An overview of representations, warranties and indemnification in M&A

Reps and warranties: Nearly every asset, stock or membership interest purchase agreement will include representations and warranties (or “reps and warranties” as they are referred to in practice) from the seller and the purchaser. A representation is a statement of fact and is intended to disclose information. A warranty is an assurance. Reps and warranties are one of the most critical and heavily negotiated aspects of a purchase agreement. While it is highly deal and industry-specific, a purchase agreement for a middle-market transaction will typically have between 25 to 40 reps and warranties for the seller and/or target company to make and about five for the purchaser to make. The reps and warranties for the seller are much more detailed and onerous and require disclosure schedules for information that needs to be disclosed.

The following are common topics and a very brief summary of reps and warranties that sellers make:

Organization and good standing: The company is duly organized and in good standing under the laws of its state of organization/incorporation.

Authority and enforceability: The company has the authority to enter into the purchase agreement and the purchase agreement is enforceable against the seller.

Noncontravention: Entering into the purchase agreement will not conflict with any other agreement the seller is a party to and no third-party consents are required.

Capitalization: The owners and ownership percentages listed on the capitalization table are accurate.

Financial statements: The financial statements of the target company are true and accurate.

Title to shares or membership interests: The sellers hold title to the shares or membership interests free of liens and encumbrances.

Title to assets: The seller holds title to all the assets of the business, free of liens and encumbrances.

Inventory: The target company’s inventory list provided is true and accurate and the inventory is in good condition.

Compliance with laws: The company has complied with all laws.

Permits: The target company has all required permits and licenses required to operate the business.

Real property: The target company has good and marketable title to the real property and there are no liens, leases, violations, issues or claims regarding the real property.

Intellectual property: The target company owns the intellectual property disclosed. if any, and there are no infringement issues.

Environmental matters: There are no hazardous materials at or environmental issues regarding the business premises and the target company has at all times complied with environmental laws.

Tax matters: The target company has timely filed all tax returns and paid all taxes.

Employee matters: This rep typically requires the seller or target company to provide a list on the disclosure schedule of each worker including, among other things, each individual’s title, classification, start date and compensation and confirm each worker is classified properly.

Employee benefits: This rep typically requires the seller to provide a list on the disclosure schedule of all employee benefits and confirm that the company is in compliance with applicable employee benefit-related laws.

Absence of certain events: The business has operated only in the ordinary course of business and has not done anything outside of the ordinary course of business since a specified date such as, for example, suffered extraordinary losses, incurred indebtedness, made a capital expenditures in excess of a specified amount or made material changes in compensation.

Contracts: This rep typically requires the seller to list on a disclosure schedule all contracts that the target company has entered into that fall within the definition of “material contracts” per the purchase agreement and represent, among other things, that there are no defaults under such contracts.

Litigation: The target company is not a party to any pending litigation and sellers are not aware of any potential claims.

Insurance: The target company is and has been sufficiently insured.

Broker’s fees: This rep is where a seller would disclose if the deal involved a broker.

The following are common topics of reps and warranties that purchasers make: Organization and good standing, authority and enforceability, noncontravention and broker’s fees.

In many deals, the reps and warranties are classified into three categories: (1) fundamental; (2) regulatory or intermediate; and (3) nonfundamental. The reasons for the classification are (1) because the parties deem certain reps and warranties to be more significant than others and therefore, the more important reps and warranties will have a longer survival period than the less important reps and warranties and (2) to exclude a certain classification or classifications of reps from liability thresholds. The parties should negotiate the survival period for each classification.

The most important reps and warranties are referred to as “fundamental.” While the specific reps and warranties that are deemed fundamental can be highly negotiated, deal-specific and industry-specific, those that are almost always deemed fundamental include: organization and good standing; authority and enforceability; capitalization; title to assets; title to shares or membership interests; and broker’s fees. The typical survival period for fundamental reps is between three to five years after closing.

The reps and warranties that are often classified as “regulatory” or “intermediate” include: tax matters; environmental matters; employee matters; and employee benefits. The typical survival period for regulatory or intermediate reps varies but is typically 30 to 60 days after the expiration of any applicable subject matter statute of limitations period.

Any reps and warranties that are not classified as “fundamental” or “regulatory” are by default deemed “nonfundamental.” Nonfundamental reps are not as critical and tend to have a lower risk of a material impact on the purchaser if any turns out to be untrue. Accordingly, nonfundamental reps will typically have a shorter survival period than fundamental reps. The typical survival period for non-fundamental reps is between 12 and 24 months after closing.

The seller should negotiate the reps and warranties by adding qualifiers such as “material” or “knowledge” language or limiting the scope or time period. For example, “the company has complied with all laws” may be negotiated to say, “to the company’s knowledge, the company has been in material compliance with all applicable laws during the five years preceding the closing date.” The purchaser might push back on such qualifiers or attempt to broaden the scope. The word “knowledge” should also be defined. A seller will want the definition to include actual knowledge without the duty of inquiry and be limited to the fewest number of individuals as possible. A purchaser, on the other hand, will want the definition to include information the individual knew or should know the duty of inquiry and as many individuals as possible, such as members/shareholders, managers and high-level employees.

In addition to negotiating the language or the rep and warranty or adding qualifiers, a seller should also make disclosures when necessary. For example, if there was an environmental issue, provide a description of the issue on the applicable schedule. If the target company recently did something outside of its ordinary course of business, such as making a large capital expenditure, provide a description on the applicable disclosure schedule. If there is pending litigation, the case should be disclosed on the applicable schedule. If the target company is in default under a material contract, a summary of the issue should be disclosed on the applicable schedule.

If a rep or a warranty is untrue, inaccurate or a document issue or event is not disclosed, it is a breach of the purchase agreement. It is best practice to properly disclose an issue, document, matter or event in the disclosure schedules rather than have the purchaser discover the issue post-closing. This is where indemnifications come into play.

Indemnification: An indemnification clause is an agreement between the parties in which one party will compensate the other party for any losses or damages that may arise from a particular event. In a typical transaction, the parties will typically agree to indemnify each other for: (a) a breach of a rep and warranty; (b) a breach of a covenant and (c) fraud, misconduct or an intentional misrepresentation. There may be additional indemnifications provided by the seller, such as for seller’s transaction expenses, taxes or “special indemnitees” which are highly deal-specific, negotiated between the parties and are often a result of an issue that is uncovered during diligence.

An example of how the indemnification process typically works is as follows: The seller failed to disclose something that the purchaser ultimately discovers and it causes losses to the purchaser. The purchaser then notifies the seller of the issue, provides documentation and requests indemnification as set forth by the instructions in the purchase agreement. The seller will have a certain number of days to respond by either agreeing or disputing. If the seller agrees, the seller can pay the amount equal to the losses directly to the purchaser or it can be offset by the purchaser against a seller note, indemnity escrow funds (discussed further below), holdback funds or as otherwise allowed by the purchase agreement. If the seller disputes the claim, the parties would typically work in good faith to resolve the issue and, if unsuccessful, they would have the dispute resolved by a court or third party, all of which should be set forth in the purchase agreement.

In the event a seller note is involved, the purchaser should be sure it is able to offset against the note. An example offset provision is as follows:

“The Purchaser shall have the right to offset any indemnifiable Losses against, in each case on a dollar-for-dollar basis, from any other payment due to the Seller or its respective Affiliates, including, without limitation, the Note.”

Caps and baskets: Caps and baskets are common mechanisms to define the limits under which a seller is responsible for indemnifying a purchaser. A specified maximum amount in which the seller could be liable for is referred to as a “cap.” A threshold amount of loss needed for the purchaser to sustain in order to request indemnification from the seller is referred to as a “basket.”

In a recent study, more than 92% of deals included a cap. In deals that did not involve rep and warranty insurance, the median cap was around 10% of the purchase price. As further discussed below, the purchaser should be sure that the cap does not apply to fraud, intentional misrepresentation, fundamental reps or regulatory reps.

There are typically two types of baskets: (1) true deductibles and (2) tipping baskets. With a true deductible, the seller is only responsible for losses exceeding the basket amount. With a tipping basket, once the basket amount is reached, the seller is responsible for all losses from the first dollar. A third type of basket is a mini basket, which provides that claims less than a certain amount are not counted towards the basket threshold and thus not indemnifiable. In a recent study, about 95% of deals involved baskets with the median basket size at 0.5% of the purchase price.

An example of a true deductible and mini basket provision is as follows:

“The Indemnifying Party shall not be liable to the Indemnified Party for indemnification under Section [X], until the aggregate amount of all Losses in respect of indemnification under Section [X] exceeds [$[NUMBER]/[%PERCENTAGE]% of the Purchase Price] (the “Deductible”), in which event the Indemnifying Party shall only be required to pay or be liable for Losses in excess of the Deductible. With respect to any claim as to which the Indemnified Party may be entitled to indemnification under Section [X], the Indemnifying Party shall not be liable for any individual or series of related Losses which do not exceed $[NUMBER] (which Losses shall not be counted toward the Deductible).”

An example of a tipping basket provision is as follows:

“The Purchaser shall not be entitled to recover under [insert applicable Section] until the total amount of all Indemnifiable Losses under [insert applicable Section] exceed on a cumulative basis an amount equal to $X (the “Basket”), at which point the Purchaser shall be entitled to recover for the full amounts of such claims from the first dollar; provided that the Basket shall not apply to any Loss resulting from a breach of a Fundamental Representation or Fraud.”

Fraud carve out: The purchaser should ensure that fraud is an exception to the various limitations and thresholds placed on a purchaser’s indemnification rights and recourse mechanisms, such as survival periods, caps, and baskets described above.

An example of a fraud carve out provision is as follows:

“Notwithstanding anything contained in this Agreement to the contrary, no limitations on indemnification set forth in this [Article X], including with respect to time limits, Basket and Cap, will apply with respect to claims based on Fraud, gross misconduct or intentional misrepresentation.”

Further, it is increasingly common for fraud to be defined in the purchase agreement. Without a definition, sellers may expose themselves to post-closing liabilities beyond the original intent of the fraud exception. For example, a seller should argue for the definition of fraud to be limited to the reps and warranties expressly contained within the “four corners” of the purchase agreement and include a requirement of actual knowledge of falsity of the breached rep or warranty.

An example of a seller-friendly fraud provision is:

““Fraud” means, with respect to a party, an actual and intentional misrepresentation of a material existing fact with respect to the making of any representation or warranty in Article [X], made by such party, (a) with respect to Seller, to Seller’s Knowledge or (b) with respect to Purchaser, to Purchaser’s actual knowledge, of its falsity and made for the purpose of inducing the other party to act, and upon which the other party justifiably relies with resulting Losses.”

Materiality scrapes: A “materiality scrape” is a pro-purchaser provision in a purchase agreement that disregards or “scrapes” any “material” or “Material Adverse Effect (MAE)” qualifiers from the seller’s reps and warranties in the context of an indemnification claim. It can be one of the most important and impactful provisions in the purchase agreement and yet is often overlooked or not fully understood. Materiality scrapes come in two varieties: (1) single materiality scrape and (2) double materiality scrape. A single materiality scrape provides that when determining the amount of losses resulting from any inaccuracy or breach, any materiality qualifiers in the applicable reps and warranties will be ignored for the purpose of determining damages. A double materiality scrape provides that any materiality qualifiers will be scraped when determining whether a rep or warranty is inaccurate or incomplete AND also when determining the amount of losses resulting from any such inaccuracy or breach.

Materiality scrapes are included within the indemnification provisions or in a standalone provision. An example of a standalone double materiality scrape provision is as follows:

“Notwithstanding anything to the contrary herein, for the purposes of determining the existence of any breach of a representation, warranty, covenant or agreement made by the Sellers or the Company, and for the purposes of determining Losses, each representation, warranty, covenant, and agreement made by the Sellers will be deemed made without any qualifications or limitations as to materiality and, without limiting the foregoing, the words “material” and “material adverse effect,” and words of similar import will be deemed deleted from any such representation, warranty, covenant, or agreement.”

While uncommon, the purchaser could also negotiate the scrape to include any “knowledge” qualifiers, as well.

Sandbagging: A “sandbagging” or “pro-sandbagging” provision essentially states that a purchaser’s ability to make a claim against the seller under the purchase agreement is not impacted regardless of whether the purchaser had knowledge, at or prior to closing, of the facts or circumstances giving rise to the claim.

Therefore, if a pro-sandbagging provision is included in the purchase agreement, even if the purchaser was aware of an issue prior to closing (such as the target company’s noncompliance with a law, a potential litigation, the company’s breach under a material contract or other breach of a rep, warranty or covenant) it could decide to complete the acquisition and subsequently make claim against or “sandbag” the seller pursuant to the purchase agreement.

An example of a pro-sandbagging provision is as follows:

“The right to indemnification, payment, reimbursement, or other remedy based upon any such representation, warranty, covenant, or obligation will not be affected by any investigation conducted or any Knowledge acquired at any time, whether before or after the execution and delivery of this Agreement or the Closing Date, with respect to the accuracy or inaccuracy of, or compliance with, such representation, warranty, covenant or obligation.”

An “anti-sandbagging” provision, on the other hand, prohibits the purchaser from seeking post-closing recourse regarding issues which the purchaser knew about at or prior to closing. An example of an anti-sandbagging provision is as follows:

“Notwithstanding anything contained herein to the contrary, Shareholders shall not have (a) any liability for any breach of or inaccuracy in any representation or warranty made by Shareholders to the extent that Purchaser, any of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of the facts as a result of which such representation or warranty was breached or inaccurate or (ii) was provided access to, at or before the Closing, a document disclosing such facts; or (b) any liability after the Closing for any breach of or failure to perform before the Closing any covenant or obligation of Shareholders to the extent that Purchaser, of its Affiliates or any of its or their respective officers, employees, counsel or other representatives (i) had knowledge at or before the Closing of such breach or failure or (ii) was provided access to, at or before the Closing, a document disclosing such breach or failure.”

Most purchase agreements are silent as to sandbagging. The effect of the purchase agreement being silent on sandbagging depends on the law in which the purchase agreement is governed. In 2022, the Delaware Chancery Court reaffirmed that Delaware is a pro-sandbagging state and allowed the purchaser’s claim for breach of contract to proceed regardless of seller’s assertion that the purchaser knew the seller’s reps and warranties were false prior to the closing.

New York is another pro-sandbagging state. New York law provides that a purchaser’s reliance is not an element of breach of contract claim. However, there is a small caveat regarding the actual source of the information. Under New York case law, if the source of the information or news of the “bad act” or issue comes directly from the seller to the purchaser (as opposed to the purchaser learning about the issue through its own diligence or from a third-party), there is an argument that the purchaser waived its ability to proceed with a breach of contract claim.

Finally, both Texas and California are anti-sandbagging states. In these states, in the event the applicable purchase agreement does not include a “pro-sandbagging” provision, a purchaser must demonstrate reliance on the seller’s representation and warranty in order to make a breach of contract claim.

Joint and several vs. several and not joint: In the event there are multiple seller parties, the purchaser should argue for “joint and several” liability. Therefore, each seller is responsible for the total amount of any claim that may arise. In this situation, a purchaser does not have to be concerned about each seller’s creditworthiness and does not have to go after each seller for such seller’s pro rata share of the claim. Joint liability means that the parties are jointly responsible liable for the loss at issue. For example, if three shareholders are jointly and severally responsible under the purchase agreement and the purchaser has an indemnification claim worth $100,000, the purchaser can approach any shareholder, with each one being responsible for the entire claim, or a combination of both shareholders to pay the claim. Joint and several liability gives no regard to the shareholder’s ownership percentage or pro rata share. If the sellers desire, they could enter into a contribution agreement to establish their respective liabilities and agreements between each other, which would be separate from the purchase agreement.

Alternatively, if the liability is “several and not joint,” each seller is responsible for only such seller’s pro rata share of the claim.  This is unfavorable to the  purchaser.

Indemnity escrow: Often a portion of the purchase price will be placed in an escrow account to serve as payment for indemnity obligations. These funds are intended to be utilized in the event a purchaser has a claim regarding the seller’s reps and warranties. Typically, a third-party escrow agent will hold the funds pursuant to an escrow agreement that is negotiated between the escrow agent, the seller and purchaser. While a recent study showed that about 50% of deals have an indemnity escrow, the concept has been steadily declining due to the use of rep and warranty insurance. In deals where indemnity escrows were utilized, the amount escrowed was between 5% and 10% of the purchase price. Indemnity escrow periods are typically between 12 and 18 months.

Client alert authored by Margaret M. Salinas, principal, msalinas@chuhak.com.

This Chuhak & Tecson, P.C. communication is intended only to provide information regarding developments in the law and information of general interest. It is not intended to constitute advice regarding legal problems and should not be relied upon as such.