After Closing: The Moral Hazard of Third Party Claims

This is the sixth article in our After Closing Series highlighting frequently occurring post-closing issues that should be considered before signing an M&A agreement.

The Dilemma of Misaligned Interests in Defending Third Party Claims  
Anyone with experience in private M&A transactions knows third party claims often arise following the closing of a transaction. The parties to the transaction --- and their respective counsel --- spend a considerable amount of time negotiating who will bear the cost and risk of loss associated with such claims.

What is often given less attention is the question of who will control the defense. More often than not, the answer is --- or defaults to ---  the buyer.

Unfortunately, that result has a tendency to produce something of a moral hazard issue. Because the buyer may have the right to recover costs of defense and losses from the seller from an escrow or otherwise, the buyer does not have the same incentive as the seller to mitigate the cost of defense or even the ultimate resolution of the claim, so long as the total sum is within the escrowed amount. This misalignment of interests often produces unfavorable results for sellers who are expecting their escrowed proceeds.

Negotiate for the Right to Control or Participate
One solution to address the issue of misaligned interests in defending third party claims would be to negotiate the ability for the seller to have the right (at its option) to defend third party claims. A reasonable provision to induce the buyer to agree to such right would be:

If [Seller] acknowledges, in writing, that it is obligated to indemnify, defend, and hold harmless the [Buyer] under the terms of its indemnification obligations hereunder in connection with a particular Third Party Claim, then [Seller] shall have the right to assume the defense of such Third Party Claim with its own counsel, which counsel shall be reasonably satisfactory to the [Seller].

Most buyers, however, are reluctant to give up control of the defense if the claim could materially affect the ongoing business of the surviving company (e.g., an IP infringement claim) or involves material damages. However, they may concede the right to defend matters where that is not the case (e.g., a wrongful termination claim or breach of contract claim from a previously terminated supplier).

Wherever possible, sellers and their counsel should push for such right, even if contractually or as a practical matter it means they are de facto creating an indemnification situation. If given the right, the seller will at least have the option of assuming the defense with the corresponding ability to mitigate and control the economic consequences of defending the claim, or turning the right down (e.g., if it does not want to go out-of-pocket for any costs of defense or loss).

If negotiating a right for the seller to control defense of claims is not attainable, sellers should, at a minimum, have the right to participate in the defense alongside the buyer. Participation rights are often present in the indemnification sections of merger agreements but are not spelled out, leaving the parties to determine later, usually in the context of an actual claim, what such right means. If the buyer takes a limited view of "participation", the seller's position is weakened in addressing the moral hazard issue. For that reason, sellers should be very specific about what the participation right actually entails (e.g., participating in selection of counsel, collaborating on defense strategy, input on budgeting, ability to review filings, and right to receive status updates from counsel). An actual sample provision seen in agreements follows:

If any third party claim is brought against an indemnified party, the Indemnifying Party [Seller] is entitled to participate in the defense of such claim. Such participation includes the right to participate in the selection of counsel, the formation of the defense strategy, any updates provided by the chosen counsel, any documents shared regarding the claim, any settlement conferences and discussions, as well as the budgeting of the defense.

The moral hazard issue and the seller protection discussed above becomes very real when and if such claims arise. If not addressed adequately, sellers can find that the allocations of risk, cost, and loss they negotiated in the area of indemnification are obviated quickly. For that reason, the right to control and/or participate in the defense of third party claims during the post-closing period of private M&A transactions should be given as much weight as other provisions of indemnification sections in the M&A agreement which allocate the economic burden and risk of post-closing issues between the parties.