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Hold Free And Harmless Clauses or Indemnification Clauses – One of the Main Issues in post contractual M&A Arbitration Proceedings

Mark C Hilgard, Mayer Brown, Germany

Most M&A transactions are subject of arbitration proceedings. As the parties – seller and purchaser – are not interested in disclosing details of their transaction to a court and the audience (or even the press!) that may be sitting there, the parties in M&A transactions (Share Purchase Agreement or Asset Purchase Agreement) almost as a rule agree on arbitration which by definition is confidential.

One of the main practical and controversial issues in M&A disputes are „hold free and harmless" clauses. There are of course many situations in which one of the parties may be inclined to use such clauses in the Purchase Agreement or Asset Purchase Agreement underlying the transaction. This article will only address the situation that the purchaser of a company ("Purchaser") wants to cover the company that he bought ("Target") and himself against risks that he is aware of but which he is unable to evaluate and thus feels unable to protect against them by way of a guarantee. These may be tax risks, environmental issues or risks emanating from governmental investigations or the financial exposure of the Purchaser (or the Target) resulting from debts or contracts of the Target, issues or which are connected with law suits of the Target. For the benefit of ease, this article only deals with the situation that the Purchaser, and not the Target, is the beneficiary of such a claim. It goes without saying that there are hundreds of different situations in which either the Target or the Purchaser or both are harmed by the relevant risk. All these risks are intended to stay with the seller of the company ("Seller"). The Purchaser simply does no longer want to deal with them.

In M&A transactions a contractually agreed provision to hold the Purchaser "free and harmless" can be a very useful tool to secure the Purchaser against risks which appear indeterminable at the time of the transaction.

As statutory law usually does not offer the solution that they need, the parties to an M&A deal themselves have to negotiate and finally agree on legally acceptable terms and wording of hold free and harmless clauses that exactly cover the relevant situation. This is of utmost importance to the Purchaser who wants to protect his investment and will be – in the scenario at hand – the beneficiary of such a clause. Absent an efficient provision in the SPA he finds himself "sitting between two chairs": On the one hand side he – or the Target company that he bought – is exposed to (or has to bear the financial burden of) a third party's claim, and on the other hand side he has to deal with a Seller who most likely will be unwilling to satisfy the third party and prefers to have the issue solved by Purchaser and third party without his own involvement.

The difficulties which arise in connection with "hold free and harmless" clauses are for some part based on the terminology used. In particular in situations in which the language of the M&A transaction is not English, the transfer of English terms into the applicable legal system can also change the meaning of the terms. Although the parties may have a view on what a clause may mean, under the applicable law there are English language terms which may not always mean the same when transferred into another legal system, and non-English parties may have their own view on what they aim at. Does "hold free and harmless" have the same meaning as "obligation to indemnify" or "compensation for loss" (or should it read "compensation against loss")? Does "indemnity" have the same meaning as "indemnification"? And how would you translate this into your language? If the parties use another language, for example the German language, they may confronted with the question whether "Freistellung" has the same meaning as "Befreiung". Which of the various English terms described above does entitle the Purchaser (or the Target) to be freed from a legal obligation, liability or risk? And how exactly does this work? And what exactly does it mean when the SPA stipulates that the Purchaser should be "held free"? Does this mean that the Purchaser as the benefitted party should not suffer any disadvantage at all? How exactly should this be implemented?

Since – at least in Germany – the kind and level of statutory warranty rights of a Purchaser does not meet the requirements of the parties of an M&A transaction, detailed and individually tailored contractual stipulations including those addressing "hold free and harmless" clauses, indemnification clauses and guarantees are considered necessary. Guarantees, which are a common feature in all M&A contracts, are not always the ideal solution for the problem at hand. In particular, if risks cannot be quantified (for example: an environmental accident may expose the Target to damages in the thousands, millions or even billions), "hold free and harmless" or indemnification clauses may fit much better; whatever the problem is, the Purchaser wants to get rid of it.

If a contract in the German language uses the word "Freistellung", unless negotiated differently, this typically covers the "obligation to indemnify" as well as an "obligation to defend" of the Seller as the obligor of the relevant obligation to hold free. That means that the party protected by such clause (in our scenario: the Purchaser) does not only have a right to be protected against third party claims, but also has the right to request from the Seller the takeover of the costs of his legal defense. On the other hand, the Seller's obligation to hold the Purchaser free and harmless includes the obligation to defend him (or the Target) against third party claims, whether or not they appear to be justified. Even if third party claims have no legal basis, the Seller as indemnifying party has to deal with them. It is simply not relevant whether or not the third party claims have a legal basis. Also, knowledge or intent of the party obligated to hold free and harmless is totally irrelevant. The purpose of the hold free and harmless obligation means that the Seller as the party who is obligated to hold free and harmless does not have a reimbursement claim against the Purchaser as protected party once the Seller as obligated party has successfully defended the third party claim (which in the English system is often referred to as "obligation to hold harmless").

As long as the third party claim has not been satisfied, the hold free and harmless claim is directed at the "holding free" of the obligation, but even if this is a pecuniary obligation it is not directed at the payment of money to the Purchaser as benefitor. Due to this particularity, the Purchaser cannot assign his right to be held free and harmless to any party other than the third party whose monetary claim is subject of the relevant hold free and harmless clause.

As M&A practitioners will probably agree, it is not at all sufficient to use a "standard" hold free and harmless clause in an SPA. Depending on the individual situation, in connection with a hold free and harmless obligation many details should be addressed in the relevant contract in detail. For example, the parties should agree on the due date of the hold free and harmless claim (in order to avoid that the claim becomes due immediately). Also, in many cases, the "joint" defense of Purchaser and Seller against third party claims requires a close cooperation between Purchaser and Seller. This cooperation should be regulated in detail as the interests of Seller and Purchaser will necessarily differ once the deal has been closed. The parties should also stipulate commencement and term of the statute of limitation. In this connection one could consider to agree on a certain date at which the statute of limitation stops running, to tie the statute of limitation to the due date or statute of limitation of the third party claim, or to the date at which knowledge or information of the third party claim has been obtained.

In order to avoid lengthy and costly post-contractual disputes, it is advisable to provide detailed provisions in a M&A transaction covering the situation that the Purchaser does not want to litigate the third party claim because he feels to be protected by the free and hold harmless clause and wants to shift the issue back to the Seller (i.e., solve the situation on the cost of Seller). Sometimes the Purchaser or the Target are under pressure to solve the issue quickly in order not to endanger the Target's or Purchaser's current business. In such a situation, the Purchaser may be tempted to settle the third party claim quickly rather than to litigate over years. What if the Purchaser concludes a settlement which the Seller does not like at all? Can the Purchaser force the Seller to hold him free and harmless of the impacts of the settlement even though the Seller would have preferred to litigate the third party claim vigorously? Thus, another important question is whether Seller or Purchaser is in control of the negotiations with the third parties. And also: who should bear the legal costs in connection with the negotiations and a potential settlement with the third party? If the parties have not agreed on individual stipulations in the SPA, then the parties may find themselves in a very uncomfortable situation later.

Hold free and harmless clauses may constitute powerful instruments for the parties; as very general rules may lead to a myriad of legal issues, the parties should address potential scenarios in as much detail as possible to secure that in a post-contractual conflict situation the wording of hold free and harmless clauses in an SPA offers a workable instrument to solve the situation. Otherwise, the Purchaser as the party entitled to enforce the hold free and harmless claim will find himself "between the chairs" and is endangered to be exposed to claims by the third party and by the Seller at the same time – a situation which is very likely to lead to arbitration