Indemnification clauses are common in share purchase agreements (“SPA”). Post M&A disputes frequently concern alleged breaches of such clauses. These disputes raise difficult questions of both substantive and procedural law. The reason is that an indemnification dispute involves at least four parties: The target company, the third party who raises claims against the target company, the seller (= the indemnitor) and the buyer (= the indemnitee).
Reasons to Include Indemnification Clauses in SPAs
In the due diligence phase of a transaction, the seller of the target company discloses to the prospective buyer which claims or potential third party claims against the target company exist and the seller typically confirms in the SPA that all potential liabilities of the target company have been disclosed. All undisputed and specifiable third party claims can be taken into account in the calculation of the purchase price and do not require any specific rules in the SPA. The situation is different with respect to indeterminable third party claims, claims which are unknown to the parties of the SPA or claims which the seller considers to be without merits. These include, for example, potential contractual or tortious claims of third parties, claims of environmental authorities regarding the elimination of pollution on company properties or potential claims of tax authorities due to outstanding tax inspections. With respect to those uncertain third party claims the SPA typically provides that the seller has to indemnify and hold harmless the buyer if a third party claim is raised.
Scope and Wording of Indemnification Clauses
The scope and wording of indemnification clauses in SPAs differs substantially. Sometimes, the clause simply reads: „Seller shall indemnify the target company from and against all claims which arise out of or relate to (…)”. Such a broad language frequently leads to disputes between the parties of the SPA if the seller is of the opinion that the claim raised by the third party against the target company is unjustified. In particular, it is often unclear whether the buyer / target company or the seller has to defend against allegedly unjustified third party claims and whether or not (and if so how) the other party has to support the defense. Such disputes then have to be resolved on the basis of the applicable substantive law.
In view of these uncertainties, indemnification clauses in SPA’s should deal with these issues. Unfortunately, this requires detailed provisions which make such clauses quite complex. The indemnification provisions in an SPA often define which claims under which preconditions will be covered by the indemnification obligation. They also provide whether the buyer / target company or the seller has to defend against unjustified third party claims, how the other party has to support the defense and under which conditions a settlement can be concluded with the third party. The goal is to avoid later disputes between the buyer and the seller with respect to the indemnification obligations of the seller.
Potential for Disputes
Even where the indemnification provisions in the SPA are elaborate, there is still a substantial potential for legal conflicts. The seller and the buyer may have different opinions with respect to the merits of a third party claim against the target company. They may disagree about the right defense strategy. They may be unable to reach an agreement as to whether or not both parties have to participate in court or arbitration proceedings against the third party. In case the target company loses the litigation / arbitration against the third party, the seller may argue that the defense by the buyer / target company was inappropriate and that the case was lost due to reasons for which the buyer is responsible. Finally, the buyer and the seller may have different opinions concerning settlement negotiations with the third party. If the buyer / target company settles the matter independently and requests a reimbursement from the seller, the buyer runs the risk that the seller will argue that the settlement agreement concluded by the buyer was unreasonable and that no settlement agreement should have been concluded or at least only on more favorable terms for the buyer.
Avoidance of Post M&A Disputes
To avoid post M&A disputes about indemnification obligations, it is important that the buyer and the seller closely cooperate in the defense against third party claims and that the outcome of the negotiations or proceedings between the target company and the third party has a legally binding effect for the seller with respect to the indemnification claim of the buyer. If both the SPA and the legal relationship between the target company and the third party provide for dispute resolution through state courts, these goals can normally be reached rather easily since most rules of civil procedure allow for “third party notices” or “third party complaints” by which the buyer can thereby bring the seller into the proceedings with the third party. In both cases, the outcome of the proceedings between the target company and the third party will become binding upon the seller in subsequent litigation concerning the seller’s indemnification obligation. In other words: The seller can no longer argue that the third party litigation was not handled properly by the buyer / target company because the seller had the opportunity to join the litigation and to introduce additional defense arguments and evidence if he considered this to be necessary. The seller can also no longer argue that the decision in the proceedings between the target company and the third party was wrong as the third party notice or complaint has a res judicata effect for the seller with respect to issues which are also relevant for the later indemnification claim.
However, the situation is different if the contract between the target company and the third party and / or the SPA provide for dispute resolution through arbitration, which is regularly the case in an SPA. An arbitration clause is only binding between the parties to the arbitration agreement. A third party is not bound by such an arbitration agreement and can therefore not become a third party defendant or intervener in arbitration proceedings, unless the parties to the arbitration agreement and the third party reach an agreement to that effect. Such an agreement is in most cases impossible to conclude once the dispute has occurred. Thus, it is highly recommendable to deal in the SPA with the issue of coordinating the proceedings against potential third parties with possible indemnification proceedings under the SPA. To achieve this, the arbitration agreement in the SPA should provide for rules which make sure that the outcome of the dispute with the third party becomes similarly binding upon the seller as in the case of a third party complaint or notice. In addition, the seller must, if he is not obliged to manage the defense, get the opportunity to bring forward all defenses in the litigation or arbitration between the target company and the third party which he considers necessary. Only when the SPA provides for similar results as a third party notice or complaint, a cooperation of the parties in the defense against a third party claim can be reached and contradictory decisions can be avoided.