In a perfect world, all issues as between a purchaser and a vendor of a business (whether assets or shares) are settled at the time of closing. Unfortunately, this is not how the real world operates, notwithstanding the level of due diligence conducted by a purchaser and its professional advisors. To protect against go-forward liability, vendors, who covet keeping as much purchase price as possible, build protections into their acquisition agreement to limit their potential liability. These protections range from incorporating knowledge and materiality qualifiers into their agreement, making representations on a several (versus joint and several) basis, limiting the survival period of their warranties and so on. This blog post discusses two additional limitation of liability concepts that are popular among vendors of a business and their professional advisors: indemnification baskets and liability caps.
One very common limitation on liability is known as an indemnification basket. In this case, a vendor is not liable to indemnify the purchaser until the aggregate amount of losses suffered by the purchaser exceeds a certain dollar threshold. The purpose of such a provision is to avoid vendor liability for claims considered to be minor in nature relative to the size of the transaction. However, once the threshold is met, depending on the clause, the vendor may only be liable for the amount of the loss in excess of the threshold (known as a deductible basket) or may be liable for the entire amount of the loss (known as a first dollar basket).
According to the 2014 Canadian Private Target Mergers and Acquisitions Deal Points Study (2014 ABA Study), which was published last year by the American Bar Association with the help of two partners in the Toronto office of Norton Rose Fulbright, 50% of relevant transactions included a first dollar basket, 36% included a deductible basket, 6% included a combination of the two and 8% included no indemnification basket. With respect to the amount of the threshold as a percentage of transaction value, in 42% of the relevant transactions the threshold was 0.5% or less and in 30% of the relevant transactions the threshold was between 0.5% and 1%.
Another common limitation on liability is a cap which acts as a ceiling on the vendor’s liability for losses suffered by the purchaser. Where an acquisition agreement contains a cap, a vendor will only be liable for losses up to a certain dollar amount. For example, if a cap is set at $10 million, the vendor will only be liable to indemnify the purchaser for up to $10 million, even if the losses suffered are much greater (subject to the exceptions noted below). According to the 2014 ABA Study, 60% of the relevant transactions included a general cap which was less than the purchase price, 19% included a cap which was equal to the purchase price, 11% included a cap which was not determinable and 10% did not include a cap.
Both indemnification baskets and caps often carve-out certain types of losses from their application. For example, according to the 2014 ABA Study, the most common carve-outs from the indemnification limitations related to losses in respect of fraud (included in 48% of relevant transactions), due authority (32%), due organization (30%) and taxes (30%). Likewise, the most common carve-outs for caps related to losses in respect of fraud (77%), taxes (24%), due authority (24%), due organization (22%), title to/sufficiency of assets (22%) and intentional breach of sellers representations (22%).