With regard to the scope of indemnification, if you are the buyer in a M&A transaction, you can simply require the seller to bear all contingent or potential liabilities, especially for those mandatorily required liabilities, such as the payment obligation of social security, housing provident fund and taxes. In order to ensure that such indemnification obligations can be effectively fulfilled, the buyer may also require the seller to deposit the contingent or potential amount of indemnification into an escrow account within the agreed time period, so that such amount can be deducted from the escrow account when indemnification obligation is actually triggered.
If you are the seller of a M&A transaction and have certain bargaining power, you need to consider in a more complex way regarding your liability for indemnification. Usually, the seller has the following methods to narrow down the amount and scope of its indemnification liabilities:
1. Liability Cap: The seller may require a ceiling on all its total liabilities under an equity transfer contract, beyond which no compensation shall be paid. This ceiling can usually be a certain percentage of the equity transfer price (e.g., 20% to 100%). It should be noted that, where the potential amount of certain liabilities can hardly be estimated (for example, damages caused by environmental pollution), the buyer may require excluding such event from the application scope of the Liability Cap.
2. Seller Deductible: in addition to the Liability Cap, the seller can request for buyer’s waiver of some small-amount claims, such as the claim in which the losses suffered by the buyer are less than RMB500,000. Such arrangement can avoid unnecessary negotiations and transaction costs caused by small-amount claims.
3. How to determine the specific amount and scope of indemnification can easily trigger disputes between the parties and thus should be clearly defined to the extent possible. For instance, as agreed in this case, the indemnification amount on the housing provident fund issue shall be determined in accordance with the written payment notice issued by the government department. This is a relative objective standard which can avoid excessive claims of the employees and is easy for the Buyer to prove. It is also agreed in this case that both the Buyer and the Seller are entitled to engage lawyers, and the cost of which shall be borne by one of the parties. However, some specific issues may not be agreed upon, for instance, whether the legal fees should be reasonable, how to determine the rationality of such fees, whether there is any ceiling for such fees. In practice, the absence of such specific agreement often triggers disputes.
4. The indemnification scope of the seller shall be restricted to those claims that are legally valid and enforceable. Taking unpaid social security as an example, in principle, if an employee has left the company for more than two years, even if he/she goes to the government department to claim for supplementary payment of his/her previously underpaid social security, the government department will no longer provide remedy. Therefore, the seller may claim that it will not bear indemnification obligation for any employee’s claim that exceeds the 2-year time limit. If the buyer or the target company voluntarily repays such amount for any reasons, it is irrelevant to the seller.