- WHAT IS INDEMNIFICATION?
In private M&A transactions, some of the most highly negotiated issues are those dealing with post-closing indemnification. Situated in the purchase and sale agreement, a contractual indemnification provision typically stipulates that one party (the indemnifying party) undertakes to compensate the other party (the indemnified party) for certain losses and expenses incurred by the indemnified party relating to the transaction.
Indemnification provisions are important considerations for counsel when negotiating a purchase agreement because indemnity provisions:
- allow for the customization of risk allocation between the parties;
- allow the parties to protect or limit its respective liability from damages and lawsuits that may result from the transaction; and
- introduce a predictability of recourse for the non-breaching party whereas without the provision a party would have to rely on an uncertain breach of contract action at common law.
If a purchase agreement does not contain a properly drafted indemnification provision, a party may be subject to continuing liability for circumstances outside of its control.
- PRIVATE M&A DEAL POINT STUDIES
As soaring deal activity continues entering 2022, we wanted to look back on how transactions involving private targets being acquired by public companies have structured indemnity provisions through a cross-border lens. To do so, we relied on the American Bar Association's 2021 edition of the "Private Target M&A Deal Points Study" (the "American Study") covering transactions for which definitive agreements were executed and/or completed in 2020 and the first quarter of 2021. The American Study analyzed 123 acquisition agreements involving private targets being acquired by public companies.[i]
Comparatively, Thomson Reuters Canada's "What's Market: Legal Trends in Canadian Private M&A" was prepared in 2021 for the Ontario Bar Association (the "Canadian Study") and analyzed transactions signed or completed in 2020 involving Canadian private targets. The Canadian Study reviewed 67 purchase agreements purchase agreements publicly filed on Canada's System for Electronic Document Analysis and Retrieval (SEDAR) or the US equivalent, the Electronic Data Gathering, Analysis and Retrieval (EDGAR) System.[ii]
Both the Canadian Study and American Study should be read carefully with appropriate considerations taken when analyzing each report. The Canadian Study reported that transactions in the Natural Resource industry accounted for 31% of the sampled deals with Other (12%) and Consumer Goods (10.4%) rounding out the top three most active industries.[iii] In the American Study, the top three principal industries were Health Care (15.4%), Technology (13%) and Industrial Goods & Services (12.2%).[iv] When a target's significant assets consist solely of resource and land claims, a purchaser may tend to not be as concerned with the operational representations and warranties of the target compared to a target business operating in a service-based industry. Furthermore, every year many transactions close involving only private parties. The agreements in these transactions are not disclosed, leaving a vast segment of "what's market" unknown.
- TRANSACTION VALUES
Transaction size – often an indicator of the strength of the market – differed dramatically between the two jurisdictions. In the American Study sample, transaction values ranged from $30 million to $750 million with a median transaction value of $180 million and 12.2% of transactions were valued at over $500 million.[v] Conversely, the Canadian Study sample contained much smaller transactions, with values ranging from $5.4 million to $399 million. The median transaction value captured by the Canadian Study was $20 million. Notably, none of the sample transactions were valued above $500 million.[vi] Although Canadian transactions generally follow US trends, it is clear the scope and scale of US transactions continues to far exceed that in Canada.
- KEY INDEMNIFICATION DEAL POINTS
Indemnification provisions can be complex and lengthy, thereby forming the subject of extensive negotiation. Irrespective of which jurisdiction governs a transaction, prudent counsel should concern themselves with all aspects of an indemnity provision. However, several elements tend to receive the most attention, including: (i) survival, (ii) indemnity baskets and (iii) indemnity caps.
Survival periods allow the parties to specify how long after closing a party may bring a claim for indemnification based on a breach of representation and warranties (and sometimes covenants). Typically, indemnification provisions will include a default survival period along with a carved-out survival period for certain representations and warranties such as fundamental representations and tax matters. These carve-outs will carry a longer or indefinite survival period to reflect a purchaser's unwillingness to bear any risk associated with these matters.
The Canadian Study showed that the bulk of transactions established a default survival period between 12 to 24 months. For transactions with an established default survival period, 24 months was the most common for both share purchase and asset purchase transactions (35% and 33% of sampled transactions, respectively).[vii] A lengthier survival period will favour a purchaser by allowing them more time to run the business and complete at least one post-closing audit of the target's operations. This typically provides enough time to uncover any significant issues with the business.
In a more competitive US M&A market, survival periods have been shortened, with 12 months being the most common survival period length. Notably, 33% of the transactions sampled in 2020 featured an express no-survival period and only 5% of transactions had a survival period of 24 months.[viii] Transactions containing no survival periods have become increasingly popular in a competitive market where a purchaser will rely on representation and warranties insurance ("RWI") to recover any losses from a third-party insurer rather than from the vendor.
RWI coverage allows a purchaser to compete on terms that may be more attractive to the vendor. For example, a purchaser can require limited escrow or holdback requirements from the vendor at closing as the purchaser will rely on RWI for indemnification protection. In effect, the vendor will walk away with more cash on closing and smaller contingent liabilities going forward. However, vendors must understand that RWI is not a blanket protection to substitute post-closing indemnification. An RWI insurer will typically run a parallel form of due diligence on the vendor during the transaction. As the diligence process concludes, the insurer may determine that some of the key risks the vendor is looking to address are excluded from the coverage.
- Indemnity Baskets
Indemnity baskets are a common form of limitation on an indemnifying party's liability. An indemnity basket establishes that certain covered losses cannot be recovered until the losses exceed a defined amount. Indemnity baskets can be structured as either:
- Tipping or First Dollar Basket: when the defined loss amount in the agreement is reached, the indemnifying party is liable for the total amount of losses.
- Deductible: when the defined loss amount is reached, the indemnifying party is liable for any losses in excess of the defined loss amount.
- Partial Tipping Basket: a combination of first dollar and deductible baskets where a party can recover some but not all of the defined loss amount.
All three types of indemnity baskets may be subject to certain carve-outs. The most common basket exceptions are for specified fundamental representations, fraud and covenants.
Canadian and US practices diverge on the preferred method of basket. A first dollar basket will be more favourable to a purchaser as it allows them to recover the entire indemnified amount once the threshold is triggered, whereas a vendor will prefer a deductible basket to narrow their exposure to indemnification claims. The American Study reported that vendors succeeded in implementing a deductible basket in 75% of the sampled transactions compared to 13% of the transactions using a first dollar basket.[ix] Alternatively, the Canadian Study demonstrated that purchasers utilized their negotiating leverage with 70% of transactions using first dollar baskets compared to 28% using a deductible basket.[x] Partial tipping baskets in both Canada and the US continue to be the least favourable approach.
The size of the indemnity basket as a percentage of the transaction value continued to differ between Canadian and US transactions, with basket sizes being larger in Canada. The American Study reported that 96% of deals included a basket of 1% or less of the purchase price while only 77% of the deals in the Canadian Study included a basket of 1% or less of the purchase price.[xi] As noted above, transaction values tend to be smaller in Canada compared to those in the US. This difference can explain the discrepancy in basket sizes between the two jurisdictions; when the transaction value is lower, the basket size as a percentage of transaction value tends to be higher.
- Indemnity Caps
An indemnity cap is a limitation on the amount an indemnifying party may be required to pay on a successful indemnity claim. A cap may be expressed as a set dollar amount or a percentage of the purchase price and typically will include carve-outs that are not subject to the cap for special representations relating to fundamental representations, taxes and fraud.
Both the American Study and the Canadian Study indicate that almost all deals with a reported survival provision include a cap, with US transactions containing a substantially lower cap size as a percentage of transaction value.[xii] Notably, the American Study reported that only 1% of US transactions contained a cap at 100% of the purchase price and all these transactions included RWI. For US deals, a cap at less than 1% of the purchase price was reported in 41% of transactions.[xiii] Canadian transactions contained much larger caps with the median percentage cap at 40% of transaction value and 27% of transactions included a cap exceeding 100% of the base purchase price. A cap exceeding 100% of the purchase price takes into account all proceeds received by the vendor, including earn-outs. If Canadian transaction values increase, we may see a shift in the Canadian practice towards lowering cap amounts to further align with the US approach.
- FINAL THOUGHTS
Indemnification provisions remain an extremely important consideration to both purchasers and vendors in a M&A transaction. As cross-border transactions continue to flourish it is important to carefully consider the duration, dollar amount and exceptions attached to a party's indemnification obligations. Understandably, a mistake can have a large dollar impact on an indemnifying party post-closing.
[i] American Bar Association M&A Market Trends Subcommittee, Mergers & Acquisitions Committee, "Private Target M&A Deal Points Study" (2021) [American Study].
[ii] Thomson Reuters Canada Limited, "What's Market: Legal Trends in Canadian Private M&A (2020 Transactions)" (2021) [Canadian Study].
[iii] Canadian Study at page 6.
[iv] American Study at page 7.
[v] American Study at page 6.
[vi] Canadian Study at pages 4-5.
[vii] Canadian Study at page 62.
[viii] American Study at pages 88-89.
[ix] American Study at pages 96-97.
[x] Canadian Study at pages 68-69.
[xi] American Study at page 97; Canadian Study at page 69.
[xii] American Study at page 105; Canadian Study at page 72.
[xiii] American Study at page 107.