Publications: Challenges in Defending Indemnification Claims

In today’s market, post-closing disputes between the buyer and seller are increasingly common. Unfortunately, when a seller is negotiating the purchase agreement with the buyer, the seller will frequently focus exclusively on the fundamental economic issues in indemnification (e.g., the size of the basket and the cap and the expiration period of the representations and warranties), but will not focus on other important issues which only become apparent when a dispute arises.

Months or even years after selling his business, without any warning the seller may receive a tersely worded notice of indemnification from the buyer demanding indemnification. Often accompanying the notice of indemnification is a notice to an escrow agent, demanding the release of escrow funds, a notice of set-off against a note issued to a seller at the closing or even a notice of foreclosure against equity held by the seller. From the seller’s point of view these actions represent buyer’s remorse, and are merely the first step in re-trading a previously agreed upon transaction.

However, these actions frequently have the effect of pressuring the seller into negotiating a quick settlement of the indemnification claim. A seller must be cautious about commencing settlement negotiations with the buyer early in the indemnification process unless the seller is able to overcome the informational asymmetry that exists between the parties.

Prior to the closing, the c-level executives of the seller are intimately familiar with every aspect of the business. That situation is almost completely reversed after the closing. At the closing, the seller generally turns over all books and records to the buyer and often is no longer an employee of (or even a consultant to) the business. This puts the buyer in complete control of the information regarding the indemnification claim. It also leaves the seller in a precarious position of being drawn into settlement negotiations without having complete information about the nature and strength of the buyer’s indemnification claim. Overcoming this challenge requires the seller to negotiate carefully in the purchase agreement and take decisive actions after the indemnification claim is brought.

Purchase Agreement Issues
Unlike claims involving third parties, purchase agreements generally deal with claims made directly by the buyer against the seller in a remarkably cursory manner. In some cases, the purchase agreement merely requires the buyer to notify the seller of the existence of the claim. This type of provision encourages the buyer to do the bare minimum in notifying the seller of the existence of a claim and not provide meaningful information about the claim. In order to address this issue, the seller should require that the purchase agreement include provisions that:

• require that any notice of indemnification include detailed back-up information regarding the claim;
• permit the seller to retain copies of financial and other documentation relating to periods prior to closing;
• permit the seller (and its attorneys and agents) to have access to books and records of the buyer in order to evaluate the claim; and
• permit the seller (and its attorneys and agents) to interview key management personnel of the buyer in order to evaluate the claim.

The purchase agreement should include specific penalties for failure to comply with these procedures, which could include:

• prohibiting the buyer from setting-off against any deferred purchase price (including any note or earn-out payment) until the procedures have been complied with;
• requiring the buyer to pay the seller’s attorneys’ fees in defending the indemnification claims if the procedures have not been complied with on a timely basis; or
• barring the buyer from bringing the claim if the procedures have been willfully disregarded.

If the purchase agreement includes these types of protections, the buyer will be incentivized to cooperate with the seller in gathering information about the indemnification claim.

After Receiving the Indemnification Notice
After the seller receives a notice of indemnification, he should immediately contact his counsel to review the claims made. The seller should also send a letter to the buyer requiring the buyer to fulfill its information sharing obligations under the purchase agreement and to retain all documentation relating to the indemnification claim (especially e-mail and related materials).

Once the seller has received the information relating to the claim, the seller should review all the documentation with counsel and any experts necessary to evaluate the strength of the claim. If additional documentation is required, requests for that information should be made through counsel. Only after the seller believes it is fully apprised of the nature of the claim should formal negotiations begin. It is frequently helpful at this point to go through mediation in order to gain a neutral’s insight into the strength or weakness of the buyer’s claim. These steps will enable the seller to objectively determine if a settlement is appropriate or if it is necessary to go through formal litigation or arbitration.

In almost every indemnification situation, the seller is playing catch-up with the buyer. The steps outlined here should help the seller to catch-up faster and create circumstances where settlement may be reached earlier in the process.