Do Carveouts to Caps Work the Way You Intend?

Merger agreements frequently contain carveouts to caps on levels of indemnification coverage for various types of claims. A typical formulation may specify that selling stockholders’ exposure to loss for claims related to most types of breaches of representations or warranties is limited to the escrow but that the buyer can recover for losses in excess of the escrow for matters such as intellectual property, capitalization, tax and other similar issues.

Parties should clarify whether indemnification caps are intended to be inclusive or exclusive of each other.

Many agreements, however, do not address whether these limits are inclusive or exclusive of each other. For instance, if the agreement says most claims are limited to the escrow amount, but tax matters can go up to 50% of the purchase price, could the buyer recover the escrow amount plus the 50% tax cap or is their total potential recovery limited to 50% of the purchase price? Many selling stockholders, if asked, would say that their maximum potential risk in this transaction is 50%, but that might not be the case. Losses in excess of 50% potentially could occur if, for example, the buyer brought a customer contract claim that wiped out the escrow and then separately brought a tax claim equal to 50% of the purchase price (for a total recovery of 60% of the purchase price). If this is not what the parties intend, they should make clear that the exposure on the tax matters in this example is equal to 50% of the purchase price less amounts paid on any other claims.

In SRS Acquiom’s experience, this point frequently is not well defined in merger agreements, and the merger parties should clarify whether indemnification caps are intended to be inclusive or exclusive of each other.