What is a Basket and Indemnity Cap?
Whenever a purchase agreement is made, the seller makes certain representations and warranties attesting that certain things are true. For example, these include that there are no lawsuits pending or that the owner is the true lawful owner of the assets in question and has full authority to effect a sale.
Both the purchaser and the seller can be protected through indemnification of caps and baskets which essentially limits the liability of the seller post-closing if any of the representations and warranties turn out to be untrue and dictates the amount that the purchaser can recover from the seller in the event that it incurs losses. As well, general indemnities which are exchanged on the purchase of a business provide each purchaser and seller side with comfort. The seller indemnifies the purchaser to the extent of any liability that arises before the closing date, and the purchaser indemnifies the seller to the extent of any liability that arises after the closing date.
What happens if liability does occur and the indemnity must be actioned?
The general rule of thumbs in basket and indemnity caps is that neither the seller nor the purchaser should pay more than he is gaining in the transaction.
Let’s turn to each contractual provision in turn:
The indemnification cap refers to the financial limit or cap to which typically the seller is liable against any breach of reps or warranties. Fundamental reps and warranties, such as a representation that the seller is the owner of the shares or assets being sold—are fundamental to the successful transaction. The purchaser must be provided with some insurance that these representations are true. If it comes to light post-sale that a representation was false, thereby incurring loss, the purchaser can recover his loss up to a certain limit. This limit is often valued at 50% of the enterprise value of the purchase although the amount can vary greatly depending on the size of the transaction. Smaller transactions usually realize larger percentage caps.
The idea is that the seller should not enter into a sale arrangement where it has unlimited and unfettered liability – and where it potentially has the ability to be liable for more than the entire purchase price. Such a transaction is not in the interests of the seller, as the seller may stand to lose more than it stands to gain.
An indemnity cap will limit the amount of liability a seller has under the terms of the agreement. The cap is typically 50% however can be as high as 100%. The very idea of the cap is that the seller should not be liable for more than the purchase price, being the amount of money landing in their pockets as a result of the transaction.
When negotiating an indemnity cap, obviously a seller would like to negotiate the least amount possible while the purchaser would like to negotiate the largest cap possible.
An indemnification basket refers to the size of the damage incurred before a seller become liable to reimburse the purchaser for any losses. There are two types of “baskets”: true deductibles and threshold/tipping baskets. In other words, if the purchaser were to suffer a loss of $500, is this sufficient to action the indemnity? When an indemnity is actioned, lawyers become involved and legal fees will likely well exceed the $500 claim. For this reason, a basket is introduced to ensure that only significant claims will tip the basket.
True deductibles obligates the seller to reimburse the value of the damage that exceed the basket. For example, if there a basket of $100,000 and the losses incurred are $130,000, then the seller is responsible to pay for the value exceeding the basket, ie. he must pay $30,000.
The other type of indemnity basket is threshold/tipping basket, which obligates the seller to reimburse the purchaser against losses only when the tipping point of the basket is reached. Once reached, the seller may pay out not only the value exceeding the basket but the full amount: the basket amount and the value in excess of the basket. For example, if there is a threshold basket of $100,000, and the purchase incurs losses of $150,000, since the tipping point of $100,000 was reached, the seller is liable to pay the full $150,000.
It should be kept in mind that there is a survival period during which a purchaser can recover his losses where there was a breach in representations or warranties or a general indemnity item. This limit is generally 1 or 2 years. Further in more complex and higher value transactions, it might be wise for the purchaser to purchase Reps and Warranties Insurance, which ultimately protects both buyers and sellers involved in transactions from financial loss and helps the transaction to close more smoothly.
Kalfa Law and Corporate Commercial Experience
When negotiating a deal, it is crucial to determine the indemnity cap and the basket threshold to protect the buyer as well as the seller. Survival periods is another element that is negotiated at this time. It is essential that all parties of a transaction have an experienced lawyer in business law to assist them in negotiating these provisions. The team at Kalfa Law have extensive experience in commercial transactions, handling about 10 purchase and sale deals a month. Our experience is your asset.
You work hard for your money. We work hard for you to keep it.
-Shira Kalfa, Founder & Partner
© Kalfa Law, 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.