In the previous blog post (blog post #4) of the M&A blog series, we discussed the drafting of warranties in the sale and purchase agreement. In addition to the warranty package, the sale and purchase agreement typically includes one or more indemnities provided by the seller to the buyer. In this article, we take a closer look at indemnities.

An indemnity is not a strictly defined legal term, but can best be described as a contractual arrangement between the buyer and seller under which a previously identified risk is borne by the seller. 

For example, suppose the buyer has conducted due diligence (audit of the company’s records) on the target company and has found that the company has failed to comply with regulations regarding the protection of personal data. This could be because personal data is not properly secured or because a data breach was not reported. In such cases, there is a risk that the Data Protection Authority may impose a penalty on the target company. 

Given that the buyer has become aware of the seller’s non-compliance with privacy laws and the potential for a penalty from the Data Protection Authority, the buyer would typically not be able to make a claim for a breach of warranty against the seller under the sale and purchase agreement. In this scenario, including an indemnity clause is the appropriate approach for the buyer to shift the burden and risk of potential damages - such as the fine from the Data Protection Authority as well as the costs incurred to achieve compliance - to the seller. 

An indemnity clause might read as follows:

Indemnities can be agreed upon for a wide range of topics, such as the protection of personal data, environmental risks, and tax risks. If the previously identified risk materializes (e.g. the target company is fined), the buyer can pass the damages and costs on to the seller. 

In practice, a great deal of attention is typically paid to drafting and negotiating indemnities. To that end, we will outline the key considerations that the seller and buyer should keep in mind in this regard. 

Key considerations for the seller:

§  As a result of an indemnity, a previously identified risk will be borne by the seller. In effect, this can be seen as a reduction in the purchase price. Therefore, only provide indemnities for specifically identified risks that justify an indemnity, i.e. not for potential or hypothetical risks.

§  Do not provide indemnities for business risks inherent to the target company, such as the common risk of a dispute with a dissatisfied customer.

Key consideration for the buyer:

§  Always negotiate an indemnity clause if you are aware of a specifically identified risk, as claims under the warranties in the sale and purchase agreement are typically not possible in such cases.

§  It is common practice to include a tax indemnity clause in the sale and purchase agreement in favor of the buyer. As a result, the seller will continue to be liable for past tax liabilities. This is considered reasonable as the seller has also benefited from past profits. 

Now that we understand what warranties and indemnities entail, it is also important to clearly distinguish the differences between the two. In the next blog post (blog post #6) of the M&A blog series, we will take a deeper dive into the differences between warranties and indemnities.