We all know that the typical insurance policy has a simple coverage section followed by what seems like endless paragraphs of exclusions. In M&A purchase agreements, the allocation of financial risk between the parties is accomplished much more subtly. The following is a very basic primer on some of the key ways that is done.
- Knowledge and Materiality Qualifiers
These qualifiers determine how broadly or narrowly the representations and warranties are applied. Knowledge qualifiers limit the representations and warranties to either the actual knowledge of certain individuals or what those individuals reasonably should know, even if they had no actual knowledge. The more knowledge qualifiers included, the less financial risk to the seller.
Materiality qualifiers (such as “material,” “materially adverse,” or “material adverse effect”) restrict what must be disclosed under a representation and warranty or set a significant threshold for a breach.
In most cases, both sides will ultimately aim for more of a fair balance relative to the deal at hand, rather than an expectation that one side can railroad the other into accepting the addition or deletion of knowledge and materiality qualifiers that are calibrated to unreasonably favor one party or the other. Said differently, a deal should not collapse solely over the failure to agree on the usage of these qualifiers.
The foregoing doesn’t mean that the first draft of a purchase agreement will strive to be fairly balanced and that negotiations over the use of these qualifiers will not be contested. Expect just the opposite to occur.
- Definition of Indemnifiable Losses
The definition of what constitutes an “indemnifiable loss” can either be broad—covering a wide range of potential damages—or narrowly tailored, limiting the buyer’s ability to recover for certain types of losses. There may not be a middle of the fairway resolution of this definition and it may be more likely than not that it favors one party or the other. Both buyers and sellers really need to be coached-up by their respective counsel on the definition that is set forth in the first draft of the purchase agreement so that they understand the implications of it.
The definition of indemnifiable “loss” or “damages” is usually contained in a lengthy section of the purchase agreement containing all of the definitions, with the unintended consequence that it is not focused on by the parties unless counsel calls it to their respective client’s attention.
- Anti-Sandbagging Provisions
This provision determines whether a buyer can seek indemnification for issues it knew about before closing. An anti-sandbagging provision would prevent the buyer from recovering losses for any breach the buyer was aware of before closing. In contrast, a pro-buyer provision will specifically allow the buyer to pursue claims even if it had prior knowledge, ensuring that the representations and warranties remain enforceable.
From the buyer’s perspective, it’s the seller’s responsibility to provide accurate representations and warranties. A buyer does not want to litigate what it “knew” or “should have known” in a post-closing indemnification claim. Moreover, the buyer may argue that an anti-sandbagging provision is a disincentive to conducting thorough due diligence because it would only increase the likelihood of the seller asserting that the buyer “should have known” about a breach discovered after closing.
The seller, however, may contend that an anti-sandbagging provision maintains the integrity of the deal because it prevents the buyer from setting up post-closing claims that could have been addressed before closing by disclosing same and providing the seller with the opportunity to cure or otherwise resolving to the satisfaction of the buyer.
- Materiality Scrape
A materiality scrape is a buyer-friendly provision that disregards materiality qualifiers in representations and warranties in two ways:
- First, it may apply when determining whether a breach has occurred. If a seller agrees to this, any minor inaccuracy in the representations and warranties (including the failure to disclose minor details in the disclosure schedules) constitutes a breach. • Second, and separate from the first, a materiality scrape may apply to the calculation of damages once a breach is established. In this scenario, all damages, whether minor or not, are recoverable after a breach occurs.
A “single scrape” applies to either breach determination or damage calculation, while a “double scrape” applies to both. Sellers rarely agree to a scrape on breach determination but may accept a scrape on damage calculations, especially if there is an indemnification basket (discussed in paragraph 6).
- Representation & Warranty Survival Period; Classification of Reps & Warranties as Statutory or Fundamental
The survival period for representations and warranties determines how long after closing a buyer can make claims for breaches. Fundamental representations—such as title, authority, or capitalization—typically survive longer, sometimes indefinitely, as they go to the heart of the transaction. Statutory representations, such as those related to taxes, employee benefits or environmental matters, also have longer survival periods, usually tied to statutes of limitations.
In contrast, general business representations and warranties often have shorter survival periods. A seller might propose a 12-month survival period, while a buyer may push for between 24 and 36 months.
- Indemnification Caps and Baskets
Indemnification caps and baskets define the seller’s financial liability for post-closing claims. An indemnification cap sets a maximum limit on the seller’s liability for breaches of representations and warranties, often based on a percentage of the purchase price. A low cap significantly limits the seller’s exposure.
Baskets establish thresholds below which the buyer cannot make claims, similar to a deductible in an insurance policy. A “tipping basket” requires the seller to pay for all damages once the threshold is exceeded, while a “deductible basket” makes the seller liable only for losses above a certain amount.
Experienced M&A counsel representing the buyer will be on the look-out for any seller’s draft that places “covenants” under the indemnification cap, as this would limit recovery for seller’s breaches of covenants, something a buyer should not generally accept, nor should a seller expect it to be accepted.
Specific line-item indemnities, such as those covering tax as just one example, are often excluded from the general indemnification cap or have separate much higher caps, because of an assertion by buyer that may be reasonable under the circumstances of the deal, that seller should be asserted responsible for paying those liabilities outside of the indemnification limitations.
Conclusion
The foregoing terms were highlighted because they are typically included in every purchase agreement irrespective of the structure of the deal. This is not intended to be an exhaustive analysis of the subject matter, but just an eye-opener for those not deeply engrained in this subject matter.
As one can imagine, these provisions are often the source of intense negotiation between buyers’ and sellers’ counsel. How much of this can be mitigated by addressing it in the LOI will be the subject of a separate post.
THIS POST IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSTITUTE LEGAL ADVICE.
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