Photo of Joe BrennanBy Joe BrennanJuly 21 2017
Business Law

Use Indemnification to Allocate Acquisition Risks M&A Basics Series – Article 7

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The indemnification provisions at the back of a typical private company acquisition agreement set out the terms under which a seller will be obligated to indemnify the buyer for losses the buyer may suffer post-closing. The buyer wants the seller to give serious consideration to the seller’s representations, warranties and covenants contained in the acquisition agreement and be on the hook for any faulty disclosures made to the buyer in that agreement.  Conversely, the seller wants to have certainty upon the closing of the transaction and does not want to be “at risk” following closing. Therefore, the buyer will want the indemnification provisions to be as broad as possible while the seller will want to limit the scope, duration and aggregate potential liability of such indemnification obligations. Given that these provisions have a significant impact on the allocation of risk of the transaction, and could also have a significant impact on the purchase price, time and attention should be taken by the parties to negotiating and drafting these provisions. 

Scope

Typically, the Buyer will want indemnification for any losses resulting from:

(i) Non-Performance - any non-performance or non-fulfillment of any covenant or agreement on the past of the Seller;

(ii) Misrepresentation - any misrepresentation or breach of any warranty made by the Seller; and

(iii) Pre-Closing Obligations - any liabilities (other than those agreed to be assumed by the buyer) resulting from the activities of the acquired business which occurred prior to closing.

These are generally accepted in Canada. However, additional matters may arise during due diligence (i.e. certain lawsuits) that the parties may wish to specifically include or exclude from the scope of the indemnification provisions.

Survival periods

Survival periods set forth the time during which a party can bring a claim for indemnification. In Canada, the survival period for breaches of most representations and warranties typically range from 12-24 months with 18 months becoming increasingly common. Twenty-four months used to be the norm in Canada as it matched the statutory limitation period in most jurisdictions. However, the trend has been towards adopting the US standard of 12-18 months to reflect that the fact the buyer should be able to conduct a thorough audit of the business during the first 12 months of ownership and therefore be able to identify any claims during that time.

Note that the survival period for tax-related matters typically extends to the end of the allowable reassessment period for a given tax year. And the survival period for pre-closing environmental liabilities is usually much longer that 24 months (sometimes indefinite) and is often the subject of significant debate since the statutory limitation period for environmental liabilities is usually unlimited.

Nonetheless, with Canadian survival periods shrinking, buyers will need to spend a lot more time and energy on post-closing due diligence to ensure any claims are identified within the survival period.

Caps

The indemnification cap is the maximum amount that the seller will have to indemnify the buyer. Historically, Canadian indemnification provisions tended to cap the seller’s indemnification obligations at or near 100% of the purchase price while the US norms have historically been much lower with the American Bar Association 2016 deal study showing 81% of US private M&A transactions capping the seller’s indemnification obligations at 15% of the purchase price or less. 

Canadian deal caps have been trending lower with the American Bar Association 2016 deal study showing that only 23% of Canadian private M&A transactions capped the seller’s indemnification obligations at 100% of the purchase price.  Still Canadian indemnification caps tend to be much higher than in the US with only 23% of 2016 Canadian deals capping the seller’s indemnification obligations at 15% of the purchase price of less. 

Nonetheless, with Canadian indemnification caps decreasing, buyers will need to spend a lot more time and energy on pre-closing due diligence.

Tipping Baskets vs Deductibles

An indemnification basket is the dollar threshold of the losses that the buyer must incur before the buyer is entitled to receive indemnification. In Canada, the predominant practice has been to use “tipping baskets” which permit indemnification of all losses after an agreed threshold has been exceeded. Conversely, in the US, the predominant practice has been to use “deductibles” which only provide indemnification for losses in excess of the threshold which effectively increases the purchase price by an amount of the losses up to the amount of the deductible.

However, the trend in the Canadian market is towards the adoption of the US deductible approach (14% of Canadian deals in 2012 vs 36% in 2014 vs 41% in 2016).  As such, buyers will need to spend a lot more time and energy on pre-closing due diligence.

Materiality Scrape

A single materiality scrape eliminates any materiality qualifiers in representations and warranties for the purpose of calculating losses.   A double materiality scrape eliminates any materiality qualifiers in representations and warranties for the purpose of both (i) calculating losses and (ii) determining whether a breach of any representation and warranty has occurred in the first place. A double materiality scrape makes it easier for a buyer to establish a claim that a representation or warranty has been breached.   

Only 39% of Canadian deals in the latest study had any materiality scrape and 57% of those only had the single material scrape.  Conversely, 70% of US deals had a materiality scrape and 57% of those had a double materiality scrape.

No materiality scrape favors sellers while a double materiality scape favors buyers.

Escrow

Escrow is the placing of a percentage of the purchase price with a third party trustee for a pre-determined period of time following closing before it is released to the seller. Escrow provides the buyer comfort that there will be readily available funds to satisfy potential indemnification claims.  According to the American Bar Association 2016 deal study, approximately 80% of US deals have an escrow with the mean amount of the escrow being equal to approximately 10% of the transaction value. In Canada, less than half of the deals include an escrow and, of those that do, the escrow amount is typically around 8% of the transaction value. 

Holding cash provides leverage so sellers prefer no escrow while buyers prefer escrow. In situations where there is no escrow, buyers need to be extra vigilant in their due diligence. In situations where there is escrow, sellers need to be extra careful in reviewing their representations, warranties and covenants.

Invitation for Discussion:

At Shea Nerland LLP, we have a wealth of experience as legal advisors on M&A transactions, both large and small, and understand the many nuances of indemnification provision in M&A agreements. If you are contemplating buying or selling a business, please do not hesitate to contact one of the lawyers in our business law group.  We would be happy to assist you on this exciting journey.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

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