BLOG: Indemnification — Who is on the hook for the liabilities of the practice?
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Key takeaways:
- Indemnification spells out who is responsible for liabilities related to the pre-closing operations of the practice.
- Another way to handle risk allocation is to purchase representation and warranty insurance.
You’ve made the decision to sell your practice, got your house in order and hired advisers. Now you need to start making decisions regarding the terms of the sale.
While all sellers like you would love to sell their business, get their money and ride off into the sunset, leaving the buyer responsible for all liabilities associated with the business, the buyer will rarely agree to that. The buyer will want the sellers on the hook for some of these liabilities.
Indemnification is a contractual remedy negotiated and put into the purchase agreement that spells out who is responsible for liabilities related to the pre-closing operations of the practice and to what extent.
There are several elements to indemnification:
- Scope: As a baseline, indemnification will generally address damages arising from breaches of the representations, warranties and covenants that the buyer will require the sellers to make in the purchase agreement regarding the practice. For example, if the sellers represent that the practice has paid all taxes owed but the practice has not (or that the practice has complied with all laws but it has not), and after the sale the buyer suffers financial losses as a result of the misrepresentation, then the buyer could make a claim under the indemnification provision in the purchase agreement to recover the losses from the sellers. Scope could also cover specific known liabilities; for example, if there is a pending qui tam investigation against the practice, the buyer may require the sellers to indemnify the buyer for all or part of the damages associated with the investigation.
- Survival period: Indemnification provisions will also detail how long they will survive and thus how long the sellers will be financially exposed after the sale. Survival periods are often customized based on claim type. For example, survival periods for breaches of most representations and warranties tend to range from between 1 to 2 years after the sale, while survival period for certain “fundamental” representations and warranties (such as representations that the sellers own the practice) will often be longer and sometimes indefinite. Survival periods for “special” indemnification items, such as the qui tam matter raised above, are negotiated on a case-by-case basis.
- Caps and other limits: Indemnifiable damages are often subject to a negotiated cap, which will vary based on the type of claim. The buyer and sellers may also agree to a threshold dollar amount that a claim must hit before the buyer can bring an indemnification claim — called a deductible or basket. There may even be a “mini-basket,” which is the minimum amount the buyer’s losses must exceed for a single claim before the buyer may bring such a claim. It is very much like insurance where the sellers often have to provide “insurance” (indemnity) for the representations they make (but the buyer has certain deductibles and other limitations in respect of that “insurance”).
- Funding the indemnity: Buyers generally will want to avoid having to proceed directly against sellers for their indemnifiable damages; it’s unpleasant for everyone if the sellers (who may now be employed by the buyer) have to write a check to the buyer. In lieu of that, a buyer may seek to either hold back or escrow a portion of the purchase price to fund future claims, releasing the funds after a designated period of time.
While this blog has discussed risk allocation vis-à-vis sellers and buyers, another way to handle risk allocation is to purchase representation and warranty insurance. If purchased, an insurer is bearing the risk and paying for damages associated with breaches of representations and warranties. Note: Representation and warranty insurance cannot cover breaches of covenants or any known liabilities (ie, if the sellers disclose a pending litigation as an exception to its representations and warranties, the insurance will not cover damages associated with this litigation).
This blog only skims the surface of indemnification provisions. Your legal adviser will be able to advise you of these provisions in more depth.
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