In a post called “Anatomy of an Indemnification Provision,” I previously provided an overview of the major features of an indemnification provision – a provision in which one party (the indemnifying party) agrees to reimburse another party (the indemnified party) for specified recoverable damages that arise from certain covered events.
Such obligations, however, typically are not unqualified. Parties to indemnification provisions may limit or alter their scope by imposing limitations, which allow parties to adapt indemnification provisions to the particular facts and circumstances of their deal. Such limitations include caps, liability baskets, materiality and knowledge qualifiers, duration clauses and anti-sand bagging clauses.[1]
Caps
A cap (also called a limitation of liability) on indemnification limits indemnifiable damages to a maximum amount, i.e., $500,000. Certain fundamental representations and warranties – such as those concerning existence, authorization, taxes, employment matters and broker fees – may be carved out of the cap. Separate caps may be established for different types of liabilities. For example, there may be a separate, higher cap on environmental liabilities where the buyer has reason to believe that the purchased business may be subject to significant environmental liabilities going forward.
Liability Baskets
Parties may include liability baskets to protect against indemnification claims for small amounts. There are two basic types of liability baskets, thresholds and deductibles. Thresholds (or tipping baskets) provide that the indemnifying party is responsible for all indemnifiable amounts once the threshold is reached, e.g., if the threshold is $200,000, the indemnifying party does not have to provide indemnification until the total amount of indemnifiable claims is greater than $200,000; however, once that threshold is met, the indemnifying party is responsible for all claims from the first dollar. In a deductible, the indemnifying party only is responsible for amounts in excess of the deductible, e.g., if the deductible is $200,000 and the total amount of claims is $201,000, the indemnifying party is responsible for $1 of claims.
Materiality and Knowledge Qualifiers
Materiality and knowledge qualifiers can be used to limit the scope of indemnities for breaches of representations and warranties, e.g., the goods are free from material defects in materials and workmanship; to the best of seller’s knowledge, no litigation is threatened. The materiality qualifier prevents the indemnified party from obtaining indemnification unless it can prove that the breach was material. And, the knowledge qualifier prevents the indemnified party from obtaining indemnification unless the indemnifying party had knowledge of the matter that the representation or warranty concerns, e.g., knowledge that litigation was threatened.
The liability baskets discussed above already impose a materiality restriction on the availability of indemnification by excluding certain small claims from indemnification coverage. Therefore, in order to avoid a double materiality hurdle to indemnification, agreements containing liability baskets sometimes provide that the materiality qualifiers on representations and warranties are disregarded for purposes of determining whether indemnification is available for a breach. Such a provision is called a materiality scrape.
Duration Clauses
Parties can limit the duration of indemnification provisions. For example, many stock and asset purchase agreements provide that the representations and warranties (and indemnification for their breach) will survive for 18 months after closing. Any indemnification claims for breach not brought by the indemnifying party within the indemnification period are waived. Certain fundamental representations and warranties may be excluded from a duration limitation and survive for a longer time period.
Anti-Sandbagging Clause
An anti-sandbagging clause excludes from indemnification coverage damages from a breach of a representation or warranty that the indemnified party knew was false when it was made. Such provisions assume that a party should not be able to profit from the breach of a representation or a warranty if it knew of the breach when the representation or warranty was made.
On the other hand, sandbagging clauses provide that an indemnified party can receive indemnification for damages resulting from the breach of a representation or warranty even if the indemnified party knew that the representation or warranty was false when made. Such provisions assume that the buyer paid for the representations and warranties as part of the purchase price (like a warranty on a purchased car) and the buyer should receive the benefit of the representations and warranties regardless of whether it knew that they were false when made.
[1] Caps, liability baskets, materiality and knowledge qualifiers and anti-sand bagging clauses are especially common in stock and asset purchase agreements for the sale of a business.
