Three Key Limits to a Buyer’s Right to Recover When the Seller Breaches the Purchase Agreement

Are you reading an agreement for the purchase of a business and feeling some combination of severe fatigue from endless pages of legaleze and paralyzing fear that you might be missing something important in your agreement?   Two pieces of advice for you:  (i) get a strong cup of coffee, and (ii) stay awake long enough to read the “indemnification” section, which is often found towardthe end of your agreement (or just flip back there now; it’s important!).

My prior post on the subject, which you can find here, explains what indemnification is and why you should care about it.  For now, though, let’s focus on something that you as a Buyer absolutely must understand when it comes to your indemnification rights, and that is:  your rights will most likely be limited by the terms of the purchase agreement.

Let’s clarify that last point.  In a negotiated acquisition of a business from a Seller represented by a competent lawyer, the Seller is likely to negotiate for several critical limits to your indemnification rights.  More specifically, your contractual right to be reimbursed by the Seller for contract breaches and liabilities that should stay with the Seller will likely be limited in the following ways:  (1) the duration of time during which you can seek reimbursement; (2) the amount that can be recovered; and (3) the types of damages covered.

1.  Diamonds are Forever, but Your Indemnification Rights are Not:  Durational Limits

No Seller will want a perpetual indemnification obligation and any Seller’s counsel who is modestly competent will demand that a reasonable time limitation be placed on the Seller’s indemnification obligations to the Buyer.

The key here is determining how much time is reasonable. One approach is to ask: how long should it take the Buyer to discover defects for which the Seller should be on the hook?  It’s not unusual for the Seller’s indemnification obligation to survive for as few as six months and for as long as the limitation period dictated by the applicable statute of limitations.

There are, of course, exceptions to every rule.  As the Buyer, you should seek a longer indemnification period for matters that could create significant liability for you.  Say, for example, you are buying a nuclear power plant from Monty Burns and you know Monty was somewhat careless in his operation of the plant.  You also know that the Environmental Protection Agency is likely to conduct some sort of inspection on the site after you buy it, and it might take a few years before (i) the EPA can even send an inspector to your power plant or (ii) before any real problems start to become evident.  In this kind of situation, as the Buyer, you could reasonably insist that your indemnification rights for environmental problems survive until the plant passes at least one EPA inspection, and perhaps even longer if your due diligence reveals a strong potential for leaks of nuclear materials or other environmental problems.

2.  The Bucks Stop Here:  Limits on Amount

Let’s start this part of the discussion with a question.  If you’re buying a startup IT company for $1,000,000, would it be reasonable for you to ask the Seller to indemnify you for up to $10,000,000 of damages?

Of course not.  Making such a request could offset any profit made by the Seller on the sale, and the request alone would likely make the Seller run in the other direction, sabotaging your deal.  Accordingly, the Seller will likely push hard for a “cap” on the maximum indemnifiable damages to which the Buyer will be entitled.  The amount of that “cap” will almost always be a fraction of the total purchase price and almost never more than the total purchase price.  For example, the Seller might push for a “cap” that is 10% of the total purchase price (so, $100,000 in our hypothetical $1,000,000 IT company acquisition).

In a similar vein, the Seller will likely negotiate for a “deductible,” such that the Seller won’t have to start reimbursing the Buyer for indemnifiable damages until the total amount of all damages reaches some minimal value.  For example, the Seller might push for a “deductible” that is 10% of the “cap” amount (so, $10,000 in our example).  The use of a deductible allows the Seller to avoid a payment obligation until the total damages reach a “material” level agreed upon by the parties.

Note that a true deductible (or “basket”) is like your car insurance deductible: the Buyer can only recover damages that exceed the amount of the basket.  For example, a $10,500 claim in a deal with a $10,000 basket will net the Buyer $500 in reimbursed damages from the Seller.  A “tipping basket,” on the other hand, will allow the Buyer to recover all losses back to the first dollar of damages.  (For example, a $10,500 claim in a deal with a $10,000 “tipping basket” will net the Buyer $10,500 in reimbursed damages from the Seller.)

3.  You Can’t Always Get What You Want:  Limits on the Types of Damages Covered

“. . . but if you try sometimes, you just might find, you get what you need.”  The Seller will often try to limit the types of damages the Buyer can recover under the purchase agreement.  For example, the Seller may argue that it should not have to indemnify the Buyer for lost profits, consequential damages, or punitive damages suffered by the Buyer as a result of the Seller’s inaccurate representations or other breach of the purchase agreement.

While some Buyers may overlook the value of consequential damages, they do so at their peril.  In many cases, consequential damages make up a significant portion of the Buyer’s actual damages.  On the other hand, it’s not unusual for Buyers to negotiate away their rights to indemnification for punitive damages.

One final suggestion on this topic for the Buyer:  consider conceding that some type of damages (e.g., punitive damages) will not be subject to indemnification by the Seller, in exchange for a favorable concession from the Seller elsewhere in the agreement (e.g., Seller agrees to deliver cake and balloons to Buyers’ principal place of business weekly).

Okay, let’s sum this up.  Yes, a thoughtful Seller will seek to limit your rights to be reimbursed (indemnified) for damages that you as the Buyer suffer as a result of the Seller’s breach of the purchase agreement.  But, here’s the take-away: there should be limits on those limits, driven by concerns and issues you’ve uncovered during your due diligence review of the Seller’s business The better your due diligence is, the better able you’ll be to negotiate and assess the reasonableness of the limits proposed by the Seller.  So, be careful in your due diligence and be proactive in determining, with the help of your advisors, where the risks are and what level of limits you can tolerate on Seller’s indemnification obligations to you.

This blogpost was jointly written by Paul Schwinn and Aaron Ghais (owner of this blog site).  Paul is currently in his final year of the JD/MBA program at the University of Missouri-Columbia and will be joining the law firm of Shulman Rogers Gandal Pordy & Ecker, P.A., as an incoming associate, starting in September 2014.

Photo by Kyle@SuburbanDollar.com on Flickr

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