Indemnification clauses in purchase and sale agreements are intended to address the obligation of one party to indemnify and hold the other party harmless from direct and third party claims. However, indemnification clauses also allocate the risk of losses between the parties.
An indemnification clause should specify the rights of the parties following a breach of representations, warranties, covenants or the occurrence of a specific liability. On one hand, a buyer will negotiate an indemnification clause to expand the scope or availabilities of other remedies, at law or equity, including adding other persons whom the buyer may otherwise have difficulty recovering from and expanding the types of recoverable losses. On the other hand, a seller will negotiate an indemnification clause to limit indemnification as the exclusive remedy to permit more predictable outcomes and mitigate potential liability.
The indemnification clause is impacted by other provisions in the purchase agreement and a drafter needs to be consistent to be sure that the representations, warranties and covenants set out the full scope of what is covered by the indemnification clause.
Some ways in which the indemnification obligations can be limited include materiality of breach or claim amount, caps on indemnification, baskets, and payment adjustments for insurance proceeds or tax benefits.
Sellers often like to include materiality qualifiers in the indemnification clause as to the claim amount and the type of claim. Buyers often insist on excluding materiality qualifications in the representations for indemnification purposes – referred to as a materiality scrape. A seller can limit the scope or impact of the materiality scrape by:
- Increasing the basket amount
- Excepting certain representations from materiality qualifiers, such as material adverse effect
- Excluding certain representations from a basket
Caps or ceilings on liability limit an indemnified party’s maximum total recovery to a stated dollar amount. Generally the cap is the amount of the escrow or a percentage of the purchase price. A buyer will attempt to mitigate the impact of a cap and will negotiate an exclusion of certain losses or attempt to:
- Set a high cap amount
- Exclude certain areas of potentially significant liabilities
- Exclude seller-assumed liabilities
A basket limits indemnification obligations to prevent an indemnifying party from being liable for inaccuracies in or breaches of certain representations until losses exceed a specified minimum amount. Generally fundamental representations are carved out of baskets. Baskets can be structured as one of two ways:
- Tipping – a basket in which the indemnifying party is liable for the total amount of losses once the minimum amount is exceeded (often preferred by buyers)
- Deductibles – a basket in which the indemnifying party is only liable for losses over the minimum amount (often preferred by sellers)
In addition, baskets can consist of mini-baskets that further limit an indemnifying party’s obligations. Mini-baskets are established to require a loss from a particular claim to exceed a certain amount before those losses can be counted toward the overall indemnity basket.
