Oh, Sh*t! Anatomy of an Indemnity Claim
The Anatomy of a Deal Newsletter May 28, 2021
- Indemnity claims arise when a buyer alleges that the seller did not deliver on its promises after closing.
- Proper disclosure of issues pre-closing may help sellers escape liability from indemnification claims.
- Default dispute resolution provisions are often overlooked until a dispute arises, at which point they can be incredibly influential.
- “Winning” the indemnification claim alone is just the start of another complicated process of determining how much the winner collects.
- Some would-be indemnification claims can be avoided or mitigated by virtue of thorough diligence, insurance, and robust contractual protections.
For the next few installments, we turn our attention to what happens after the deal closes. There’s a common misconception that, once the ink is dry and handshakes (or elbow bumps) are exchanged, then everyone simply sings Kumbaya and lives happily ever after.
Except that doesn’t always happen.
This month, we look at what happens when the buyer comes back after the closing and claims that the seller didn’t deliver what was promised: the dreaded indemnification claim.
At the outset, you should know that indemnification claims are actually relatively rare. There are a number of reasons for that, including the following:
- Extensive due diligence – If the buyer, the seller and their respective advisors are doing their jobs, they usually ferret out most—but perhaps not all—of the significant issues before closing. These issues then get dealt with as part of the deal negotiations, rather than resorting to post-closing fights. It’s better for everyone to address these issues prior to closing, rather than after the deal is done.
- Representation & warranty insurance – While merely having this insurance doesn’t directly reduce the possibility of an indemnity claim arising after the closing (though the insurer’s underwriting process indirectly reduces the likelihood of a claim), the insurer may assume all or a significant part of the risk for post-closing indemnification. In that case, the seller may be largely absent from the indemnification dispute. In fact, where the seller retains or rolls-over equity post-closing, the seller may actually be aligned with the buyer in pursuing a claim that the insurer ends up paying to their mutual benefit.
- Buyer reputation – For repeat buyers, including active strategic buyers and virtually all financial buyers, there is a reputational risk to making too many or too petty indemnification claims. The reason is simple. If would-be sellers and their advisors perceive that a particular buyer has a penchant toward clawing back purchase price through indemnity claims—no matter how unfair that characterization may be—sellers will avoid that buyer like the plague. Also, when the seller is retained by the buyer in some capacity post-closing, the buyer may be loath to make a claim against the seller when the buyer is relying on the seller’s efforts to achieve the buyer’s post-closing growth plans. For these reasons, buyers often swallow extra hard before pulling the trigger on a claim.
- Cost – After investing meaningful dollars actually closing the deal, neither the buyer nor the seller is super eager to rack up additional costs fighting over disputes post-closing. And even though the indemnification provisions often require the “loser” to pay the fees of the “winner,” that final reimbursement may not come for years, if at all.
Nonetheless, indemnification claims do happen. And though they’re relatively infrequent, chances are, if a claim arises, it’s probably going to be significant.
So let’s take a look at what happens when the sh*t hits the fan post-closing.
Don't Jump to Conclusions
This may come as a surprise to some people, but despite their pristine reputation in the community, lawyers sometimes get a bad rap. I know, hard to believe.
One of the (many) reasons people don’t love lawyers is that they feel like everything is a technicality when the lawyers get involved. And so it is in the world of indemnification claims.
Let’s use an example. Let’s say that Acme Corp decides to acquire the assets of Initech. The agreement contains the usual slate of representations and warranties and also includes an exclusion of all known and unknown pre-closing liabilities of Initech. It also contains the customary indemnification limits, which in this particular case include a $100,000 deductible for claims relating to breaches of representations and warranties.
Let’s then say that Acme finds out after the closing that Initech has not been following the law to a “T.” In fact, Acme discovers that Milton has been working at Initech for some time without pay; Initech’s former management team “fixed the glitch,” but didn’t tell Milton or Acme. They even took his favorite stapler away! Acme, staring down a potential employment claim from Milton (who’s been threatening to burn the place down if the issue is not rectified), claims it lost at least $100,000 from this fiasco, including the amounts required to pay Milton what he’s owed, fines and penalties, accounting and legal fees, and so on.
Acme dusts off the asset purchase agreement and finds that Initech represented and warranted that it was complying with employment laws. Aha! Initech’s former owners owe Acme $100,000. Case closed!
Not so fast, Matlock. Initech says that, even if not paying your employees is illegal (DISCLAIMER: it’s illegal), Acme doesn’t get the full $100,000, assuming that’s even the real amount of losses Acme sustained. In fact, Acme shouldn’t get a dime from Initech’s owners. Why’s that? Because the indemnification limitations say that Initech isn’t liable for breaches of the representations and warranties until the “deductible” is met. In this case, the deductible just so happens to be $100,000.
Acme is displeased. So it takes a closer look at the asset purchase agreement. This time, Acme conjures up a new legal theory. OK, Initech. Maybe your slick lawyer can get you out of that one, but remember that we didn’t assume any of Initech’s pre-closing liabilities. And it just so happens that Acme is entitled to a “specific indemnity” relating to all of Initech’s liabilities. And that “specific indemnity” isn’t subject to any of the limitations, including the $100,000 deductible. Take that, Lumbergh!
The moral of this story? The type of claim is as important as the factual basis for the claim itself. A claim based on language in one part of the agreement may be limited, while a claim based on language elsewhere in the agreement may not. And some types of claims—including some fraud claims (a bigger topic we’ll tackle another time)—may not be part of the agreement at all.
To the untrained eye, the purchase agreement can be difficult to navigate. A thorough understanding of how it works is critical to successfully instituting—or defending against—an indemnification claim.
Check the TPS Reports
We’ve touched on this before, but many indemnification claims come down to the simple question of whether the seller properly disclosed an issue before closing. If so, the seller may be able to escape liability for an indemnification claim.
Unfortunately, however, disclosure schedules are often rushed and come together just hours—or sometimes minutes—before the closing. While both buyers and sellers should be fully invested in getting the schedules right, the reality is that they sometimes don’t get the attention they deserve.
Let’s say that Initech included the following disclosure in the “Disclosure Schedules” included with the purchase agreement:
“Except as set forth on Schedule X, Initech has paid all compensation due and owing to its employees up to the Closing Date.”
Once the Milton issue is discovered, Acme flips to Schedule X, and sees this gem:
“Former employees of Initech are paid only through their last day of employment with Initech.”
Now, what the hell does that mean?
“See, it’s disclosed right here,” Initech’s lawyers cry out. “Initech paid Milton through his last day of employment. The fact that Acme let him keep coming to work is their problem, not Initech’s.” Suckers…
Acme’s lawyers retort that Acme couldn’t possibly have understood that this cryptic passage means anything more than the fact that Initech doesn’t pay severance. It doesn’t say anything about Milton having been terminated by Initech. How was Acme supposed to know that Milton was no longer on the payroll?
So, which side is right? And who ultimately decides? Good question!
Every Single Day is Worse Than the Day Before
Well, now we’ve got a dispute on our hands. Who decides who’s right? A judge? A jury? An arbitrator? The Bobs?
You should already know the answer: it depends!
Most properly constructed acquisition agreements will contain dispute resolution provisions in the miscellaneous section. To businesspeople, “miscellaneous” is code for “no one cares—stop wasting time and money fighting about that stupid stuff.”
Except, when an indemnification claim arises, you will really start to care what these provisions say. Otherwise, an already unpleasant situation becomes worse every day. If Acme is based in New York and Initech is based in Texas, you can bet that Initech will be disheartened to find that they have to engage lawyers in New York to fight their case in a New York court.
At least Initech can take solace in the fact that a jury of their peers—even though they’re New Yorkers—will be able to see through this injustice. Wait, what’s that you say? The agreement says there’s no jury? But what about my rights? DISCLAIMER: You can waive the right to a trial by jury in a civil case in advance, and most M+A agreements contain just such a waiver.
And what about an arbitrator? That sounds better, doesn’t it? Well, maybe or maybe not.
It’s beyond the scope of this article to point out the pros and cons of each dispute resolution option. But suffice to say that these provisions matter greatly once you’re embroiled in a dispute.
But wait. Don’t most cases settle before going to court anyway?
Why, yes, they do. But don’t underestimate the leverage one party gets by having a favorable default dispute resolution provision. If Acme knows that Initech wants to avoid litigating in New York at all costs, Acme will be pretty emboldened going into settlement negotiations.
So the moral of this story: pay attention to the miscellaneous section, no matter how painful it is to do so.
Fractions of a Penny...Over Time They Add Up to a Lot
Let’s say that Acme finally wins and proves it was harmed by Initech’s mishandling of the Milton situation. All done, right?
Nope. Not even close. Now we have to figure out how much Acme should be paid.
Acme says that it lost $100,000, which includes all kinds of stuff, including back wages to Milton, fines and penalties, accounting fees, legal fees and more. But Acme still has to prove that it should get the full $100,000.
So how does Acme go about proving its losses? And even if Acme can show that it actually incurred $100,000 in costs, not all of those may be recoverable as losses. Huh?
First, Acme has to “mitigate” its damages. In other words, Acme can’t use the “blank check” that it’s getting from Initech to run up costs unnecessarily. If Acme keeps on not paying Milton after discovering the problem and the backpay, fines, and penalties continue to rack up as a result, Acme isn’t going to get paid for the additional losses resulting from Acme’s failure to properly and timely address the situation.
Second, certain types of “indirect” damages may not be recoverable, either by law or by the terms of the agreement. Certain “consequential” damages (i.e., those that don’t directly result from Initech’s breach, but are an eventual consequence of that breach) generally must be “reasonably foreseeable” to be recovered. And the agreement may in some cases entirely exclude these “consequential” damages and other fun things like “incidental” damages and “diminution in value” damages, among others.
If Milton finally carries out on his threat to burn the place down, can Acme recover the cost of rebuilding its business from the fire? How about the loss of customers and employees resulting from being shut down while it has to rebuild? After all, none of that would have happened if Initech had just paid Milton as it should have.
I’m not going to even try to explain all of these here. Suffice to say that “winning” the indemnification claim alone is just the start of another complicated process of determining how much the winner collects. And also, how it actually gets paid. Which leads us to…
I Never Really Liked Paying Bills
So Acme has successfully convinced a judge in New York that Acme is entitled to indemnification from Initech. And Acme has also proved that it should get the full $100,000. Please tell me we’re finally done now.
Many people mistakenly think that a court judgment or arbitration award is the end of the story. After winning in court, Initech drops a suitcase full of cash on the table and skulks away sobbing, right?
In most cases, it doesn’t work like that. Collecting a judgment is often a painful—and sometimes fruitless—process in itself. However, many buyers at least see this risk coming and provide for a source of funds to help pay for any post-closing indemnification dollars owed from the seller. Buyers will often deduct a portion of the purchase price in the form of escrows (i.e., funds deducted from the purchase price and held by a third party, such as a bank, for a period of time after the closing) or holdbacks (i.e., funds deducted from the purchase price and retained by the buyer for some period of time after closing). These arrangements help, but don’t solve all of the issues.
What happens if the escrows or holdbacks have been exhausted? Or what if the seller is owed money from the buyer? That’s when things get really interesting.
Collecting judgments is beyond my expertise—I’ve spent my entire career trying to stay out of court. But it’s important to note that getting paid isn’t automatic. So both sides need to be thinking about how to protect themselves against the possibility that the other side may not have the ability or willingness to pay up.
Most purchase agreements also require the “indemnitor” (i.e., the one who is required to indemnify the other) to reimburse the “indemnitee” (i.e., the one who is indemnified by the indemnitor) for its costs of pursuing the indemnification claim. That can include reasonable attorney’s fees, accountant’s fees, and a whole host of other expenses. But if the parties settle their claim, the indemnitee may not automatically be entitled to be repaid these costs. And just what is “reasonable” in this context? So these issues become a big part of the overall settlement negotiations.
For buyers, the basic premise of every transaction is that the buyer should get what it paid for with no surprises. For sellers, the basic premise is that the seller should get its purchase price and keep it. Indemnification, and the relevant limitations on indemnification, are critical components to the fundamental deal calculus on both sides. Even though these disputes are relatively infrequent, the stakes are huge for both sides.
Some would-be indemnification claims can be avoided or mitigated on the front end by virtue of thorough diligence, insurance, and robust contractual protections. But unexpected indemnification claims do creep up. So both the buyer and the seller will want a clear understanding of the related risks before closing and try to address those risks to the greatest extent possible in the agreement.
So if you could just go ahead and make sure that you pay attention to this stuff before closing on your next deal, that’d be great. Mmm, k?
Next Month: Adjustment Disputes
Read last month’s piece: Crash Course in Family Succession Strategies – Part 3