As we discussed in Part One of “Why you need a well-drafted indemnity clause in your M&A agreement”, a well-drafted indemnity will appropriately apportion the future risk in a transaction respecting the purchase and sale of a business (“M&A Transaction”), and will also compensate or reimburse the purchaser for certain specified losses, damage or injury that may arise after the closing date of the M&A Transaction. The indemnity must be drafted with specificity to enumerate the types of losses covered by the indemnity, as well as the specific limitations on or exclusions to the indemnity (“carve-outs”).
Without appropriately drafted limits and carve-outs, an indemnity can become an unlimited source of potential liability for the indemnifying party (usually the seller) in an M&A Transaction. This article will focus on the different types of limits or carve-outs to the indemnity that can be included in an M&A agreement, and how these limits and exclusions operate.
Limiting the scope of an indemnity
Contracting parties in an M&A Transaction can limit the scope of the indemnity by excluding certain forms of liability, by limiting who is entitled to claim the indemnity (the “indemnified party”), and by limiting what losses are covered by the indemnity. These limits can be contained in a limitation of liability clause that applies to the indemnity or enumerated directly in the indemnity clause.
CARVE-OUTs in the indemnity
For example, carve-outs may exclude indemnification for unilateral or bilateral claims such as (note that the following is not an exhaustive list):
- Claims for legal fees;
- Claims arising from the negligence, fraud or intentional/wrongful conduct of the party seeking indemnification;
- Claims for breach of contract;
- Claims arising from the actions of a third party;
- Claims for losses suffered directly by the indemnified party (in contrast to claims for losses suffered by third parties);
- Claims for economic loss/loss of profit, punitive damages, indirect/consequential damages, and/or special damages;
- Claims seeking cumulative remedies; or
- Any other specific claims that the contracting parties negotiate.
other limitations on the scope of the indemnity
The scope of the indemnity can also be limited by utilizing the following contractual provisions:
- Mitigation: the obligation to mitigate can be imposed on the indemnified party, according to the standard required to be used by the indemnified party that was negotiated between the parties (for example, this can include the use of the standard of “best efforts” or “reasonable efforts” by the indemnified party to mitigate its losses).
- Payment from third parties: the obligation to seek payment from third parties (such as insurers) can be imposed on the indemnified party - the indemnified party would be required to deduct any amounts collected from the third party from its claim.
- Events under the indemnifying party’s control: the right to indemnification can be limited to events that are within the indemnifying party’s control.
Limit the duration of the indemnity
Although indemnities are subject to provincial limitation periods, the contracting parties in an M&A Transaction can also limit the duration of the indemnification offered (“survival period”), and/or any exclusions to the general survival period (“survival period carve-outs”). The survival period included in an indemnity will typically be of a shorter duration than the statutory limitation period.
- Survival period: a survival period included in an M&A agreement will specify the time limit during which the parties (usually the purchaser) may make an indemnification claim. For example, the survival period of an indemnity provision may only be for 12 months or 18 months from the closing date of the M&A Transaction.
- Survival period carve-outs: exclusions to the survival period can also be specified in the M&A agreement, which may apply a longer (or indefinite) duration for certain claims than is otherwise offered by the general survival period. For example, the survival period carve-outs may apply to claims for a breach of the fundamental representations and warranties in the M&A agreement, or for fraud on the part of the seller/indemnifying party.
There is no “universal” law on indemnities in Canada. Indemnities are drafted by contracting parties, and ordinary principles of contract law apply to their interpretation. Indemnities should always be drafted to reflect the unique circumstances of each transaction and the parties. Accordingly, indemnity provisions can vary widely between contracts, industries and parties. The foregoing discussion is merely an overview of some of the contractual tools that may be utilized to limit the scope of an indemnity in an M&A Transaction. Avoiding the use of “boilerplate” language or provisions, and retaining an experienced M&A Transaction team, will be essential for purchasers and sellers.
Carscallen LLP’s M&A Experience
Carscallen’s team of experienced M&A lawyers can assist both buyers and sellers in an M&A Transaction. We have extensive experience in advising on different purchase and sale transactions for both private and public companies and can help you understand your options, identify potential issues and how to overcome them, and to negotiate the most beneficial terms for your position.
Please contact any member of our Mergers, Acquisitions & Divestitures team with any M&A questions you may have, or any other business-related legal issues.
*This update is intended for general information only on the subject matter and is not to be taken as legal advice.