In an acquisition agreement, a very common term provides that the seller remains liable to (and usually indemnifies) the buyer for activities that occur or relate to the period before the acquisition. Correspondingly, the buyer will assume liability for activities that occur or relate to the period after the acquisition. While simple in concept, the application can be complicated, as illustrated by a recent Seventh Circuit Court of Appeals decision. (HK System, Inc. vs. Eaton Corporation 7th Cir. No. 07-3596)

The facts of the case are involved, and are best summarized in a timeline:

  • December 1994 - IBP issued a letter of intent to purchase a new material handling system from Eaton-Kenway (Eaton's subsidiary) and Alvey.
  • February 1995 - Eaton sold its Eaton-Kenway subsidiary to HK Systems. Under the contract, Eaton indemnified HK Systems for occurrences before the sale. HK Systems indemnified Eaton for occurrences after the sale.
  • March 1995 - HK Systems signed the contract with IBP.

In 1998, IBP sued HK for fraud and breach of contact. HK ended up settling for $8 million ($5 million paid by Alvey). HK then sued Eaton under the indemnification provision in the contract for the sale of Eaton-Kenway. Eaton tried to get the trial judge to dismiss the case, but the judge refused and let the jury hear the case. The jury decided Eaton should pay around $3 million to HK. But, in a surprising development after the trial, the judge had a change of heart and decided HK's claim should be dismissed. So HK received nothing, in spite of the jury verdict in its favor. HK appealed but, unfortunately for HK, the 7th Circuit Court of Appeals agreed that HK should receive nothing from Eaton.

But didn't HK sign the contract just one month after the acquisition? From HK's perspective, almost everything took place on Eaton's watch. Why is HK responsible?

The court acknowledged that determining who "caused" the loss was problematic. But the 7th Circuit court found that HK was in the best position to avoid the loss by making sure its new acquisition, Eaton- Kenway, would be able to comply with the contract. The court compared this claim to an insurance claim. Said the court, "[I]nsurance policies are presumed not to insure against liability for breach of contract. The reason is the severe 'moral hazard' problem to which such insurance would often give rise. The term refers to the incentive that insurance can create to commit the act insured against, since the cost is shifted to the insurance company." The court felt the same reasoning applied here. "Thinking that it would be indemnified for any losses on its contract with IBP, HK had a diminished incentive to try to minimize its potential liability for such losses in negotiating the terms of the contract. HK actually wants us to treat Eaton just like an insurance company." [emphasis in original]

HK asserted "no prudent business relies on an indemnity to avoid meeting its business commitments." Although the court acknowledged this point, it noted that, "[A]rmed with an indemnity, a business will take risks that it would not take had it to bear the entire cost of its mistakes." In support, the court cited an unfortunate statement in HK's own brief that "the broad indemnity by Eaton was a substitute for the assessment of risks" by HK.

The case illustrates the hazards of negotiating an acquisition of a business with contracts and transactions in progress (which the business no doubt has, otherwise it would not be an attractive candidate for an acquisition). It also is a lesson for acquiring companies not to rely on an indemnification clause for commitments made after the acquisition, even though the principal negotiations were conducted by the seller before the acquisition.