a "deductible" that losses must reach before a party's indemnification obligations are triggered. Under a "basket," often referred to as a "tipping basket," the indemnified party will pay all losses resulting from breaches of representations and warranties under the purchase agreement until those losses reach the agreed upon threshold or basket, then the indemnifying party must indemnify the indemnified party for the entire amount of the threshold back to the first dollar of loss. Conversely, under a deductible, once the threshold is reached, the indemnifying party only needs to indemnify the indemnified party from the first dollar over the threshold. For these reasons, sellers prefer deductibles, and buyers prefer baskets. However, it is standard for any basket or deductible to not apply in the event of fraud by the indemnifying party, and it is not uncommon for any basket or deductible to not apply to breaches of any fundamental representations and warranties.
3. Caps on indemnification liability
The last indemnification concept that is heavily negotiated in the purchase agreement are the "caps" on the indemnifying party's indemnification obligations. Similar to survival periods, there are typically different caps for fundamental representations and warranties and non-fundamental representations and warranties. Usually, the indemnifying party's indemnification obligation for fundamental representations and warranties is capped at or close to the purchase price of the transaction. The indemnification obligation for non-fundamental representations and warranties is capped at an agreed upon percentage of the purchase price. With that being said, indemnification caps will differ based on the size of each respective transaction – for example, in a small transaction it is not uncommon for the indemnification liability for non-fundamental representations to be capped at the purchase price, or for a very large transaction for the cap on indemnification liability to be a smaller percentage of the entire purchase price of the transaction. Lastly, it is standard for any indemnification liability cap to not apply in the case of the indemnifying party's fraud.
Overall, these are the standard terms and concepts you can expect to see in indemnification sections of a purchase agreement. These sections are heavily negotiated and will depend on the specific facts and circumstances of each transaction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.