This is the third article in Fortis' After Closing Series highlighting frequently occurring post-closing issues that should be considered before signing an M&A agreement. The series focuses on helping selling shareholders avoid common pitfalls in the post-closing period.
Indemnification is one of the most heavily negotiated areas in merger and acquisition transactions.
A significant amount of time is spent crafting the particulars around a buyer's right to seek indemnification from the sellers. These details include: types of indemnification claims that can be made, time limits to make indemnification claims, caps on the amount of total potential liability, baskets or deductibles for individual claims, and escrows or holdbacks to satisfy indemnification claims.
However, the negotiations often end there and the remainder of the indemnification section of a merger agreement consists of language left over from a prior transaction or form agreement. Third-party claims provisions tend to fall into this category. Specifically, the language in many merger agreements is vague with respect to a buyer's right to seek indemnification for defense and investigation expenses and settlement amounts related to third-party claims.
A typical third-party claim provision states that the sellers will be required to indemnify the buyer for claims brought by third parties for indemnifiable matters (i.e. a breach of a representation or warranty). Many buyers assume that this generic language will also allow them to seek indemnification for fees and expenses incurred in investigating and defending a claim.However, in the absence of specific language to that effect, this assumption is false. The indemnification obligation only arises if a breach of a representation or warranty has in fact occurred (unless the contract states otherwise).
This issue was recently brought to light in Winshall v. Viacom International, Inc. et al. (Del. Ch. Dec. 12, 2012). Viacom acquired a business that was later sued for intellectual property infringement. Viacom sought indemnity from the sellers for legal costs it incurred in connection with defending the lawsuits.The issue the Delaware Chancery Court addressed was if an indemnified party could seek indemnity for costs and expenses whether or not there was a breach of a representation. The court held that absent a breach of a representation, the sellers had no duty to indemnify, and, therefore, no duty to pay defense costs.
Although the alleged breach in Winshall arose after the closing of the transaction and thus there was no ambiguity as to whether or not a breach occurred, the holding is not limited to the facts of that case. The court focused on the contractual obligations and emphasized that its conclusion was supported by the text of the indemnification provision, which stated that the defense fees would be paid by the "indemnifying parties." If Viacom was unable to demonstrate a breach of a representation, then the sellers had no obligation to pay the costs associated with defending the third-party claim.
In handling numerous indemnification claims in our capacity as a sellers' representative, we at Fortis often face claims made by buyers for indemnification for third-party suits where it is unclear whether or not a breach of a representation has occurred. In many instances, the buyer will settle a case without any determination as to whether or not there was a breach. This often leads to a dispute between the buyer and seller, since the buyer expects to be indemnified for its costs and the settlement amount irrespective of the merits of the claim, while the sellers object because the alleged breach was never proven and therefore there is no indemnification obligation.
To avoid these disputes and avoid delays in disbursing any escrowed proceeds, the parties should make sure that the agreement accurately reflects the intentions and expectations related to third-party claims.
We suggest that sellers specifically exclude all costs, fees, and expenses related to investigating or defending a third-party claim, as well as any related settlement amounts, unless sellers have acknowledged a breach of a representation or warranty or such a breach has otherwise been proven. However, if the parties have agreed that a buyer should be able to recover its costs irrespective of whether a breach has actually occurred, the agreement should clearly state this point.