In M&A transactions, the buyer and seller will both seek to protect themselves from liability for losses arising post-closing. Indemnification provisions provide a contractual remedy for both parties to allocate risk and recover damages after the M&A deal closes. It is important for a company’s in-house counsel to understand the key aspects and limitations of indemnification clauses, including the scope of the indemnification obligations of the parties, the survival periods for different indemnification obligations, the funding process, and the relevant notice procedures.

Indemnification provisions are common in M&A transactions involving private companies. Indemnification clauses are rare in acquisitions involving a public target company because such a company has a large shareholder base that would be impractical to recover losses from.

Since the buyer faces a higher risk of incurring losses after the closing, the buyer will try to negotiate broad indemnification rights. The seller, on the other hand, will seek to place limitations on its post-closing indemnification obligations. Nowadays, representations and warranties insurance (“reps and warranties insurance”), is often purchased to provide the buyer an additional layer of protection and to shift some of the buyer’s post-closing risk to an insurance company.

If the seller breaches its representations, warranties, or covenants under the merger agreement following the acquisition closing, the buyer may be able to bring an indemnification claim against the seller. For example, the buyer may claim that the seller has breached the non-compete or non-solicitation covenants in the agreement.

The buyer may negotiate to have the “indemnified parties” defined to include not only the buyer, but also its affiliates, directors, officers, employees, and other agents of the buyer. Depending on the particular indemnification claim, the indemnified parties may be able to recover losses for attorney’s fees, incidental damages, consequential damages, or indirect damages. When multiple indemnifying parties are involved, the liability may be structured as (i) joint and several, (ii) several but not joint, or (iii) joint but not several. If the indemnification obligation is joint and several, each indemnifying party may be held entirely responsible for the breach. If the indemnification obligation is several but not joint, an indemnifying party is just liable for its own portion of the obligation.

The survival periods for indemnification obligations vary, but they generally mirror the survival period for the associated representation or warranty in the agreement. Many of the representations and warranties have survival periods of 12 to 18 months following the merger closing. The buyer may negotiate longer survival periods for representations it deems to be especially important, also known as fundamental representations.

An indemnification escrow may be established ahead of closing the merger. The escrow account may be funded with a percentage of the purchase price and the funds may remain in the escrow account for a specified period of time after closing. The buyer may be keen to have an indemnification escrow account if it has concerns about the seller’s ability or willingness to pay its post-closing obligations.

The seller will try to limit its post-closing indemnification obligations by negotiating baskets, caps, and materiality qualifiers. The purpose of an indemnification basket is to reduce the potential losses that can be recovered. The basket can set a threshold, commonly referred to as a tipping basket, which makes the indemnifying party responsible to pay the total amount of losses once a specified minimum amount is exceeded. Alternatively, the basket can be structured as a deductible, also referred to as an excess liability basket, which makes the indemnifying party only responsible to pay the losses over the specified minimum amount. The indemnification clause may also include materiality qualifiers. The parties may negotiate a materiality scrape, which permits the materiality qualifiers in the agreement’s representations to be excluded for indemnification purposes.