Indemnification Clauses – How to Steer Your Merger Clear of Lawsuits

If a liability emerges after a deal closes, who’s responsible: the buyer or seller? Indemnification provisions are designed to answer this question. They’re a critical piece of an M&A deal agreement and, not surprisingly, hammering them out sometimes involves contentious negotiations.

Well-crafted clauses are important because, if they contain too few liability limits or provisions, a lawsuit can result. In the event of a postmerger liability, either party might claim breach of contract. So as you work with your advisors, spend some time thinking of as many worst-case scenarios as possible so they can be written into your indemnification clause.

Compromising on Core Issues

Indemnification provisions address any damages arising from postmerger breaches of representations, warranties and covenants. Generally, sellers seek immunity from all liabilities after their business has been sold. Buyers want sellers to be responsible for postsale issues that originated before the company was acquired. For example, buyers don’t want to be liable if an employee who worked under the previous owner sues for discrimination. 

Indemnity provisions, therefore, generally require both parties to compromise. Given the number of possible postsale claims, from tax liabilities to product-related suits to environmental issues, the parties need to set their priorities but remain flexible.

How Provisions Work

To protect the parties, indemnification clauses should be as precise as possible. For example, a seller might disclose during due diligence that it’s being sued by an employee, with the understanding that it will be responsible for any costs related to that suit. But if a government agency follows up on the earlier lawsuit and sues the new owner, the seller would want to specify that it won’t be liable for postsale litigation. 

Typically, such a scenario isn’t considered a breach of representation because the seller has disclosed the initial lawsuit. However, a buyer might try to insert language into the indemnification clause that would compel the seller to cover unpredictable risks associated with running the business postsale. So, if the buyer wants additional protections, it may have to compromise in other areas. (See “How long can this go on?”)

Caps and Other Details

In addition to negotiating types of liabilities, M&A parties need to arrive at financial limits, or caps. Typically, caps are set as a percentage of the deal’s overall purchase price.

The indemnification clause should state the amount of losses that trigger a claim. For example, the buyer may be responsible for covering liabilities under $10,000. Liabilities over $10,000 would fall to the seller. This prevents sellers from being hit by various minor charges — such as a $500 registration fee that the former owner forgot to disclose — but still protects buyers from substantial liability claims.

During negotiations, the parties also need to decide exactly who has to pay damages for an indemnification claim. For example, they might agree that the buyer will seek payments from any implicated third parties — such as a vendor — before approaching the seller for payment. 

Then there are “mitigation provisions” that discuss a seller’s recourse if the buyer doesn’t work to prevent further damages. If property is damaged postsale because of something that’s arguably the seller’s fault, the mitigation provision would reduce the seller’s obligation if the buyer didn’t work to limit the damage. Take, for example, a situation where the previous owner failed to adequately insulate a warehouse and inventory was damaged. If the buyer knew that damage was ongoing and failed to prevent further destruction, it would be responsible for at least some of the damage.

Eye for Details

Indemnification provisions can take a lot of work to negotiate. But even what appear to be minor details now could have major financial effects down the road. The better the parties are prepared, the more satisfied each is likely to be.