Indemnification in M&A Contracts Part IV: Caps, Baskets, and Deductibles
Given the wide range and variety of claims covered by the Indemnification Section, parties often ask if there are any limitations on indemnification to protect each party. Normally, the answer is yes.
Besides the Indemnification Period itself (covered in Part III of this series), many Purchase Agreements also include cap(s), baskets, and deductibles which place dollar limits on certain types of claims. Each is described in more detail below:
Deductibles and Baskets
Deductibles or baskets, also sometimes called thresholds, are designed to set a minimum limit on when a party is responsible for indemnification. They state for both parties how significant or material a claim has to be before one party contacts the other party to address the claim. Given the size of most acquisition transactions (millions of dollars), most parties do not want to worry about $500 issues, but a $25,000 issue (or collection of issues totaling $100,000 or more) is another story.
These minimum amounts take two different forms that work slightly differently. A deductible means that until the claims reach the deductible level (for example, $50,000), the buyer is not able to seek indemnification for breaches of the representations under the Purchase Agreement. If the total aggregate claims reach $50,000.01 or above, however, then the buyer can seek indemnification for amounts above $50,000, but not the initial $50,000. The $50,000 deductible works just like an insurance deductible, as a minimum amount one party is responsible for before the other party jumps in to indemnify for amounts above the deductible.
A basket or “tipping basket,” in contrast, states again that until claims reach the basket level (for example, $50,000) the buyer is not able to seek indemnification for breaches of the representations under the Purchase Agreement. However, if the total aggregate claims reach $50,000.01 or above, then the buyer can seek indemnification for all amounts including the original $50,000 basket.
In either case, the deductible or basket will not apply to claims based on fraud, and may or may not apply to claims for breach of the Fundamental Representations and Warranties.
A cap or caps, in contrast, set the maximum amount of indemnification that a party will be responsible for under the Purchase Agreement. It is normal in the M&A world to separate the different types of claims into categories with different caps (or no caps) applicable to different types of claims.
Deal surveys indicate that there are a few very common categories of claims that caps apply to, although each deal is different.
General representations, excluding Fundamental Representations and Warranties, fraud, and intentional misconduct are the most common caps used in Purchase Agreements, and apply to most representations and warranties of the seller in a Purchase Agreement, excluding the Fundamental Representations and Warranties, fraud, and intentional misconduct. In other words, certain important (though generally seldom breached) representations are excluded from the cap, but most representations and warranties use the cap. This cap (the “General Cap”) is most commonly set at 10% of the total Purchase Price, although this may be higher or lower for certain deals. The cap on Fundamental Representations and Warranties is often set at up to 100% of the Purchase Price or even uncapped, and fraud claims are typically uncapped.
In addition to the General Cap, the parties may agree to higher caps for certain types of claims where the risk is ascertainable or generally known.
Per Shareholders Cap
In addition to the General Cap, another potential cap is a limitation concerning each individual member, shareholder, or owner’s responsibility to the total Purchase Price paid to that individual owner. This provides additional protection to shareholders since caps are generally limited to breaches of representations and warranties and not other categories of indemnity claims, such as covenant breaches (these additional categories are generally uncapped).
All Liability Cap
In addition to the General Cap, the parties will occasionally agree to a total cap on all liability of a party (usually excluding fraud or misrepresentation). Total liability caps vary extensively between transactions, but generally would not be below 70% to 100% of the Purchase Price or uncapped at the high end. Per Shareholder Caps and All Liability Caps are less common but sellers, who are understandably averse to any form of uncapped liability, will often try to negotiate for some form of upper limit along these lines.
Usually, a combination of one or more deductible or basket and one or more cap is used in deals. It is not at all uncommon to see five or six different caps and deductibles that each apply to different categories of representations, warranties, and claims.
Joint Versus Several Liability
In deals with multiple seller entities or multiple owners of a seller company selling their shares or membership interests, joint liability versus several liability for claims is also an important concept. Joint liability means that individuals, entities, or persons are jointly responsible (liable) for a particular issue. For example, if Company A and Shareholder B are jointly and severally responsible for employment claims, and the buyer has an employment claim worth $50,000, the buyer can approach Company A, Shareholder B, OR more typically a combination of both Company A and Shareholder B, to pay the $50,000 claim. With joint liability, it is important to note that Company A OR Shareholder B could be required to pay the entire $50,000 employment claim.
Several liability, in contrast, means that each individual, entity, or other person is individually responsible for a particular set of claims, typically pertaining to that specific individual, entity, or other person OR up to the total Purchase Price received by him/her/it. For example, Shareholder C and Shareholder D may agree to be severally liable for representations and warranties surrounding share ownership. If Shareholder C does not own the shares, Shareholder C will be liable to the buyer for breach of that representation and any damages. However, because the liability is “several,” Shareholder D will not be responsible for the breach or any damages (because it was Shareholder C’s representation and liability).
Similarly, the agreement might say that each shareholder is severally responsible for claims related to ownership of the shares, not to exceed his/her/its pro-rata share of the purchase price. In the case of this language, Shareholder D would be responsible for damages resulting from Shareholder C not owning his/her/its shares, but Shareholder D’s liability for the damages is capped at the pro-rata share of the Purchase Price received by Shareholder D.
A buyer in an equity deal will often seek to have the shareholder/members/owners jointly and severally responsible for all claims. The shareholders/members/owners and the seller entity will often want some form of several liability for certain claims, to limit each individual owner’s exposure.
Join us soon for our fifth and final post regarding indemnification, which will cover materiality scrapes.
 Readers of this series should note that each transaction is different and generalizations herein may not apply to every transaction. This is particularly true where Representations and Warranties Insurance has been obtained for the transaction.