[Startup Must-Know Laws] Legal Issues Regarding Indemnity Clauses in M&A Contracts

Key Points of Indemnity Clauses in M&A Contracts
Mechanisms for Adjusting Value and Ensuring Transaction Stability

Ahn Hee-cheol, Attorney at Law, DLG Law Firm

In merger and acquisition (M&A) contracts, indemnity clauses are among the most carefully reviewed provisions by the contracting parties. This is because they specify remedies if the other party fails to fulfill the contract. While general contracts allow termination and damages for breach, M&A contracts often prohibit contract termination after the closing. This is to maintain legal stability and preserve the effectiveness of the completed acquisition. Instead, it is common to resolve contractual issues through indemnity mechanisms.

Indemnity clauses in M&A contracts serve not only as compensation but also as a mechanism to adjust the value of the acquired company, which is a core element of the transaction. The acquirer receives financial, accounting, legal, and managerial information from the seller and the target company and evaluates the corporate value based on this information to proceed with the deal. However, if unforeseen issues arise after closing, the indemnity clause allows for value adjustments.

Key elements of indemnity clauses include De Minimis, Basket, Cap, and Deductible. De Minimis sets a threshold below which individual losses are not recognized as damages. The Basket refers to the minimum cumulative amount of damages that must be reached before indemnification can be claimed. The Deductible is a provision that indemnifies only the amount exceeding the Basket threshold. The Cap sets the total limit of indemnity, thereby limiting the seller’s liability. It is important to set these amounts appropriately when concluding an M&A contract.

Additionally, it is common to set survival periods for indemnity obligations related to representations and warranties. For example, tax and environmental representations and warranties typically survive for 5 to 7 years, labor-related ones for 3 years, and other matters for about 18 months. The longer the survival period, the greater the seller’s burden; the shorter it is, the less protection the buyer has, making this a critical consideration during negotiations.

In conclusion, indemnity clauses in M&A contracts play a crucial role beyond mere compensation responsibility by ensuring transaction stability and adjusting the value of the acquired company. Therefore, it is important to fully understand the structure of indemnity provisions before signing the contract and to establish appropriate terms through reasonable negotiations between the parties.