• Indemnity Clauses under Share Purchase Agreements
  • September 27, 2016
  • Law Firm: Erdem Erdem Law Office - Istanbul Office
  • Introduction

    Under share purchase agreements (“SPAs”), numerous contractual representations and warranties are made by the sellers to the purchasers about the nature of the company being purchased. Indemnity clauses under SPAs protect the purchaser against the breach of representations and warranties given by the seller, as a means of allocating risks and liabilities. This Newsletter examines, among other things, the obligation of the seller to indemnify the purchaser, the means of limitation of liability of the seller, cases where such limitations shall not apply, third party claims, purchaser’s obligation to mitigate damages, and the prohibition of double recovery.

    Liability to Indemnify

    Under an SPA, it is possible either to determine specific breaches that would give rise to indemnification claims, or to draft a general breach and indemnification clause. Indemnity clauses regulate the seller’s liability to indemnify and hold the purchaser harmless against all losses or liabilities arising in connection with the breach of the representations and warranties, which may or may not include the indirect losses and loss of profit, depending on the parties’ agreement.

    The indemnifying party may be determined as the seller, or in case of more than one seller, all or only one of the sellers. It may be regulated that all of the sellers shall be jointly and severally liable, or they may be held liable in proportion to their shareholding percentage in the subject company. The indemnified party may be the purchaser and/or the subject company.

    Limitation of Liability

    The liability of the seller under an SPA is not unlimited. The parties include clauses that limit the liability of the seller especially in terms of time and amounts. To what extent the liability will be limited depends on the parties’ negotiations.

    Notwithstanding the foregoing, under nearly all of the SPAs, the parties agree that the limitation of liability of the seller shall not be applicable in certain cases, such as the following: (i) if the claim arises due to fraud or wilful misconduct by the seller; (ii) to the extent the claim relates to the title of that seller’s shares, as explained under the following sections; or (iii) to the extent a claim for reimbursement of any criminal or statutory fine or penalty is related to an event or circumstance that occurred prior to the closing.

    Time Limitations

    The first type of limitation in terms of time is the period in which the purchaser is required to notify the seller following when the purchaser became aware of the fact, matter, or circumstances giving rise to a claim. In practice, this period is usually regulated as between fifteen to thirty days. It is also possible to regulate that the period commences on the date when the purchaser became, or reasonably should have become aware of such fact, matter or circumstance. The awareness requirement may be applicable also to the subject company, affiliates of the purchaser or directors, employees or advisors thereof.

    The second type concerns the general time limitation, following the expiration of which the seller shall have no liability. This period is usually regulated separately for the claims arising out of different matters. For example, claims due to tax warranties are generally time-barred by six years following the closing date (subject to the legal prescription period applicable to tax claims under the applicable laws); other claims are time-barred by shorter periods, such as eighteen to thirty six months; and claims relating to the authority and organization of the seller, the seller’s ownership to and validity of the shares are not made subject to any time limitations due to their significance and core characteristics in a share purchase transaction.

    The seller’s liability under the SPA shall be eliminated with respect to the claims notified to it after the end of the said periods, without the need to give any response or notification. Further, SPAs may also regulate that the seller shall not be liable if the notice for the relevant claim is given at a time when the subject company is no longer a subsidiary of the purchaser.

    Monetary Limitations

    Monetary limitations are also regulated under two categories under indemnity clauses: upper limits and lower limits.

    It is common that the liability of the seller is limited to a certain percentage of the purchase price of the subject company. It may be regulated that the aggregate liability of the seller in respect of a claim under the SPA shall not, when aggregated with all other claims, exceed such determined percentage. Notwithstanding the foregoing, similar to the case explained under the time limitations above, claims relating to different matters may be regulated separately, by specifying higher percentages for more significant representations and warranties. Claims relating to the authority and organization of the seller, the seller’s ownership to and validity of the shares are often either limited to 100% of the purchase price or not limited at all. It is also important to regulate that such monetary caps are not cumulative, i.e. claims under one representation and warranty would reduce the cap for the claims made under another representation and warranty.

    In addition to the upper limits, an individual de minimis amount is regulated under the SPAs so that the seller shall not be liable in respect of any claim, unless the amount of the liability exceeds a certain amount, which can be determined either as a specific amount or a percentage of the purchase price (usually from 0.1% to 1.5%).

    Moreover, even if a claim is greater than the de minimis amount, a threshold (or basket in other words) may be regulated under the SPA that must be reached in aggregate for the purchaser to be able to make a claim against the seller. In such cases, it is regulated that the seller shall not be liable in respect of any claim unless the aggregate amount of such claim and all other claims under the SPA (each being in excess of the de minimis amount) exceeds a certain percentage of the purchase price. It is up to the parties’ negotiations as to whether the seller’s liability shall be limited to the amount by which such aggregate amount exceeds the threshold, or it shall be liable for the whole amount instead of only the exceeding part.

    Non-Liability

    Finally, indemnity clauses regulate the cases where the seller shall not be liable at all, in respect of the claims by the purchaser. The following are several examples to such cases: To the extent that the claim arises out of, or is increased by, where applicable, (i) an act, omission or transaction carried out by the purchaser after the closing date; (ii) any change in the law or its generally accepted interpretation, including new taxations after the closing date; (iii) a breach by the purchaser of its obligations under the SPA; (iv) an act or omission of the seller made at the request of the purchaser; (v) the matters, facts or circumstances that have been disclosed to the purchaser in the data room, in the accounts or elsewhere, or which were publicly available prior to the signing of the SPA; (vi) the matters for which provision or allowance has been made in the accounts of the company as delivered to the purchaser.

    Other Provisions

    Third Party Claims

    If a matter, fact or circumstance that may cause the liability of the seller arises from the claims, allegations or acts of third parties, including public authorities, which are referred to as third party claims under the SPAs, the SPAs generally require the purchaser and/or the subject company to notify the seller in writing, within a determined time period following becoming aware of such matter, fact or circumstance.

    It may be regulated under the SPA that the purchaser, upon the seller’s request, will allow the seller to assume the case or legal proceedings, and defend the third party claim on behalf of the purchaser and/or the company through its own legal representatives, and at its own cost. The purchaser may also choose to participate in the case or the proceeding at its sole discretion. If the case is conducted by the seller, the purchaser should, and should procure to the company to, provide the seller with all necessary information, documents and assistance, and to provide access to the company’s premises, accounts, records, etc. in order for the seller to be able to make the required defence. In the event that the defence is not assumed by the seller and, therefore, is conducted by the purchaser, it is the obligation of the seller to provide the requested information. The SPAs also regulate that the purchaser shall not, and shall procure the company not to, make any admission of liability or settlement without the prior written consent of the seller.

    Mitigation

    Indemnity clauses may burden the purchaser with the obligation to take, and to procure the company to take, all reasonable steps to avoid or mitigate any loss or damage incurred by it, prior to directing a claim against the seller.

    Remediable Breaches

    Indemnity clauses may provide for the opportunity to remedy the breach so that the seller shall not be liable for such claim to the extent that the fact, matter or circumstance giving rise to such claim is remediable, and is remedied by or at the expense of the seller within a determined time period. The purchaser may be required to cooperate with the seller in such rectification process as and when necessary. In such cases, the purchaser shall be entitled to direct the relevant claim towards the seller only if the breach has not been remedied.

    No Double Recovery

    Indemnity clauses often prevent the purchaser to recover more than once in respect of the same matter, fact or circumstance upon which the relevant claim is based. Further, if the seller made any payment to the purchaser as indemnification and the purchaser and/or the subject company is entitled to recover from any other person or under any insurance coverage any amount in respect of the relevant claim, the purchaser shall be required to assign such right to receivables to the seller or, if already received the payment, return such amount to the seller.

    No Other Remedies

    It is generally agreed by the parties that the seller’s liability under the SPA shall be exclusively governed by the SPA, and the purchaser may claim compensation from the seller only based on the provisions of the SPA, and no other remedy under the applicable laws shall be available. However, it must be taken into consideration that such exclusion may not be allowed under the applicable laws, and the mandatory rules of such applicable laws may apply despite the parties’ agreement.

    Conclusion

    SPAs include indemnity clauses to protect the purchaser against the breach of the representations and warranties given by the seller, as a means of allocating risks and liabilities. However, the liability of the seller for indemnification is limited by the parties especially in terms of time and money, except for the claims arising due to fraud or wilful misconduct by the seller. The extent of the limitation may differ according to the subject matter of the claim. Indemnification clauses also regulate, among other things, the purchaser’s notification requirement in the event of third party claims, the purchaser’s obligation to take all reasonable steps to avoid or mitigate any loss or damage incurred by it prior to directing a claim towards the seller, prohibition of recovery more than once in respect of the same matter upon which the relevant claim is based, and non-availability of other remedies under the applicable laws other than the provisions of the SPA.