With the high-stakes mergers and acquisitions increasing daily, a necessary provision to include in the applicable agreements is indemnification.
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 is an indemnity contract [Section 124 of the Indian Contract Act, 1872].
Indemnification comes into play to cover the actual or notional loss on account of a breach of the said representation and warranties. This provision is enforceable in India under the contract laws and provides for a recovery in case of a breach.
TRIGGERING INDEMNIFICATION
Indemnification is triggered when either party incurs a loss due to the action of the other. Defining the term ‘loss’ in the agreement is crucial. The Courts have considered the definition of loss while determining if, the breach can be attributed to the loss incurred, and thereby, the party be indemnified.
Indemnification helps narrow the risk allocation and places responsibility on parties to fulfil their duties towards each other.
LIMITATIONS AND EXEMPTIONS TO INDEMNIFICATION
During extensive negotiations, both parties intend to limit their exposure for indemnifying the other party. It may be in terms of amount or time for invoking claims arising from breach of representation and warranties.
While enforcing indemnity, the claim for breach of representation and warranties is capped, ranging from 10-100% of the transaction value. The time limit for a claim for a general representation is 3 years, whereas, for tax warranties, it is 7 years. Fundamental warranties extend indefinitely, allowing the buyer to claim damages if a breach is discovered over a period after closing.
Another way to limit the exposure is by including De Minimis amount, i.e., a minimum threshold amount which single claim must exceed to trigger the indemnity.
Along with the De Minimis amount, Basket is generally included in the provisions, which results in establishing a minimum threshold that must be exceeded by the aggregate loss incurred by the buyer before claiming indemnity. This generally ranges from 0.5-2% of the transaction value.
While we suggest having indemnification to cover all representation and warranties, the anti-sandbagging provision kicks in when included in the agreement for the matters already known to the buyer prior to signing or closing the deal being sought to be indemnified.
The Anti-sandbagging provision allows the sellers to restrict the indemnifications only to the matters unknown to the buyer.
The buyer, in case an anti-sandbagging provision is included in the agreement, may aim to mitigate the clause and restrict the knowledge to actual knowledge alone, as against implied or constructive knowledge.
THE CROSS-BORDER REGULATION
RBI amended the FEMA regulations, effective May 20, 2016, to require prior approval if the indemnity obligations exceeded the prescribed limits.
The limits are – consideration amount may be deferred up to 25% of the consideration for 18 months. If the consideration is fully paid, the indemnity offered by the Indian seller can be up to 25% of the total value for 18 months. The said amount, if agreed by the parties, can be held in escrow.
The period of 18 months is calculated from the date of signing the agreement and not from the date of closing. This results in the reduced time available for invoking the indemnity if any breach is identified after the closing.
This rule is referred to as the 18/25 cap on indemnities in cross-border M&A deals.
It is unclear when the approval is required to be obtained, i.e., at the time of signing the agreement or at the time of invocation of indemnity. However, the business practice has been to obtain approval at the time of invoking indemnity. The downside is that if RBI does not grant the approval, the non-resident buyer will have to claim damages under contract laws, implying a lengthy legal trial.
Adopting a post-transaction audit at regular intervals can help identify any indemnity-claim incident early on.
WARRANTY AND INDEMNITY INSURANCE
Though at a very nascent stage, the concept of warranty and indemnity insurance is gaining some attention. It is a mechanism introduced and relied upon to bridge the gap post negotiations between parties.
While the insurance helps bridge the gap, it comes at a cost. It involves discussions with the underwriters to reach mutually acceptable terms. Tax warranty insurance is the most sought, considering the potential loss on account of a breach and litigation involved in a tax matter.
Exclusions from warranty and indemnity insurance primarily include
- items expressly disclosed in the agreement
- any information/act that the buyer has prior knowledge of – identified either through due diligence or through the public domain
- any fines or penalties levied after closing on account of wrongful deeds
- any specific exclusions
CONCLUSION
Pursuing the growth in M&A in India, extensive due diligence has been on the rise. Not only are the title checks undertaken while signing the deal, but post-closing diligence is also preferred to keep a check on the representation and warranties agreed in the agreement. Enforcing the indemnity clause through an arbitral award is also paving the way when the contractual terms aren’t clearly drafted. Hence, to avoid discrepancies, it is best to have a well-drafted indemnity, representation and warranty clause in the deal agreements.
This is only for informational purposes. Nothing contained herein is, purports to be, or is intended as legal advice and you should seek legal advice before you act on any information or view expressed herein. Endeavoured to accurately reflect the subject matter of this alert, without any representation or warranty, express or implied, in any manner whatsoever in connection with the contents of this. This isn’t an attempt to solicit business in any manner.
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