Because most indemnification claims are made by a buyer, the seller seeks to limit its indemnification obligations. Some ways in which the indemnification obligations can be limited include:
- Materiality of breach or claim amount
- Caps on indemnification
- 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. These qualifiers serve the purpose of limiting the right of the buyer to indemnification. In the case of a basket, the buyer should insist on excluding materiality qualifications in the representations for indemnification purposes – referred to as a materiality scrape or a read out of materiality. The reason for this is that the basket already provides one level of materiality and it would be subject to double materiality if the materiality qualifiers were not eliminated. The seller can limit the scope or impact of the materiality scrape by:
- Increasing the basket amount
- Excluding certain representations such as material adverse effect
- Making certain representations not subject to a basket
Caps or ceilings 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. If a buyer has particular concerns over potential losses, it should attempt to exclude them from the cap or try to:
- Set a high cap amount
- Exclude areas of potentially significant liabilities
- Exclude liabilities that the seller has agreed to assume
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. Certain representations and warranties are generally carved out of baskets, such as fundamental representations. Baskets can be structured as either:
Thresholds – dollar one or tipping baskets
- Where the indemnifying party is liable for the total amount of losses once the minimum amount is exceeded
Deductibles – excess liability baskets
- Where the indemnifying party is only liable for losses over the minimum amount (often preferred by sellers)
Indemnification often is tied to the survival period for representations and warranties in the business contract. For example, contractual indemnification claims may be brought based upon the limitations set forth in the agreement, which may be less than the applicable statute of limitations. Fundamental representations set forth in a purchase and sale agreement generally are enforceable indefinitely while other representations and covenants are enforceable for a period of time (e.g., 60 days) following the expiration of the applicable statute of limitations.
An example of a deductible basket is “Notwithstanding anything contrary in this agreement, in no event shall the liability of seller for damages exceed in the aggregate more than 20 percent of the purchase price; provided, however, the purchaser indemnitees shall not be entitled to make a claim for indemnification unless and until the aggregate damages suffered or incurred by the purchaser indemnities exceed $500,000 (it being understood that the first $500,000 is intended as a deductible) and the seller shall not be liable for the first $500,000 of damages for which the purchaser indemnitees are entitled to indemnification.”
An example of a tipping basket is “A buyer shall not be liable to the seller indemnitiees until the aggregate amount of all losses in respect of indemnification exceeds 20 percent of the purchase price, in which event the buyer shall be required to pay or be liable for all such losses from the first dollar.
Baskets have the risk of a seller double dipping if representations also contain materiality qualifiers. In that case, the buyer must demonstrate that both the breach and the loss met their respective materiality thresholds before it would count towards the basket. To prevent this, the buyer should read out the materiality qualifiers for purposes of indemnification.
In addition, baskets can have mini-baskets that further limit an indemnifying party’s obligations. Mini-baskets require a loss from a particular claim to exceed a certain amount before those losses can be counted toward the overall indemnity basket. The purpose of a mini-basket is to prevent the buyer from looking for minor breaches in order to reach the overall basket amount.