Many industry experts anticipate an increase in mergers and acquisitions over the next couple of years, and M&A activity has become a common discussion topic in a number of banking circles. These discussions generally focus on purchase or sale opportunities and the general process involved in such activities. Although bankers anticipate that negotiation of a purchase agreement is a necessary step in the process, many who have not experienced purchase agreement negotiations first hand may envision delegating this process to their advisors. However, professionals representing bankers greatly value informed input from their clients when negotiating an M&A related definitive agreement as the strategic decisions involving the duration, cap, and basket amount of the indemnification clause illustrate.
Once a buyer and seller enter into a letter of intent, complete due diligence, and generally agree on price, the next step is typically the negotiation of a definitive agreement. Depending on the structure of the transaction, the definitive agreement is typically 35-45 pages in length and is generally a Merger Agreement, Stock Purchase Agreement, or Asset Purchase and Assumption Agreement. Although each agreement is specifically tailored to the transaction’s structure, they all have several provisions in common; for example, any definitive agreement will contain a number of representations and warranties. Simply put, the seller makes promises to the buyer that the bank’s operations, loan files, employment related issues, real estate, etc. are in good order, and the buyer makes limited representations and warranties to the seller. The seller’s representations and warranties are naturally much more encompassing since they are vouching for their bank. If these representations and warranties later prove to be false, the indemnification clause is the primary enforcement mechanism through which the aggrieved party can obtain redress from the breaching party. In short, the indemnification clause determines how long, and for how much, a party (primarily the seller) is on the hook following closing.
Important Considerations When Negotiating the Indemnification Provision
Again, the indemnification provision provides teeth for enforcing the promises made by a seller or buyer regarding the condition of their respective organizations. The indemnification provision requires the party whose promises are untrue to indemnify or reimburse the aggrieved party for any damages the other party sustains as a result of the untrue promises. For instance, if seller promises their loan files have all original notes, and buyer later discovers during foreclosure proceedings that no original note exists in a file, buyer could demand seller indemnify buyer for any damages resulting from the lack of the original note.
Typically, the parties are interested in negotiating three aspects of the indemnification clause—duration, cap, and basket amount—each of which is explained in greater detail below. When negotiating such provisions, clients and their professional advisors should discuss and carefully consider overall objectives and all the provisions of the definitive agreement.
Duration of the Indemnification Obligation
A seller does not want to be on the hook for its promises forever, and the buyer is aware that at some point, the business becomes the sole responsibility of the buyer and buyer can no longer look to seller if something goes wrong. At the same time, buyer typically requires some assurance that if something goes wrong, for a limited time following the transaction, seller will stand behind its promises. Therefore, buyers and sellers can often agree that the indemnification obligation will expire after a certain period of time. It is up to the parties to negotiate the expiration date.
Prior to the financial crisis, the indemnification period rarely extended beyond two years from the date of closing, and sellers were sometimes even able to negotiate the closing date as the date of expiration of the indemnification period. Naturally, at the height of the financial crisis, the market favored buyers, and buyers increasingly asked for extended indemnification periods. Buyers routinely asked for five years, and the parties often agreed on indemnification periods ranging from two to three years. Current indemnification periods range from one to four years, and greatly depend upon the individual circumstances of the bank. A seller whose institution enjoys a high CAMELS rating and clean loan portfolio is often successful in obtaining a shorter duration while a seller whose institution is subject to enforcement actions can generally expect a longer duration.
Cap on the Indemnification Amount and Escrows
Sellers often want to know the extent of their liability following the sale, and buyers often realize that since they will be running the business, buyers might be subject to large unforeseen risks. Therefore, buyers and sellers are often able to agree upon an indemnification cap. This cap limits the dollar amount that the breaching party will have to pay the aggrieved party resulting from damages sustained from breaches of the purchase agreement terms, including untrue representations and warranties. The cap can vary greatly and depends on the size of the deal, but generally should not exceed the purchase price. Sellers should try to institute some cap to avoid unlimited liability.
The basket amount is similar to a deductible in the context of insurance. Since the parties recognize that some dollar thresholds are not material enough to administer the indemnification process, the parties will often agree to a basket amount, and they will not approach each other for indemnification payments that are less than the basket amount. A basket can be either a regular basket or tipping basket. A regular basket is truly like an insurance deductible. A party’s indemnification obligation only applies to the extent the damages exceed the basket amount, thus leaving the aggrieved party on the hook for the basket amount. A tipping basket differs in that while a party still has no indemnification obligation until damages exceed the basket, once damages exceed the basket amount, the basket “tips” and the indemnification obligation goes back to dollar one of damages so that the aggrieved party is not responsible for any damages. In the typical community bank transaction, basket amounts range from $25,000 to $100,000, but the basket can be larger depending on the size of the transaction.
Keeping the Big Picture in Mind
When negotiating the indemnification clause, the parties must be sure to consider other terms of the agreement and their overall strategic goals. For example, a seller may be willing to agree to more thorough representations and warranties with few “knowledge qualifiers” if they can obtain a shorter indemnification duration and lower cap. Similarly, a seller who wants to be out of the business of banking as soon as possible may be willing to agree to a lower purchase price if buyer will accept less thorough representations and warranties subject to a shorter duration and lower cap.
When negotiating any provision of a definitive agreement, bankers should keep the big picture in mind and communicate their overall strategic objectives to their counsel so that the indemnification clause and other provisions may be negotiated accordingly.