M&A Vocabulary – Understanding Experts: Third Party Claims

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner present an important term from the specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

In negotiations of company acquisition agreements, the scope of the seller's liability is usually one of the most important points of negotiation. While existing and future risks are identified by means of due diligence, the distribution of risks is primarily determined by the design of the liability clauses in the company acquisition agreement.

Indemnities usually relate to risks that are known to the parties, whereas it is usually impossible yet to estimate the risk amount and the timing when the risk would materialise. The seller indemnifies the buyer from future liabilities that might arise from circumstances prior to the transaction. For example, these may be costs of cleaning up contaminated sites or tax liabilities for assessment periods when the seller was running the business of the company being sold.

In addition, the seller usually provides representations and warranties (so-called Reps & Warranties). Their subject matter and scope depend on the particular characteristics of the target company. Frequently granted warranties concern the existence and unencumbered nature of the company shares being sold, the accuracy of  financial statements, ownership of industrial property rights, the validity of essential contracts, sufficient insurance cover of the target company, non-existence of legal disputes and the holding of public law permits.

In the case of liabilities which may arise from third-party claims (e.g. from product liability) and fall within the scope of an indemnity or a warranty obligation of the seller, it should be ensured that provisions for the specific handling of such claims are included in the agreement. In particular, it should be regulated who has the control over or takes over the handling of defence against third-party claims and how and in what form the other party can or may support the latter or intervene in such defence. Furthermore, the parties should regulate how to deal with claims that are obviously unfounded.

If, for example, the seller has indemnified the buyer from product liability claims and if, after the transaction has been completed, third parties bring legal action against the target company, the seller is required to bear all costs incurred due to the assertion of these claims.

It is generally in the buyer’s interest to organise and conduct the defence against third-party claims by himself, because the implications of such claims for the target company's business primarily affect him. Thus, from the buyer's point of view, it might be reasonable to agree to a quick settlement, e.g. in order to avoid damage to the company's reputation. Cost aspects can, by contrast, be of secondary importance, as these costs are borne by the seller as part of the indemnity or warranty obligation.

From the seller's point of view, on the other hand, it is often reasonable to be granted certain rights to influence the dispute between the buyer, or the target company, and third parties, e.g. to prevent unreasonably high settlement amounts or to influence the costs of legal defence.

Regulations that could be included in the agreement in this regard are manifold. In any case, the agreement should regulate at least cooperation obligations of the parties. Furthermore, it is possible to grant the seller the right to access only certain documents and information or the right of consent for certain issues such as the selection of legal advisers or regarding the conclusion of a settlement; the seller might also be granted the right in some cases to take control of the defence against third-party claims. From the buyer's perspective, it is always desirable to have control over handling third-party claims and to reasonably grant the seller the right to receive certain information in order to involve the seller in the claims handling process at an early stage and thus to reduce the risk of later objections and discussions with the seller on the extent of costs to be reimbursed.