Explore the intricacies of indemnification caps in M&A deals and learn from a recent case dispute over their interpretation. Gain insights into risk mitigation strategies for buyers and sellers in the world of mergers and acquisitions.
M&A Stories
May 20, 2019
Introduction:
In the world of mergers and acquisitions, a battle often ensues between business buyers and sellers over indemnification caps. These caps, along with deductibles and thresholds in purchase agreements, serve as risk mitigation tools for sellers, limiting their exposure to post-closing indemnification claims from buyers.
The Deal:
Let’s dive into a recent case to understand this better. An Akron-based private equity firm, specializing in investments in distressed or underperforming middle-market and mature companies, sold its chemical division to a buyer for $27 million. This sum included $8.4 million in cash at closing and the assumption of $18.6 million in seller debt. Additionally, the buyer agreed to pay the seller an earnout of $5.5 million if the business met specific earnings targets in the first year after closing.
The Lawsuit:
However, after the deal closed, tensions rose between the buyer and seller. The buyer was dissatisfied with the post-closing performance of the chemical division, and the seller did not receive its earnout. This dispute led them to an Ohio federal district court.
The buyer alleged that the seller had understated the costs of the business by nearly $2 million, a significant issue considering that the purchase price was $27 million, likely calculated based on earnings multiples. This disagreement brought to light a key question: What was the maximum exposure of the seller to the buyer for understating the costs of the business?
Indemnification Cap Dispute:
The heart of the matter lay in the indemnification cap provision within the asset purchase agreement. This provision capped the seller’s liability for a breach of its representations and warranties at 10% of the “aggregate purchase price actually paid” by the buyer to the seller.
The buyer contended that the cap amounted to $2.7 million, arguing that the “aggregate purchase price” equated to $27 million. In contrast, the seller insisted the cap was $840,000, which represented 10% of the $8.4 million cash purchase price, excluding the $18.6 million in debt assumed by the buyer.
The Resolution:
The court found that the provision could be interpreted in either way, making it necessary for the dispute to proceed to trial rather than being resolved in preliminary proceedings.
Comment:
Indemnification provisions are often considered part of the “boilerplate” in M&A agreements. However, they become a focal point when disputes arise post-closing. In hindsight, it’s clear that the buyer and seller should have been more precise in their cap language. Simplifying it and specifying a set amount, such as $2.7 million, could have avoided this legal battle.
Case Reference:
Main Market Partners, LLC v. Olon Ricerca Bioscience LLC, Case No. 1:18-CV-916, United States District Court, N.D. Ohio, (April 9, 2019) https://scholar.google.com/scholar_case?case=4976259500205573361&q=%22asset+purchase+agreement%22&hl=en&scisbd=2&as_sdt=2006&as_ylo=2017#r[17]
By John McCauley: I help companies and their lawyers minimize legal risk associated with small U.S. business mergers and acquisitions (transaction value less than $50 million).
Email: jmccauley@mk-law.com
Profile: http://www.martindale.com/John-B-McCauley/176725-lawyer.htm
Telephone: 714 273-6291
Check out my book: Buying Assets of a Small Business: Problems Taken From Recent Legal Battles
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