In addition to the contractual provisions that parties in an M&A Transaction can employ to limit the scope and/or duration of an indemnity provision (discussed in Part Two of our indemnities series here), parties may also negotiate indemnity caps and baskets to apportion the risk between themselves.

INDEMNIFICATION CAPS

Major/upper cap

An indemnity’s major or upper cap is one of the most important negotiated terms of the indemnity provision in an M&A Transaction. An upper cap imposed on an indemnity has the effect of limiting the total dollar value that an indemnitee (purchaser) may recover from the indemnitor (seller) in an M&A Transaction. It is usually included in the M&A agreement as a maximum amount that the indemnitor may be liable for.

The seller in an M&A Transaction will try to negotiate an indemnity with a low upper cap, and a purchaser will want to negotiate an indemnity with no upper cap (particularly with respect to fundamental representations, warranties and covenants given by the seller), or a high upper cap.

Upper caps are negotiated:

• either as a percentage of the total deal amount (purchase price) of the M&A Transaction; or
• to specify that in no event will the seller be liable for more than the total purchase price.

If exceptions to an upper cap are negotiated, they would normally be related to (the following is not an exhaustive list):

• breaches of the indemnitor’s (seller’s) fundamental representations and warranties, such as having title to the assets or shares being sold in the M&A Transaction;
• breaches of the indemnitor’s (seller’s) covenants, such as non-compete covenants or confidentiality obligations;
• tax liabilities of the seller;
• any “special” indemnification claims particular to the transaction; and
• fraud or wilful misconduct committed by the seller.

Sometimes an M&A agreement may include two indemnity caps: one upper cap that applies generally, and a higher cap (representing the total purchase price) for matters that the general indemnification cap doesn’t apply to, such as fundamental representations, warranties and covenants. Fraud committed by the seller is generally excluded from any indemnity cap.

Minor cap

A minor indemnity cap is designed to limit an indemnitor’s liability to the indemnitee for minor claims relative to the value of the M&A Transaction. A minor cap is applied as a minimum dollar value amount that a claim must exceed in order for the indemnitee to make an indemnity claim under the M&A agreement. A minor cap can be calculated as a percentage of the total deal amount or as a stated dollar amount.

INDEMNIFICATION BASKETS

Tipping basket

Similar to the minor cap, a tipping basket is a contractual tool often utilized by sellers in an M&A Transaction to limit their liability for indemnity claims for smaller monetary amounts relative to the total deal value of the transaction. The tipping basket is expressed as a threshold that the aggregate amount of all indemnity claims must exceed in order to be eligible for an indemnity claim. When the aggregate indemnity claims have exceeded the tipping basket, the indemnitee may claim the entire amount from the indemnitor. For example, if the tipping basket is set at $2 million, and the claim is for $3 million, the indemnitee may claim the entire amount of the $3 million claim because it exceeds the tipping basket amount.

Deductible or non-tipping basket

A deductible or non-tipping basket is also set as a threshold amount that the aggregate amount of all indemnity claims must exceed before an indemnitee can bring a claim. However, the indemnitor is only liable for the amounts of the claim that exceed the amount of the deductible. For example, if the deductible amount is $100,000 and the claim amount is $200,000, the indemnitor is only liable for $100,000 of the claim once the deductible is applied.

NEGOTIATING INDEMNITY UPPER CAPS AND BASKET THRESHOLD AMOUNTS

Determining an indemnity’s upper cap and the basket threshold amount will be two of the most important issues in negotiating an M&A Transaction (together with determining indemnity survival periods, which we discussed in our second article). It is essential for both sellers and purchasers to have an experienced M&A transaction team to assist them in negotiating these provisions, and contract law provides parties with flexibility to determine appropriate indemnification terms for their transaction.

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 a wide range of 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.