Financial Poise
Share this...
Purchase Agreement - Risk Allocation Provisions

The Purchase Agreement Essentials – Risk Allocation Provisions

If the transaction is not a sign and close, then the Purchase Agreement will contain risk allocation provisions regarding how a party may terminate the contract. Typically, the Purchase Agreement will provide that it may be terminated as follows:

  • the mutual written consent of the parties;
  • by either party if there is a court order permanently restraining, or otherwise prohibiting the transaction;
  • by either party if the closing has not occurred by an agreed outside date, unless the failure to close by such date is because of any failure to fulfill any obligation under the agreement by the party seeking to terminate;
  • by either party if the other party in material breach of the agreement, and such breach is not cured after notice and a reasonable cure period;
  • by the Purchaser at any time; except that the Seller might require a termination payment from the Purchaser in exchange for agreeing to this right.

Survival Periods.

The representations and warranties of the parties will survive for a negotiated period after the closing, typically ranging from 12 to 24 months, with 18 months being common. Certain specified representations and warranties will survive for a longer period. Representations and warranties for Taxes, Environmental, Health and Safety matters, and Employee Benefit matters often survive for three to five years after the closing or until the applicable statute of limitations has expired. Certain “fundamental” representations and warranties will survive indefinitely. These include Authorization, Capital Structure and Ownership, Title and Brokers.

Indemnification.

As mentioned above, the Purchaser will expect the Seller to stand behind its representations and warranties by providing indemnification to the Purchaser if there is a breach. The Seller will also indemnify the Purchaser for other breaches by Seller of the Purchase Agreement and ancillary agreements, along with any Seller-retained liabilities and any debt and liens not previously disclosed and paid off at closing. In addition, the Purchaser may require specific indemnities from the Seller if there are particular risks or concerns, for example, Seller’s requirement to secure key customer consents, or settle existing litigation.

The Purchaser will also provide indemnification to Seller for Purchaser’s breach of its representations, warranties and covenants under the Purchase Agreement, as well as any liabilities of Seller that it is assuming.

Limitation of Liability.

The Seller will likely negotiate certain limitations to the indemnification obligations. These take the form of a deductible or “basket” and a “cap.” The deductible or basket sets a floor on the amount of losses that the Purchaser must sustain before the Seller is required to indemnify for the loss. Baskets can either be “first dollar” or “tipping.” First dollar baskets mean that, once the threshold is met, the Purchaser will be entitled to indemnification going back to the first dollar of loss. Tipping baskets would entitle the Purchaser for indemnification only for amounts above the threshold. Depending on the size of the transaction, the parties might also negotiate a “minimum claim” requirement, whereby the Seller will not have any indemnification obligations for claims below a certain minimum amount.

At the other end, there will be a cap on the overall aggregate indemnification obligations. While Sellers certainly want to limit their exposure and seek the lowest cap as possible, it is usually more prudent to focus attention on receiving the highest deductible as possible. The types of catastrophic losses that would implicate an indemnity cap are rare. Much more likely are the smaller claims that might be avoided if the deductible is high enough. There are market reports provided by the American Bar Association and other industry groups that provide data on the various terms negotiated by parties to Purchase Agreements. These reports serve as helpful negotiation tools for both parties so that the terms stay within an acceptable market range.

Non-Direct Damages.

The Purchase Agreement may also exclude non-direct damages (i.e., consequential, special, indirect or punitive damages) being covered in an indemnity claim, except to the extent awarded to a third party in a third-party claim. The Purchaser will want the agreement to specify that this limitation will not preclude indemnification for damages based on diminution in value.

The limitations on indemnification will apply to both parties. The limitations generally only apply to indemnification obligations of non-fundamental representations and warranties. The limitations will not apply to breaches of fundamental representations and warranties, taxes, or any other indemnification obligation. They will also not apply to a party’s fraud or intentional misrepresentation. The Purchase Agreement might provide for how losses are calculated for purposes of a party’s indemnification obligations. Usually, losses will be calculated net of (i) any net amount actually recovered by the indemnified party from a third party or net tax benefit actually realized with respect to such losses and (ii) any insurance proceeds actually received by such indemnified party, excluding self-insurance arrangements and net of any deductible or other expenses incurred by the indemnified party in collecting any such insurance proceeds.

The Purchase Agreement will usually contain a provision as to how third party claims will be handled. Terms to be covered will include notice of the claim, that the indemnifying party can generally control the defense and that the indemnified party can take over if the indemnifying party refuses to or does not adequately handle the defense, that the indemnified party will reasonably cooperate with the indemnifying party, and that the indemnifying party will not settle the case without the consent of the indemnified party.

If there is contingent consideration, note payments or other amounts still to be paid by the Purchaser to the Seller, then the Purchaser will want set-off rights as additional security for any losses for which the Seller is obligated to indemnify the Purchaser.

The Seller will want the Purchase Agreement to state that the indemnification provisions and any rights to equitable relief (including specific performance) will be the exclusive remedies of the parties, other than for claims arising out of fraud or intentional misrepresentation. The Purchaser will want to clarify that this limitation will not limit any additional rights and remedies it may have under the ancillary agreements.

One tool that can be used to minimize risk in the event a representation or warranty is breached is to purchase insurance. To read more on this click here. Also read the first article on Purchase Agreement Essentials here.

For information on negotiating an M&A deal, we recommend this webinar and this webinar.

About Robert E. Connolly

Rob is a member of Levenfeld Pearlstein, LLC’s Corporate & Securities Group and has been with the firm since its inception. Rob helps clients structure, negotiate and close complex business transactions. He also serves as outside general counsel for a number of businesses in the middle market across a variety of industries, including: technology, cloud…

Read More »

Leave a Comment:

Share
Hide