Indemnification, Price Adjustment and Closing Conditions in an SPA: Designing Clauses on Conditions Precedent and Caps
Hello, I'm Noriaki Asato, Representative Attorney at LegalAgent.
In negotiating an SPA (Share Purchase Agreement), attention tends to focus on the representations and warranties and the transfer price. In actual transactions, however, the indemnification, price adjustment and closing clauses determine how the agreement plays out. If the parties do not agree on who takes on the issues found in due diligence (DD), the financial figures as of which date will be used to adjust the price, and what must be completed by the execution date, problems may arise at the execution and settlement stage. The chapter structure of the SPA as a whole and the interaction between its clauses are explained in The Structure of an SPA (Share Purchase Agreement) and an Overview of Its Key Clauses.
The SPA is the definitive agreement that puts the matters confirmed in the letter of intent and DD into a legally binding document. If the indemnification arrangements are inadequate, the buyer will struggle to deal with problems discovered later. On the other hand, if the indemnification liability is too broad, the seller bears the burden of carrying liability for a long time after the transaction. And if the standards for price adjustment remain vague, this can develop into a dispute over the amount payable after the transaction has been executed.
The Roles of Indemnification, Price Adjustment and Closing, and How They Interact
In an SPA, the three types of clauses on indemnification, price adjustment and closing function in relation to one another.
An indemnification clause is a provision that sets out which party bears losses, and to what extent, when breaches of representations and warranties or covenants occur, or when specific latent liabilities or tax or labor risks materialize. For the buyer, it is a means of claiming from the seller for past losses discovered after the acquisition, and for the seller, it serves to define the scope of contractual liability that remains after the transaction.
A price adjustment clause is a mechanism for adjusting the transfer price based on the financial figures as of closing. It is not always used in every M&A transaction, but in practice it is common to adopt a closing accounts approach or the like and calculate the equity value from the enterprise value based on changes in cash, interest-bearing debt and working capital. The parties determine in advance which balance sheet date will be used and who will be responsible for the calculation.
A closing clause is a provision that sets out the date and procedures for delivering the shares and paying the price, the conditions precedent to execution and the documents to be delivered on the day. Even after the SPA has been signed, the parties proceed to execution only after confirming that the conditions precedent have been satisfied or waived to the extent permitted by law and the contract.
The design of the contract as a whole changes depending on whether a problem found in DD is to be corrected in advance, deducted from the purchase price or made subject to a special indemnity. In reviewing the contract, the basic task is to determine how these three types of clauses support one another.
Designing Indemnification Clauses and Defining the Scope of Liability
The background to including an indemnification clause is that the scope and duration of what can be investigated in DD are limited. Even if the buyer conducts checks within a limited time, it cannot necessarily grasp in advance every issue such as unpaid overtime pay, past tax risks and defects in the ownership of intellectual property rights. Even where there is no indemnification clause, there remains room to consider claims based on law or other contract clauses. However, judging whether the requirements for a statutory claim are met and proving the loss require separate consideration, so in practice it is more useful to specify in the contract the requirements, period, cap and procedures for claims.
When defining what is covered by indemnification, in addition to breaches of representations and warranties and covenants, the parties consider whether to cover individually specific latent liabilities identified in DD, such as particular tax liabilities, labor risks or intellectual property risks. Comprehensive wording such as "any and all losses arising in connection with this Agreement" requires careful consideration, because it easily leads to unexpected liability for the indemnifying party. It should also be noted that whether the scope of compensation includes not only direct losses but also lost profits and attorneys' fees is not something automatically excluded as indirect losses, but is determined by the contractual definitions and the interpretation under the governing law.
As for the period during which claims can be made, one approach is to distinguish ordinary representations and warranties from those on tax and the company's fundamental matters, and to set the period item by item, taking into account when problems are likely to come to light and the statutory limitation periods. In addition, the parties check whether there is a cap on liability, a basket clause exempting minor losses, and an exclusion of matters disclosed in DD from indemnification (exclusion by disclosure). The buyer places importance on whether material risks are sufficiently covered within the cap, while the seller aims for a structure in which it is not held liable for disclosed matters that it has already explained to the counterparty.
Calculation Rules for Price Adjustment and Procedures for Preventing Disputes
When DD finds unpaid overtime pay or a failure to obtain consent under a key contract with a business partner, the parties decide in advance whether to adjust for it by reducing the transfer price, make it a condition precedent to closing, or address it through covenants or a specific indemnity. This choice is made by comprehensively taking into account the size of the amount involved, the likelihood of occurrence, the seller's financial resources and bargaining power, and the like.
In price adjustment using a closing accounts approach or the like, the reference balance sheet is compared with the balance sheet as of closing to confirm changes in cash and deposits, interest-bearing debt and normalized working capital. In practice, disputes easily arise over what to include, so the contract organizes items so that opposite-direction items, such as loans receivable from officers (an asset item) and loans payable to officers (a liability item), are not confused, and defines how accrued bonuses and lease obligations are to be included in the calculation of net debt or working capital while avoiding double counting. On the procedural side, too, clarifying the steps, such as who prepares the statement and by when, how many days the counterparty has to raise objections, and how a third-party expert such as an independent certified public accountant will be involved if the parties cannot agree, makes it easier to prevent disputes after the transaction.
Organizing Closing Conditions and Allocating Risk Between the Parties
An M&A transaction is not complete simply by signing the SPA. There are many matters to be completed by the execution date of the transfer, such as obtaining the consent of business partners and financial institutions, approvals by the shareholders' meeting or board of directors in accordance with the articles of incorporation and the Companies Act, and entering into employment contracts with key officers and employees. The allocation of risk between the parties changes greatly depending on whether these are set as conditions precedent (CPs) to closing or left as post-closing covenants.
In confirming the conditions precedent, the parties verify whether the representations and warranties are accurate as of the execution date, whether the covenants have been performed, and whether the necessary procedures under laws, regulations, permits and licenses have been completed. A provision may be included allowing the counterparty to waive satisfaction of a condition precedent that has not been met, but statutory requirements that cannot be waived between private parties, such as approval resolutions under the Companies Act and permits or licenses required by law, cannot be waived.
Preparing the documents to be delivered on the day is also essential. Documents suited to the company's structure and the transaction scheme must be arranged without excess or omission, such as notice of approval of the share transfer according to the company's corporate bodies and articles of incorporation, a request to amend the shareholder register or a certificate of matters stated in the shareholder register, seal certificates and officers' letters of resignation (including the requirements for delivering share certificates in the case of a company that issues share certificates).
The buyer's concerns lie in whether it can reliably recover from the seller losses arising after the acquisition, whether the seller has sufficient financial resources, and whether key consents necessary for continuing business will be left outstanding. The seller's concerns, by contrast, lie in not remaining bound by excessive liability after the transaction is completed and not suffering an unexpected price reduction because of vague definitions of debt and the like. An SPA can be described as an agreement for appropriately allocating the uncertainties identified in DD among price, execution conditions, limitations on liability and dispute resolution procedures, rather than aiming for a one-sided transfer of risk.
Related Practical Checks Before and After the SPA
When proceeding with contract negotiations in M&A, preparation throughout the transaction as a whole, such as the preliminary investigation, the design of representations and warranties and the outlook for costs, is helpful.
- What Is Legal Due Diligence? Its Purpose, Process, Required Documents and Costs
- M&A Attorney Fees: Fees for Legal DD, the SPA and Closing
- Risks Founders Tend to Overlook in SPA Representations and Warranties
Where to Consult on SPA Indemnification and Price Adjustment
The indemnification, price adjustment and closing clauses cannot be considered in isolation from one another. At LegalAgent, based on the results of the preliminary investigation and the individual negotiation policy, we check whether the contract clauses will function effectively at the time of execution of the transaction and afterwards.
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