Risk Allocation in M&As: The Devil is in the Details

April 2021

1. Introduction

In any M&A transaction between two (or more) parties, strong representations and warranties (“R&W”) are both essential and customary which, in turn, are usually backed by indemnities. The R&W statements relate to a period prior to a contemplated transaction, which are asserted to be true upon the date of contract execution and until the closing of the deal. They allocate risks between the contracting parties and the warrantor is bound by the veracity of the statements which, if incorrect, permit the counterparty to seek relief. Often the two terms are used interchangeably, but they do have different meanings with different repercussions. A representation is a factual assertion which pertains to an existing or past event and on which a party relies to execute a contract. On the other hand, a warranty is a stipulation in the contract that provides an assurance of the continued existence of a certain state for a defined period.

This newsletter explores the R&W and indemnity provisions in M&A transactions and related key aspects to manage and minimize the risk for buyers.

2. Setting the Context

In acquisitions, the purchaser conducts a due diligence on the target covering various areas which is significantly dependent on the quality of information provided. The extent of straight and honest responses (including candid disclosures of errors) ought to aid the parties to work easily and swiftly to a right outcome for all. But often that is not so. Therefore, a buyer seeks protection through specific R&W, which are backed by indemnities. An indemnity provision allows a party to seek compensation for loss or liability incurred by any person and shifts the entire risk of future loss to the indemnifier. Where material issues are discovered in the diligence, either the seller is asked to find an acceptable resolution or mitigate within a defined period pre-closing. While the debate between an indemnity versus damages is continuous, an indemnity is provided against breach of R&W and is the most discussed and negotiated in the transaction documents. The Contract Act is not exhaustive on the subject and covers[1] a contract of indemnity; but most contractual indemnities aim to cover varied circumstances, including those beyond the control of the indemnifier. If disputes arise, Indian courts tend to follow and apply principles adopted in UK courts. In several settled cases,[2] courts have observed that one can rely on common-law principles as sections 124 & 125[3] of Contract Act are not exhaustive on indemnity principles.  

Broadly, typical warranties include a wide array of matters including material and related-party contracts, possession of all business permits, compliance with applicable law, financial condition, indebtedness, intellectual property rights, labor and employment aspects, litigation, title to and condition of real-property plus other assets and taxes involving the warrantor. Usually, R&W are provided by sellers who control a target. In some cases, they are bifurcated amongst the different sellers, be it the promoters, other investors and some by the actual target. In an ideal situation, purchasers prefer obtaining detailed R&W from the primary sellers (often the promoter group) to preserve their investment.

Of course, as businesses evolve these “typical” provisions have undergone changes and new clauses are slowly becoming the norm. For example, issue of an opinion by reputable accounting firms which state that there is no need to deduct withholding tax with necessary rationale and statutory interpretations. If there is a gap between signature of definitive documents and the closing, a warranty about the absence of material adverse changes that affect the target’s business, its financial health or consummation of the transaction is included. Indemnifiers resist this as it affects transaction certainty and seek certain exceptions.

3. Indemnity: The Details Matter 

In M&A transactions, parties prefer indemnification clauses over a statutory claim for damages. While negotiating, it is essential to focus on the interplay of the relevant contractual provisions and their impact on a claim. Most sellers wish to have a quick exit and limit risk exposure after closing, both on content and duration. This, then, has to be balanced with the need to safeguard the buyer from potential risks identified in the diligence plus legacy issues, if any. Add to the mix, the disclosures made by the sellers qua the R&W in a letter and the “knowledge” qualifier. Additionally, if there is a time gap between signature and closing, they often seek a right to update their disclosures during that period. In practice, sellers seek to enlarge the ambit of disclosures which buyers resist. A common limitation in specific representations is the language “in the knowledge or the Seller,” which is hotly debated as actual versus constructive knowledge. As is evident, such knowledge qualifiers operate as a potent defense in potential claims. The buyer is prevented from raising claims based on such disclosures and the knowledge qualifier. Globally, it is increasingly common for buyers to use sandbagging provisions to claim a breach of R&Ws and seek protection despite the knowledge about their breach or inaccuracy. These are clearly heavily disputed and, where the sellers agree, they will seek to limit scope, duration and quantum. In Indian transactions, these are not easily agreed since the law places high value on knowledge. Regardless of the scope of the diligence, in-depth or otherwise, it is never possible to forecast with absolute certainty the likelihood of claims that may arise which could have a monetary impact for the buyers, but best estimates can be made.

3.1       Why indemnity: At this stage, it is worthwhile to briefly touch upon why an indemnity is better than damages. Sections 73 and 74 of Contract Act set out the framework for damages. The basic principle is to place an aggrieved party in the same position as if there was no default. A party would be entitled to damages that arose in the usual course of things from a breach or which the parties knew while contracting as likely to result from such breach i.e., those suffered as a direct consequence of the breach and exclude remote or indirect loss. So, damages can be claimed only when a party suffers actual loss.

In contrast, indemnity provisions of sections 124 and 125 of the Contract Act do not have any specific prohibition. Rather, an indemnity entitles an indemnified party to ask the indemnifier to pay once the liability has accrued and ensure the aggrieved is able to meet the potential liability without waiting for the indemnifier to actually discharge the liability. Parties can contractually agree and insert the concept of accrual of loss in the transaction documents. Indian jurisprudence is clear and settled that (a) damages are different than indemnity and the latter is wider; (b) an indemnity holder is entitled to sue the indemnifier prior to incurring any actual loss. Thus, it becomes important to watch the language carefully to ensure that words are not added which have the potential to dilute the ability of a party to recover upon accrual. The Bombay High Court has held[4] that an indemnity is not reimbursement and the principle is that the indemnified party is never required to pay while the indemnifier can be required to pay as soon as the liability has accrued.

Additionally, UK[5] courts have taken the position that indemnity may include indirect and consequential losses since the test of remoteness does not apply the way it does to damages. In India too there are cases[6] to substantiate that indirect losses can be claimed for fraud and misrepresentation. Therefore, an indemnity could permit the recovery of remote, consequential or indirect losses and damages, but practically it is usual to incorporate language excluding such losses and the net effect often is an indemnified party is confined to recover direct losses.

3.2      Imperatives: There are several key clauses that impact or limit an indemnified party’s ability when making a claim. While it is not possible to cover everything here, the important ones include and relate to thresholds (de-minimis, concepts of tipping baskets, deductibles); limitation of liability including caps; duration of the indemnity and, in cases of multiple sellers, joint and several liability; and sole remedy.  

(a)       Thresholds: The primary objective of any seller is to limit future claims to material ones. And, to this end, in order to minimize subjectivity, they insert a de-minimis clause for a loss or series of losses which stipulates either an agreed value or a certain percentage of the purchase consideration. Claims below this specified amount cannot be brought against the indemnifier. It is also common to negotiate a tipping basket or a deductible. But, in their endeavour to limit exposure sellers can be demanding and introduce provisions with both a basket and a deductible component. A tipping basket means where a loss exceeds the de-minimis, all losses beyond the de-minimis accumulate and they must go above the threshold in order for the indemnifier to pay. In other words, the indemnifier is liable for the entire amount once the basket threshold is tipped. In the case of a deductible, only when all losses exceed the specified figure the indemnifying party is liable for, the amount payable is what is in excess of the deductible threshold. Hence, acute attention is required towards the basket and mini-baskets for indemnification claims as well as cap on recovery for indemnification.

(b)       Overall liability:  is typically capped to a definite amount, linked with the consideration and expressed as a percentage thereof. Depending on stakes involved and the transaction value, the cap can be anywhere from 25% to the full amount. The fundamental warranties, which pertain to capacity and title and liability for fraud are uncapped or capped at 100%, while the remainder can be negotiated to a lower value or percentage.  

(c)       Duration: A limited duration of the indemnity is not of much use since many times, post-closing, the buyers take time to integrate and align with the business or the company acquired. Yet, all indemnifiers want to be certain of the duration of their liability. Often times, and perhaps, the easiest is to align with the corresponding statutory period for a claim. For instance, it may be stated any indemnity claim arising out of breach of representations may be valid for three years post-closing, excluding tax for which seven years is the norm. Usually the tussle is for a period between 18 to 36 months. Sellers, of course, look for shorter timelines.

(d)       Joint & Several: All thresholds should be assessed in the context of joint and several liability. Often, where there are multiple sellers, their preference is to have everyone severally liable for their respective warranties. In such cases, where indemnity and limitation of liability are a percentage of the consideration, it is important to understand the bifurcation per seller since claims may be made against them to the extent of their respective obligations and such seller would be liable only for specific representations provided by it or, in case of joint, its proportionate ratio of the consideration paid to it. Joint liability, on the other hand, would make all the sellers liable to the full extent of the liability. Under the joint and several liability rule, the indemnified party may apportion a part or whole of the liability to any one or more of the sellers and any one can be held responsible for the total amount regardless of the fact that such person may be liable to a small degree.

(e)       Sole remedies: Sellers try to restrict the available remedies to purchasers. While it is debatable whether a clause designed to exclude statutory remedies is enforceable, purchasers often seek a right and ability to go beyond the contract for non-monetary relief, including injunctive and specific performance.

4. Conclusion  

As noted, R&W and indemnity are among the most heavily negotiated provisions in a transaction agreement. Understanding the effect of caps and baskets on indemnification liability is, perhaps, most important for the contracting parties. These terms allow a seller to limit its potential post-closing liability and impact the amount that a buyer may recover in the event it incurs losses in connection with the transaction. While the size of the bucket from which one can claim for a breach is important; yet, it is equally necessary to be realistic about the ground realities and the circumstances that may arise which necessitate making a large claim. This means assessing the key findings arising from diligence pragmatically. Most sellers want a swift exit with a short timeline within which a purchaser can raise a claim. Eventually, how the parties find a common ground depends on the relative importance of these particular points to them combined with their respective bargaining powers and, of course, consensus on other risk-sharing provisions. In the end, the devil is always in the details but parties need to adopt a cautious yet realistic approach to ensure a fair allocation of risk so that they move to the finishing line of the transaction.  


Priti Suri

[1] Section 124 defines indemnity as a contract by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person

[2] Gajanan Moreshwar vs. Moreshwar Madan Mantri (1942 SC); Abdul Hussain Shaikh Gulamali Jambawalla vs. Bombay Metal Syndicate (1971 Bom HC)

[3] Section 125 prescribes three important rights of an indemnity holder – right to recover damages paid in a suit, right to recover costs incurred in a defense, and right to recover sums paid in a compromise

[4] See Jet Airways vs. Sahara Airline Ltd. and Ors.

[5] See Total Transport Corporation vs. Arcadia Petroleum Ltd, 1997

[6] Avitel Post Studioz Limited & Ors. vs. HSBC PI Holding Mauritius Limited & Ors (a SC case); Daichi Sankyo Company Limited vs. Malvinder Mohan Singh and Ors. (2018 Del HC).