M&A Monday: The Power of the Specific Indemnity
A couple of weeks ago a Buyer-client, Jimmy, who had closed his deal last year called me. There was a major customer who was terminating. When he asked the customer, the customer said, yea, I never told Bob the Seller I was going to terminate. Jimmy said, Eli, what do I do? I immediately remembered his deal and said, you’re in luck.
If you follow my M&A Mondays, you will know Buyer’s recourse is generally limited to (a) willful or unwilful misrepresentation in the purchase agreement reps and warranties (Seller’s list of promises), (b) fraud, or (c) breach of covenant (What is my recourse is something goes wrong?).
Thus, if there is a loss after closing, we have to furiously flip through those reps and warranties to claim seller misrepresented something. Then, we have to decide whether we have caps and baskets (Caps and Baskets), and how we will get the money (e.g., escrow, decreasing promissory note, direct from Seller).
For Jimmy, if the key customer had told the Seller they were planning to terminate, Seller misrepresented the rep that says, “To Seller’s knowledge, no Material Customer has any intent to terminate, decrease purchasing volume or otherwise alter the relationship with the Business after Closing.” Easy indemnification. However, he didn’t, so usually, unless Jimmy can claim fraud, Jimmy would be stuck with this loss since it is not a breach of rep, fraud, or covenant.
However, in this deal, we had negotiated for something very unusual. There was a high customer concentration and Buyer was nervous about customers terminating their contracts at will, so we negotiated for a Specific Representation that said (in short), Seller will indemnify Buyer for any loss related to the termination of a key customer contract. Seller was sure the customers would not terminate during the life of their contracts and agreed to stand behind that. Jimmy was able to recoup the loss from the customer termination.
A Specific Indemnity is a fourth category of protection for the buyer. It protects the Buyer from specific things. These are usually issues uncovered during diligence that we want to shift the risk to the Seller.
The most aggressive Specific Indemnity is one that says, Seller will indemnify for losses arising out of activities prior to closing. This is a broad protection for Buyer and you won’t believe how often I get this in agreements (note: be willing to give a specific indemnity for issues arising after closing).
Buyer should explain to Seller that while Buyer is responsible for running the business after closing, the Seller must stand behind the business for issues that occurred prior to closing.
This is very beneficial to a Buyer, but it can also be helpful to a Seller.
Last year, I represented a Seller. The PE buyer was getting very nervous and flustered over a certain tax strategy Seller had used. PE buyer and their army of tax lawyers got so worried they were contemplating walking away. Seller knew this tax strategy was defensible and even had an opinion letter to support them. I suggested offering them a specific indemnity saying, if the PE buyer takes any loss as a result of this tax issue, we will cover it. Issue resolved. We eventually closed that deal.
The Specific Indemnity is another tool in the toolbox of the sophisticated M&A Buyer. In most cases, you never have to pull it out, but when you have to you will be very happy it was in there.
