An indemnity is simply protection against loss. Indemnification protects a party from losses due to broken “promises” (i.e., breaches of representations and warranties or covenants), and requires that the breaching party make the other party whole for losses realized.
The representations and warranties describe what must be true and what must remain true, and this article describes what takes place in the event that the representations and warranties are not true, or in the event that a covenant is breached. In other words, this article describes how a party will be compensated in the event that they do not receive what was been negotiated in the purchase agreement.
This allows the parties to define maximum exposure in the event that a party is exposed to loss. Otherwise, damages would be determined by the courts, leaving the parties uncertain about their exposure.
Most concisely, Indemnification in a Stock Purchase Agreement will cover the following:
- The scope of the indemnitees, largely by referencing the representations and warranties and covenants in the stock purchase agreement.
- The survival period of the indemnitees (see below).
- The parties covered.
- The procedure to bring a claim (see below).
- The payment of indemnitees (e.g. in this example, the escrow and the Buyer’s right to clawback the purchase price directly from the Seller), and limits on exposure (see below).
- The indemnitees as exclusive remedy.
Indemnification Procedure: This article will also detail the indemnification procedure, which describes the rules that the party seeking indemnity (or protection against loss) must follow to bring a claim. This will be detailed for both third-party claims and for claims made directly by the Buyer or the Seller.
Survival Period: This article will also establish the time horizon over which the parties are indemnified. Survival periods often range anywhere from six months to two years. Within this description you will always certain fundamental representations and warranties that are viewed as so basic and fundamental that the indemnified party is generally protected for an indefinite period.
Liability Limits: As it relates to liability limits, the parties should consider two critical concepts: (1) “Basket” and (2) “Cap.” A Basket is a dollar amount (measured as an aggregate sum of all claims) that must be exceeded before an indemnified party can seek indemnification. Baskets may be structured as a threshold (i.e., a “tipping basket” or “dollar one threshold”) where the indemnifying party is liable for the total amount of losses, or as a deductible (i.e., an “excess liability basket”) where the indemnifying party is only liable for the amount of losses in excess of the agreed amount. The “Cap” is the absolute total dollar sum of exposure for either party in the event of loss. These terms typically would not apply to the fundamental reprensentations or any obligations or representations concerning tax matters.
Representations and Warranties Insurance: Before concluding this introduction, we want to make you aware of an alternative to this approach that has been growing in popularity in the last 10-15 years. Representation and Warranty Insurance (RWI) policies shift the risk associated with indemnification to an insurer, allowing the parties to protect themselves from breaches while simultaneously facilitating negotiation by eliminating or reducing the post-closing obligations of the Sellers under the stock purchase agreement. A buy-side RWI policy, for example, could potentially eliminate the need for an escrow. At the very least, it should allow for a smaller escrow covering only the exposure not included in the RWI policy. Securing such a policy does not typically eliminate the indemnification obligations of the parties in their entirety, but it can reduce the scope. In the event of a claim, the Buyer will first seek to recover Losses from the RWI policy before seeking to recover losses from the Sellers.
All of the concepts detailed in this article would also be included in a stock purchase agreement where the Buyer secured an RWI policy. The most significant differences in language between the two would be the following:
- Potentially eliminating or reducing the amount of the escrow.
- Language stating that the Buyer must first seek to recover damages from the RWI policy before seeking to recover damages from the Sellers directly.
- Language stating that in no event shall the damages recovered from the RWI policy and Sellers be in excess of the Losses for any particular claim.
- Including the RWI policy as an exclusive remedy.
Stock Purchase Agreement Language: The pages that follow contain hypothetical language detailing the above sequence as it might appear in a stock purchase agreement. This article references many of the sections relating to representations and warranties and covenants. To make the information easier to digest, these section numbers have been replaced with bracketed descriptions of the sections referenced. Otherwise reading this document would require a lot of cross references.