By: Luis Gerardo Ramírez Villela
In all mergers and acquisitions transactions structuring the indemnification clauses and procedures is relevant for the protection of both purchaser and seller, and the impact of drafting a clause minimizing the liabilities of the transaction will be important during the business negotiation.
In this respect, the main goal of the indemnification clause is to provide the parties under the relevant agreement with a mechanism for seeking the payment of post-closing damages and losses. Such indemnification clause is based on the survival of the representations and warranties and such process will be triggered upon the existence of any misrepresentation from any party under the relevant agreement.
The most frequent indemnification mechanisms used in mergers and acquisitions for limiting the damages and losses upon a misrepresentation would be “caps” and “baskets”.
A “cap” is a limit to the liability of indemnifying upon a misrepresentation, while the “baskets” are threshold amounts of damages and losses that must be incurred before indemnification is applicable (this would also be known as a deductible).
Regarding the “cap”, a standard practice is of approximately 10% (ten percent) of the total value of the transaction, although this may vary depending on business negotiations and value of the transaction.
With respect to the “baskets”, the threshold will be based on the assumptions of damages and losses and whether or not the parties agree on the risks allocated to the potential transaction; therefore, deciding the threshold and the deductible will be the basis for the indemnification process.
In both scenarios it will be necessary to analyze the market and specific industry of the transaction, as well as the results of the due diligence process, in order to negotiate an indemnification procedure that would work for both parties and allow them to be in a good standing position upon execution of the relevant agreement and any potential claim in the future.
It should be noted that after the closing of any transaction, the purchaser is the one having a major risk and would be the party that would seek a higher indemnification, and that any “materiality” qualifications under the representations and warranties may affect the interpretation of a misrepresentation and therefore this may complicate the indemnification process.
Finally, please be advised that in order to fund any indemnity, the most commons structures include (1) the creation of an escrow account, or (2) a holdback of the purchase price.
In both scenarios if the amount is not sufficient to cover the damages and losses, then the party to be indemnified will have to proceed directly in accordance with the dispute resolution mechanism agreed to recover such damages and losses.
