The indemnification provisions in a merger or stock or asset acquisition agreement, backstopping properly drafted representations, warranties and covenants, provide the most critical protection for a buyer’s investment in an acquired entity or assets. As the indemnification provisions play a significant role in allocating risk of loss between a buyer and a seller, they tend to be among the most vigorously negotiated transaction terms after the basic acquisition price. This article summarizes market trends in core indemnification provisions in certain recent private merger or stock or asset acquisition agreements. One key takeaway is that the terms governing escrow funds securing indemnification obligations of sellers merit the most exacting attention. This is particularly so where, as is often the case in the current market, the seller is a private equity fund or other financial investor and there may not exist post-closing a substantial going concern with assets to satisfy indemnification claims of the buyer.
The key provisions in indemnification negotiations include the duration of the indemnification period (referred to as the survival period), the scope of the losses that will be covered, the limitations on liability (including caps and baskets governing the amount recoverable), whether alternative remedies are available and the nature of the collateral securing the indemnification obligations. A review of a number of 2012 disclosed transactions indicates that the range of survival periods runs from 15 months (in an asset sale) to two years, with all survival periods lasting at least through one full audit cycle. Certain fundamental matters, such as stock ownership, title to assets, tax and ERISA matters, and environmental representations run either indefinitely or through the expiration of the applicable statute of limitations. In a number of indemnification instances, specific is procured for targeted exposures, such as pre-closing tax liabilities, known or suspected environmental conditions, pending regulatory fines or penalties, or employee liabilities.
Caps and baskets remain a hotly negotiated subject matter. The terms of the surveyed transactions tend to split fairly evenly between deals where the basket is a "tipping basket," meaning the buyer can recover from the first dollar after a claim threshold is met, and where the basket is, in effect, a deductible constituting a cost absorbed by the buyer. Regardless of the basket structure, the recent trend appears to be supportive of very low baskets, most frequently in the range of 0.25 to 0.75 percent of the purchase consideration. Caps tend to be in the range of 10 to 20 percent of the purchase price. Frequently, caps will be tiered, such that there may be a limitation of 10 to 20 percent of the purchase consideration for most claims. However, a higher potential recovery may be provided for fundamental matters such as title to stock (recovery up to the purchase price in most instances) or for specified liabilities such as tax matters or environmental claims.
Understandably, sellers are eager to box in their exposure, and most recent buyers appear willing to agree that the indemnification provisions are the exclusive remedy available in a claim for damages. With thorough representations, warranties and covenants supported by properly drafted indemnification provisions and a satisfactory indemnity cap, the buyer should not be foregoing much, if any, protection by agreeing to restrict its damages claims to those provided in the indemnification provisions. Contractual claims would arguably be duplicative of a claim of breach of a representation, warranty or covenant, and non-contract claims, such as tortious interference post-closing, should also be addressed in the acquisition agreement. Fraud and willful misconduct are generally exceptions to this limitation.
Approximately two-thirds of surveyed 2012 private transactions provide for some collateral. Occasionally, the collateral included a pledge of stock consideration received by the sellers. Of course, this arrangement presents a risk for the acquirer, as the value of the equity of the combined businesses may drop in proportion to the gravity of any indemnification claims secured by that equity. Most often, however, in a transaction involving cash consideration, the collateral consists of a portion of the sale proceeds that are deposited into an escrow account with a third-party financial institution. The range of the escrow amount tends to be approximately 10 to 15 percent of the purchase consideration. In some instances, where the seller will either cease to exist or not have substantial post-closing assets and the indemnification provisions are the exclusive remedy, the escrow amount can range as high as 25 percent of the purchase price. In a number of the transactions surveyed, the escrow arrangements provide for a step-down in the escrow over the term of the escrow period. As a rule, the escrow period is coterminous with the survival period, which, as noted, tends to run between 15 months and two years. However, if a portion of the escrow is earmarked for specific potential liabilities, such as taxes or environmental issues, the escrow period for that amount will generally be coterminous with the applicable statute of limitations.
In addition, an escrow can serve multiple purposes. The parties will often rely upon an escrow deposit to address any post-closing adjustments that may be necessary as against an interim unaudited closing date balance sheet. Some transactions provide for multiple escrows to address post-closing adjustments, indemnification claims and the costs and expenses of the escrow agent.
Not surprisingly, the buyer and seller will often negotiate extensively regarding the terms governing a call upon the escrow. On this question, the comparative eagerness of one party over the other to complete the transaction and its respective negotiating leverage will frequently come into play. The seller does not want to grant blank check writing authority to the buyer over the escrow. Conversely, the buyer will be loath to have to litigate or arbitrate each effort to draw upon the escrow. It is in the interests of both parties to seek to agree in advance to the extent practicable on the events or conditions that would authorize a draw upon the escrow. In the case of known actual or contingent liabilities, the issue may be more the scope of remediation or cure rather than whether the buyer has recourse to the escrow. To the extent a party may anticipate the likely draws upon an escrow deposit, that party may more accurately price the transaction to meet its requirements.