Allocating Risks By Limiting Indemnification In Private M&A Transactions

Caps and baskets are important risk allocation tools available to both sellers and buyers in merger and acquisition (“M&A”) transactions. These tools limit indemnification provisions and restrict the indemnification amount payable in claims for losses. When drafting an agreement relating to the transfer of a business, it may be advisable to include limitations to representations and warranties which restrict the seller’s post-closing liabilities for inaccurate representations and warranties.

Representations refer to the facts and allegations made by the seller, while warranties constitute assurances and guarantees made in regard to the company’s financial reports, liabilities, existing litigation, and other matters. Representations and warrants are normally subject to a survival period during which the parties can make claims for breaches. Sellers may inadvertently consider their liabilities to have ceased after the survival period ends; however, factoring in statutory limiting periods, some warranties and representation may actually be subject to  a longer survival period, extending the seller’s liabilities for breaches. Therefore, it may be prudent for the parties to have an additional risk allocation tool at hand.

How do Caps and Baskets work?

“Caps” establish a maximum amount payable by the seller to relieve a buyer for its losses. Most common caps hold sellers liable for a percentage of the purchase price. Baskets set a threshold that must be met before indemnity rights are triggered. If a party does not incur the amount of losses agreed upon, no right to indemnification arises and the buyer will have no claim for losses. Parties can negotiate and opt for three baskets arrangements a “deductible basket”, “tipping basket” or “mini-basket”.

“Deductible baskets” work like an insurance deductible and are one of the most commonly used baskets. If deductible baskets are put in place, the seller will not indemnify the buyer until all claims for losses exceed the amount agreed in the basket. After the threshold is reached, the seller will be liable for every dollar that exceeds the threshold amount. For example, if the buyer’s claim for losses and damages amounts to $50,000 but the seller has previously established a threshold of $30,000 (via the deductible basket), the buy will receive only the difference between the losses and the basket, which amounts to $20,000 (i.e., $50,000 (loss claimed) – $30,000 (deductible basket). While the seller’s liability is contractually limited, the buyer also enjoys the benefit of having its losses partially mitigated.

In the same scenario, if the buyer incurs in a loss of $25,000 instead, it will not have a claim against the seller, since the amount of losses has nor crossed the threshold (i.e., $30,000). Such deductible basket allows a seller a chance to foresee and assess the losses that a buyer could incur in different scenarios, and accordingly establish a reasonable threshold to trigger the obligation to pay damages and simultaneously limit the amount of damages payable.

“Tipping Baskets” are a less popular arrangement and usually appear in smaller transactions. In this basket arrangement, once the amount of all aggregated claims reaches the threshold, the seller indemnifies the buyer for the full amount of his losses starting from the first dollar. However, the seller cannot be held liable before the threshold is reached. For example, if the basket establishes a limit of $50,000 and the aggregated amount of loss claimed is $60,000, the seller will be liable for the full amount, i.e., $60,000. On the contrary, if the buyer’s aggregate claim amounts to $40,000, no indemnification right will arise against the seller.

“Mini-baskets” establish a threshold amount for single claims before indemnification rights arise. With mini-baskets, if the loss claimed does not exceed the threshold, neither will the buyer have a claim for losses nor will the amount be counted toward the basket. This strategy is useful insofar as it prevents buyers from starting several claims against the seller for the recovery of small amounts.

Conclusion

The law provides buyers and sellers with many options to mitigate risks in business transactions. It is advisable to consult a lawyer in order to identify and address potential risks in a manner that will protect your business and/or your investment capital. Caps and baskets are powerful resources not only for sellers who wish to limit their liability but also for buyers who wish to make their offer more appealing for sellers during competitive negotiations.