Indemnity Clauses (Indemnities)

In mergers and acquisitions (M&A) transactions, one of the most critical aspects of the deal is the allocation of risk between the buyer and the seller. The parties must agree on how to manage and mitigate the risks associated with the transaction, including potential liabilities, contingencies, and uncertainties that may arise before or after the closing of the deal.

One common mechanism used in M&A transactions to allocate risk is indemnity clauses. Indemnity clauses are contractual provisions that obligate one party (usually the seller) to compensate the other party (usually the buyer) for losses or damages resulting from specified types of events. These events may include breaches of representations and warranties, violations of laws or regulations, environmental or tax liabilities, and other contingencies that may arise from the transaction.

The purpose of indemnity clauses is to protect the buyer from unexpected liabilities or losses that may arise from the deal. By requiring the seller to indemnify the buyer against specified risks or contingencies, the buyer can have more certainty and confidence in the transaction, which may make the deal more attractive or feasible. Indemnity clauses also incentivize the seller to disclose and address any potential risks or issues upfront, as failing to do so may result in a breach of the indemnity clause and trigger the seller’s obligation to compensate the buyer.

Examples of Indemnity Clauses in M&A Transactions

Indemnity clauses can take various forms and cover different types of risks or contingencies depending on the nature and complexity of the transaction. Some common examples of indemnity clauses in M&A transactions include:

  • Representations and Warranties Indemnity: This type of indemnity clause requires the seller to indemnify the buyer against any losses or damages resulting from breaches of representations and warranties made by the seller in the purchase agreement. Representations and warranties typically relate to the company’s financial condition, assets, liabilities, operations, and legal compliance, among other things. If any of these representations and warranties turn out to be false or misleading, the buyer may incur losses or damages, which the seller must indemnify.
  • Tax Indemnity: This type of indemnity clause obligates the seller to indemnify the buyer against any tax liabilities or disputes arising from the transaction, including any unreported or undisclosed taxes or tax claims against the company being sold. Tax indemnities may cover different types of taxes, such as income tax, sales tax, payroll tax, or international tax issues.
  • Environmental Indemnity: This type of indemnity clause requires the seller to indemnify the buyer against any environmental liabilities or obligations associated with the company being sold, such as contamination, pollution, or hazardous waste disposal. Environmental indemnities may also cover the cost of remediation, cleanup, or compliance with environmental laws or regulations.
  • General Indemnity: This type of indemnity clause is a catch-all provision that obligates the seller to indemnify the buyer against any losses or damages resulting from any other specified or unspecified events, such as litigation, contractual breaches, intellectual property infringements, or other contingencies.

Negotiating and Drafting Indemnity Clauses

Negotiating and drafting indemnity clauses in M&A transactions can be complex and require careful consideration of various factors, including the parties’ bargaining power, risk tolerance, and the nature and scope of the transaction. Legal and financial advisors can help the parties to identify and address the relevant risks and negotiate favorable terms that balance the competing interests of the parties.

Some key issues to consider when negotiating and drafting indemnity clauses include:

  1. Scope of indemnity: The scope of indemnity is one of the most critical factors to consider when negotiating these clauses. The parties should identify the types of losses or liabilities that will be covered by the indemnity and ensure that the language used is precise and unambiguous.
  2. Cap on liability: Buyers often seek to limit the seller’s indemnification liability by imposing a cap on the amount of damages that can be recovered. Sellers may push back on such caps, arguing that they are unfair and make it difficult to accurately assess the risks of the transaction. Parties should carefully consider the risks and benefits of caps and other limitations on liability.
  3. Survival period: The survival period is the time during which a buyer can make a claim for indemnification. This period typically ranges from 12 to 24 months after closing, although it can be longer or shorter depending on the nature of the transaction. The parties should consider the potential for delayed discovery of issues and the cost of extending the survival period.
  4. Notice and opportunity to cure: Indemnification clauses often require the buyer to give notice to the seller of any potential claims and provide the seller with an opportunity to cure the issue before seeking indemnification. The parties should carefully consider the language used to ensure that the notice requirements are reasonable and provide the seller with a fair opportunity to address any issues.
  5. Indemnification procedure: The indemnification procedure should be clearly defined in the purchase agreement. This may include the procedure for making a claim, the process for resolving disputes, and the allocation of costs and expenses. Parties should carefully consider the procedure to ensure that it is efficient, fair, and cost-effective.
  6. Disclosure schedules: Disclosure schedules are typically attached to the purchase agreement and provide detailed information about the company being sold. These schedules can be used to allocate risks between the parties, and indemnification clauses may reference them to define the scope of the seller’s indemnification obligations. Parties should ensure that the disclosure schedules are accurate and comprehensive.

Amy is a Certified Public Accountant (CPA), having worked in the accounting industry for 14 years. She is a seasoned finance executive having held various positions both in public accounting and most recently as the Chief Financial Officer of a large manufacturing company based out of Michigan.