Three Indemnification Terms a Buyer Should Never Accept (Again) By Christian A. Atwood and Stephen M. L. Cohen An edited version of this article was published in Buyouts magazine on April 13, 2009. You know the drill. You’ve spent countless hours going back-and-forth on the purchase agreement, the lion’s share of which seem to have been spent haggling over the indemnification terms. At the eleventh hour, with the finish line in sight, you decide to engage in some amount of “horse trading” to get the deal done. Unfortunately, in this situation buyers often agree to indemnification terms that they should not – and should never have to – accept. The list of no-no’s is considerable, but here are the top three. Limitations on Consequential Damages A term commonly found in seller first drafts, and a mainstay of purchase agreements served up in any well run auction, is a provision such as the following: “No party will have any indemnification liability for consequential, special, incidental, indirect, punitive, exemplary, or other non-direct damages (such as diminution of value, lost profits, income, revenues or business opportunities, or reputational harm), regardless of whether the same were foreseeable.” A seller’s attorney will often attempt to justify such a provision by saying: “It’s not that we’re unwilling to indemnify you – subject to the basket, cap, minimum claim size, etc. – for losses arising out of breaches of our reps and warranties. It’s just that we want to know that we’re on the hook only for actual damages you suffer as a result of our breach.” The problem with this agreement, although it sounds reasonable, is that it’s specious. Subject to any agreed upon cap on damages, buyer should be entitled to indemnification for all damages – of whatever stripe – that it may incur as a result of seller’s breach. Consider the following example: In the purchase agreement relating to the acquisition of a manufacturing company, seller gives a “standard” set of reps and warranties, including that the target has all required permits. After the closing, a “routine” audit of the target’s facilities by a local inspector reveals that a necessary permit has lapsed. The target’s factory is ordered closed, its workers furloughed, and the business shut down until the permit can be obtained – which winds up taking the better part of a fortnight. Unquestionably, seller breached the rep in the purchase agreement that the target had all required permits. The question, however, is what are buyer’s damages and to what extent is buyer entitled to indemnification? Clearly, buyer should be indemnified and entitled to reimbursement for the cost of renewing the lapsed permit. But what about lost productivity? There are very real costs that stem from having to idle a manufacturing operation for two weeks: orders that could not be fulfilled, orders that could not be accepted, lost revenues associated with each, and so on. In such a circumstance, buyer will have suffered real, measurable damages. Had buyer agreed to a consequential damages limitation such as the one described above, however, the “loss” for which it may be entitled to indemnification could be limited to the cost of renewing the permit – an unhappy situation and one bound to result in questions from disgruntled limited partners or shareholders. The only damages that a buyer should be precluded from recovering are punitive damages that are intended to mete out punishment for “bad acts” (except where buyer or the target is required to pay such damages to a third party in connection with any third party claim) and which are not compensatory in nature. Agreeing to any other limitation on the kind of damages for which a buyer is entitled to indemnification – other than the limitation implicit in any contract claim that an indemnified party is entitled to indemnification only with CHOATE HALL & STEWART LLP Two International Place | Boston MA 02110 | t 617-248-5000 | f 617-248-4000 | choate.com respect to the damages that it can prove (and, even then, only to the extent that such damages were “reasonably foreseeable”) – only serves to preclude otherwise legitimate claims. Prohibition on Use of “Multipliers” Another term often found lurking in purchase agreements, either among the indemnification provisions or embedded within the definition of “losses,” might read as follows: “In calculating the amount of losses for which Buyer is entitled to indemnification, no “multiplier” or any other method having a similar effect shall be applied to any such loss.” The problem with such a limitation is obvious: it precludes a buyer from calculating losses based on a multiple of EBITDA or earnings. If, for instance, a recurring expense turns out to be higher than was reflected in the target’s financial statements – on which buyer’s purchase price will have been based – buyer has been damaged not only to the tune of the difference between the actual cost and the amount reflected in the financial statements but, much more significantly, by the product of that difference and the multiple buyer used to calculate the purchase price. An example involving some simple math will help illustrate this point: Rent Expense reflected in Financial Statements: $2,500,000 Actual Rent Expense: $3,500,000 Purchase Price Multiple: 7.5x Indemnification Claim (no multiplier): $1,000,000 Indemnification Claim (with multiplier): $7,500,000 On these facts, buyer will have overpaid by $7,500,000. If the “no multiplier” language is included in the purchase agreement, however, buyer would arguably only be able to claim $1,000,000. As in the case of limitations on the recoverability of consequential damages, buyer in this example will have suffered real, measurable damages – by virtue of having acquired a target with materially less cash flow than was represented to be the case – but be left without effective recourse against seller. A “no multiplier” limitation simply puts an arbitrary and artificially low ceiling on the damages for which buyer is indemnified. “Anti-Sandbagging” Clauses Perhaps the best example of overreaching by sellers is so-called “anti-sandbagging” language that has crept into many sell-side purchase agreement forms and become de rigueur in the auction context. A recent example of such a provision read as follows: “No party will be entitled to indemnification in respect of any fact or matter constituting a breach of any representation or warranty if such party had knowledge of such fact or matter on or prior to the Closing Date.” An anti-sandbagging provision is intended to prevent a buyer from withholding information from a seller for the express purpose of bringing an indemnification claim post-closing as an underhanded means of reducing its purchase price. In practice, the circumstance would be as follows: buyer learns of something in diligence that seller either doesn’t know or fails to disclose in the purchase agreement; buyer intentionally and with malicious intent withholds this information from seller; and seller’s failure to disclose the information causes one or more of its reps and warranties to be untrue. An anti-sandbagging provision is intended to protect against this type of subterfuge by precluding a buyer from effectively laying a trap for a seller by keeping the discovery to itself (and in so doing setting up an indemnification claim that could be brought immediately post- closing). The problem from a buyer’s perspective, however, is that these provisions typically do far more than what was originally intended. Instead of having to prove simply that a rep has been breached and that buyer has been damaged as a result, the inclusion of an anti-sandbagging provision means that buyer has the additional burden of proving that it had no knowledge of the breach. For example, if a buyer were to agree to the sample provision above and then, post-closing, submit a claim for indemnification, the resulting exchange between buyer and seller is likely to go something like this: Buyer: “I am entitled to indemnification for losses incurred as a result of X. Pay up.” Seller: “We’re not obligated to indemnify you for those losses because you knew about X prior to closing. No soup for you.” And so the dance begins. The unfairness of such a provision is perhaps best demonstrated by expanding upon our fictional seller’s response – seller is saying (although unlikely to be put quite this way): “Even though I failed to disclose something I should have disclosed and have breached one of my reps, despite my being in the best position to know about such things, if you, buyer, knew of facts that could have suggested a breach by me then you can’t collect.” In the absence of an escrow, earnout or other contingent consideration (which, if present, may give buyer leverage to force a resolution of the issue without having to resort to litigation), buyer will be left in the unhappy situation of having to sue seller to recover its losses – assuming, that is, that some other provision of the purchase agreement doesn’t foreclose that avenue (as many “exclusive remedies” provisions attempt to do). The best course is to insist that there is no reasonable basis for such a provision and, therefore, that it has no place in the purchase agreement. Compromise on this subject, though certainly possible, is suboptimal from a buyer’s perspective because, on balance, it only gives ammunition to a seller seeking to avoid or minimize its indemnification obligations. What should be a discussion of whether a breach has occurred and, if so, what buyer’s damages are, becomes an argument about who knew what when. Conclusion Generally speaking, a seller should be willing to live with, and take comfort in the fact that its indemnification obligations will not exceed, whatever the overall cap on damages is that the parties have negotiated. That said, purchase agreements served up by sellers are certain to include myriad limitations intended – sometimes subtly, sometimes less so – to carve back a buyer’s rights to indemnification to such an extent that buyer can be left virtually, if not entirely, without recourse after a deal closes. As a result, the fundamental rule of deal-making remains “buyer beware.” Indemnity limitations are the norm, without question, but some go too far and should be accepted only after careful consideration, when absolutely necessary to get the deal done, and with a complete understanding of what is being given up.