Indemnification Cap
The maximum aggregate amount a seller may be obligated to pay under the indemnification provisions of an M&A agreement. Limits seller exposure for breach of representations and warranties.
An indemnification cap is the maximum aggregate amount a seller may be obligated to pay under the indemnification provisions of an M&A agreement. The cap limits the seller's exposure for breach of representations and warranties and provides cost certainty for the post-closing period.
Cap categories
General cap: applies to breach of general representations and warranties. Sizing is negotiated. Without RWI, the general cap is commonly a modest percentage of the purchase price. Where RWI replaces seller indemnity, the seller's exposure is often limited to part of the policy retention, or there is no seller indemnity for general reps at all.
Fundamental cap: applies to breach of fundamental reps (organization, capitalization, authority, ownership) and certain other specified items. Typically equal to 100% of purchase price.
Special indemnity caps: apply to specifically identified risks (pre-closing environmental, identified litigation, tax). Negotiated separately based on the particular risk's expected severity.
Carve-outs from the cap
Most general caps exclude: (1) fundamental reps; (2) tax reps; (3) fraud or intentional misrepresentation; (4) covenants; (5) specific indemnities. Fraud carve-outs are common. Texas courts will not let a merger clause alone bar a fraudulent inducement claim, but a clear and specific disclaimer of reliance between sophisticated parties can preclude one. Schlumberger Tech. Corp. v. Swanson, 959 S.W.2d 171 (Tex. 1997).
RWI implications
Buy-side RWI policy limits are commonly set as a percentage of enterprise value. In a typical RWI deal, losses first fall within the policy retention, which a seller escrow may partly fund. The policy then responds up to its limit. Any seller indemnity is usually confined to fundamental reps, specific indemnities and fraud.