Risk Allocation in M&A Transactions: The Role of Indemnification

Indemnification means financially repairing the harm arising from the commission of an unlawful act. This legal duty is set forth in the law in a general and abstract fashion and is therefore seldom sufficient to address the particularities of each corporate acquisition or the interests and needs of the parties involved.

In the context of M&A contracts, indemnification provisions are not merely devices for preserving and restoring impaired assets. Rather, they function as genuine mechanisms for the allocation of risk between the parties, designed to facilitate and maximize the value of the transaction, while at the same time encouraging sound conduct in managing contingencies and losses.

Given the complexity inherent in allocating risk, it is unsurprising that indemnification clauses are often the subject of intense negotiation. One of the main difficulties arises from the parties’ divergent perceptions of risk. Risk—understood as the probability of occurrence of a future and uncertain event with an adverse effect on one or both parties—represents uncertainty, which the contracting parties tend to measure and price according to their convictions and personal interests.

Against this backdrop, market practice has developed certain indemnification criteria deemed by the parties to be the most efficient and rational in a given transaction. One such criterion is that the burden of indemnification should fall on the party best positioned to mitigate the risk—that is, the party more capable of absorbing or preventing its occurrence or aggravation.

Another widely used criterion is to assign responsibility to the party with superior information regarding the risk—since that party, among the contracting parties, is in the best position to evaluate and price it. Indeed, this very asymmetry of information explains the customary allocation whereby the seller is responsible for past liabilities and contingencies, while the buyer assumes those arising after closing.

Beyond these general standards, parties frequently adopt specific indemnification clauses as risk-allocation tools. It is common, for example, for the buyer to require safeguards to protect its indemnification rights against the seller’s potential credit deterioration, such as an escrow deposit of part of the purchase price, a holdback on payment, a third-party guarantee, or a lien on real property.

Limiting provisions serve a similar function, for instance, by addressing: (i) the maximum period of exposure to risk (longer for latent liabilities with protracted effects, such as environmental matters); (ii) the cause or origin of the risk (with stricter treatment for losses arising from fraudulent conduct, intentional misconduct, or the absence of licenses in regulated sectors); and (iii) the value of the risk (by establishing de minimis thresholds below which the seller owes nothing, and caps on indemnifiable losses so as to preserve a portion of the seller’s profit from the sale).

When properly designed, indemnification not only serves to allocate risk but also fosters a cooperative environment between the parties, thereby reducing transaction costs and generating value.

In some transactions, sellers undertake to indemnify the buyer for all losses rooted in the pre-closing period. In such cases, the purchase price received by the seller tends to be higher than under other indemnification structures. At the same time, however, the arrangement introduces greater insecurity—on the seller’s side, because it may be compelled to return a substantial portion of the price through indemnification; and on the buyer’s side, because reliance on the seller’s broad promise may lead it to conduct only limited due diligence, leaving it vulnerable to future issues that distract from and impair the management of the acquired business.

As a corrective, it is often useful to exclude from the seller’s indemnification obligation certain liabilities properly disclosed to the buyer, as well as to adopt limitations on liability within the representations and warranties. In this way, the seller is bound to indemnify the buyer only where its representations prove false, incomplete, or inaccurate, not for all pre-closing losses.

In this regard, the introduction of concepts such as “materiality” and “knowledge” into the seller’s representations reduces the circumstances in which indemnification is owed. At the same time, it instills in the buyer a heightened diligence duty: the buyer must carefully evaluate the target’s legal and financial condition and determine which matters require full and precise representations.

Another approach sometimes adopted is the so-called “as is” acquisition. Here, the buyer takes the company in its current state and relieves the seller of any indemnification obligation, regardless of whether liabilities and contingencies were disclosed. In return, the seller accepts a lower purchase price, reflecting its reduced exposure to risk.

Such “as is” deals may, however, generate perverse incentives for the seller to withhold information. To counteract this, the parties may carve out exceptions, shifting certain indemnification risks back to the seller (for example, in the case of significant or hidden liabilities). Doing so aligns the seller’s incentives by motivating it to disclose information in order to mitigate risk and avoid responsibility.

Understanding the dynamics of indemnification is essential for anyone engaged in mergers and acquisitions. Crafting indemnification rules guided by an efficient and rational allocation of risk ensures transactional value and reduces unnecessary friction between the parties.