M&A Vocabulary – Understanding the Experts: “Third Party Claims”

In negotiations of share purchase agreements, the scope of the seller’s liability is regularly one of the most important points of negotiation. While the identification of existing and future risks is carried out through due diligence, the distribution of risk is primarily managed through the design of the liability provisions in the purchase agreement.

Indemnities usually concern risks known to the parties, although the magnitude of the risk and the timing of its realization often cannot yet be estimated. The seller indemnifies the buyer against future liabilities based on circumstances prior to the transaction. For example, these could be remediation costs due to environmental liabilities or tax liabilities for assessment periods in which the seller managed the company.

In addition, the seller generally provides representations and warranties (so-called Reps & Warranties). Their subject matter and scope depend on the specific characteristics of the target company. Frequently granted warranties concern the existence and freedom from encumbrances of the sold shares, the accuracy of the annual financial statements, ownership of intellectual property rights, the validity of material contracts, adequate insurance for the target company, the non-existence of litigation, and the presence of public law permits.

In the case of liabilities that may arise from third-party claims (e.g., from product liability) and fall within the scope of an indemnity or warranty obligation of the seller, care must be taken to establish provisions for the specific handling of such claims. In particular, rules should be established regarding who controls or assumes the defense against third-party claims and how and in what form the other contracting party can or may support or intervene. Furthermore, it should be regulated how to handle obviously unfounded claims.

If, for example, the seller has granted the buyer an indemnity for claims arising from product liability and third-party lawsuits are filed against the target company after the transaction is closed, the seller is obliged to bear all costs incurred by the assertion of these claims.

The buyer generally has an interest in organizing and leading the defense against third-party claims themselves, as the future impact on the target company’s business primarily affects them. From the buyer’s perspective, it may make sense to agree to a quick settlement, for example, to avoid reputational damage. In contrast, cost aspects may take a back seat, as these costs are to be borne by the seller under the indemnity or warranty obligation.

From the seller’s perspective, however, it is often sensible to be granted certain rights regarding the buyer’s or target company’s dispute with third parties—for example, to prevent an inappropriately high settlement or to maintain influence over the costs of the legal defense.

The conceivable regulations are diverse. In any case, at least cooperation obligations of the parties should be included in the contract. Furthermore, it is possible for the seller to receive only certain inspection and information rights, or even consent rights regarding specific topics such as the selection of legal advisors or the conclusion of a settlement, or even the right to take control of the defense against third-party claims under certain circumstances. From the buyer’s perspective, it is always desirable to maintain control over third-party claims and reasonably grant the seller certain information rights in order to involve them at an early stage, thereby reducing the risk of later objections and discussions with the seller regarding the scope of the costs to be reimbursed.

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