A business acquisition involves a number of documents, the most important of which is the Asset Purchase Agreement (APA), commonly known as the purchase contract. Legal experts will define a contract as a binding agreement involving two or more people or companies (called parties) setting forth the specific actions that each party will either perform or not perform. Of all the clauses involved in a contract, few have the importance of the Indemnity Agreement. Indemnification is recognized as the act of making another party “whole” by compensating them for any damages & losses incurred or suffered. The party who provides the indemnity is called the indemnitor or indemnifier while the party receiving the indemnity is called the indemnitee. These provisions will address the remedies for any breaches of covenants or representations and warranties (topic of a separate article) that are discovered after the closing. Indemnification is purely a risk/responsibility technique that details the contract’s remedy should any material facts be found to be false or promises not honored. The most simple description is the removal of liability from one side by transferring it to the other side.
While there are some law experts that draw a distinction between a Hold Harmless Agreement and an Indemnification Agreement, most professionals will use these terms either in tandem or in some cases interchangeably. Black’s Law Dictionary, a well respected resource, has defined each of these terms as follows:
- Indemnify: “To reimburse (another) for a loss suffered because of a third party’s or one’s own act or default.”
- Hold Harmless: “To absolve (another party) from any responsibility for damage or liability arising from the transaction.”
It is important to recognize that not all acts can be indemnified. Several state and federal statutes will prevent actions that are found to be either negligent or illegal from being indemnified. Also noteworthy, is the recognition that, over the years, a number of courts in the United States have ruled that good faith must have been established for indemnification to be upheld. This requirement states that the party must have acted in the best interest of the business, and its normal practices versus a personal self interest detrimental to the enterprise.
Indemnity provisions can be drafted in a variety of ways and this structure is typically based upon the size, type, and level of complexity. These provisions often require heavy negotiation between parties given the ability to word these clauses either very broadly or narrowly. Several examples of these structuring methods include:
- Duration: In theory, the survival or duration period for the indemnity, should be determined by the time table during which a party is reasonably expected to detect any misrepresentation or beach. Exceptions to survival periods are often made. Tax liabilities would be one example as these generally have a longer period.
- Limit: Depending upon the (perceived) risk of the covenants in addition to the representations and warranties, a dollar limit or cap can be created for the total amount of liability that will be assumed. In certain cases, a deductible or basket is structured, similar to an insurance policy, where one party will only be held responsible for losses or damages in amounts in excess of this “deductible”.
- Use of Escrow Account: Setting aside a small portion of the transaction price in an attorney’s escrow account for a defined period of time is an established means of providing an assurance to a party that money is available to satisfy the indemnity obligations.
All purchase & sale contracts involve hold harmless/indemnity clauses and it will be essential for each party to fully understand these provisions and the specific circumstances where they pertain. The language used in drafting these provisions is very important as ambiguous declarations could invalidate an indemnity claim. Having experienced legal counsel involved early in the transaction to properly draft and review the contract is highly advised.
Note: ENLIGN does not provide legal, tax, or accounting advice. We maintain a national network of Business Attorneys & Certified Public Accountants who are experienced in business transactions and would be pleased to provide a referral.
