M+A: What happens when due diligence reveals a problem?

In circumstances where the parties are negotiating the terms of a sale agreement and in the course of those negotiation the buyer and/or its advisers become aware of a problem (but not one that is a deal breaker) that besets the target company/target sale assets there are at least 4 possible responses and they are:

  • Negotiate a reduction of the sale price;
  • Negotiate the inclusion of an earn-out obligation and/or an instalment payment regime;
  • Negotiate the inclusion of a condition precedent to completion that requires the seller to rectify the problem before completion can occur;
  • Negotiate an indemnity right.

It is incumbent upon the buyer’s lawyer to specifically address the risk of a loss or liability arising post completion of a concluded sale agreement via one of these mechanisms.  The balance of this article focuses on the last of these responses – an appropriately drafted indemnity right that is contained in the sale agreement. 

Why is this necessary?

Once a problem has been fairly disclosed it becomes very difficult for the buyer under a completed contract of sale to successfully prove that it relied upon the facts, the subject of the disclosure, to its detriment.  This will certainly be the case if the sale agreement states that a buyer cannot rely upon any facts fairly disclosed (or some similar form of words to this effect) to it as part of the due diligence investigation. In this situation the buyer will not have a claim that can be sustained in contract for breach of warranty and it is also possible that it will not have a claim that can be successfully brought for misrepresentation (however the latter positon is not as clear cut when actions for misleading or deceptive conduct are involved).

What is the solution?

The solution is that the buyer must negotiate the inclusion of appropriate indemnity rights in order to address any subsequent losses that arise out of circumstances revealed by the due diligence investigations that may have an adverse effect on the target company/target sale assets post completion.

The rationale is that because an action for breach of contract or an action or misrepresentation cannot be successfully brought against the seller, the matter has to be looked at not as one involving breach but as an exercise in allocating civil risk. This is why indemnity rights are required.

What is an indemnity right?

The High Court of Australia in Bofinger v Kingsway Group Limited [2009] HCA 44 (a case dealing with a guarantee and a surety’s right to subrogation to securities) at [7] and [8] defined an indemnity right in the following terms:

“In its widest sense, that apparently used by Buckley LJ in Orakpo, an indemnity includes a contract obliging one person to make good the loss suffered by another, and contracts of guarantee and those of insurance fall within that description…”

Kirby J in Andar Transport Pty Ltd v Brambles Ltd [2004] HCA 28 at [68] made the following observation regarding the use of indemnity clauses:

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