Assuming Defense of Third-Party Claims: the Moral Indemnity Hazard Problem

The dispute resolution terms in merger agreements are technical and cause many non-lawyers to glaze over when reading them. Details about who controls the defense of third-party claims, jurisdiction, arbitration procedures and similar terms are not fun to read but can be very important if problems do arise later.

One issue worthy of special attention is which M&A party controls the defense of third-party claims. There are arguments on each side for wanting this control. On the M&A buyer’s side, the third-party claim is usually a claim against the combined company, and the buyer will want to control its exposure to such proceedings. On the M&A seller’s side, if the claim relates to an indemnifiable matter, any payment of fees or settlement amounts is likely to come from the escrow, so the selling stockholders are most likely to be the ones ultimately paying the bill.

If the party that controls the defense is not the party responsible for any related payments, there can be a moral hazard problem.

If the M&A party that controls the defense is not the party responsible for any related payments, there can be a moral hazard problem. It is certainly possible that the party with control of such matters will behave differently if their own money is not at stake. For instance, if the buyer controls the litigation but the payments are to come from the escrow, the buyer might be tempted to hire more expensive counsel than they otherwise would and might be motivated to agree to settlement terms early to avoid spending more time on the matter. Similarly, if the shareholders control the defense of a claim that will be subject to the indemnification basket or that might otherwise not be paid from the escrow, they might behave differently.

Even if behavior is not driven by the moral hazard issues, the parties may simply disagree on how best to handle the third-party dispute. One side might prefer hiring premier law firms and paying a premium, while the other may have a history of looking for value in service providers. In such cases, neither may like the way the other would manage the defense.

There are checks to this behavior in most merger agreements, such as requiring the other party’s reasonable consent to any settlement, but the moral hazard risk remains at least to some extent.

To address this, SRS Acquiom suggests focusing on which party is likely to bear the economic risk in the event of various third-party claims and ensure that they are involved, or at least have the opportunity to be involved, with the process. SRS Acquiom suggests that this be done in greater detail than just having a right to approve of any final settlement terms. For instance, the sellers might want to include terms that say sellers have a right to consent to selection of counsel or, alternatively, that the parties need to reasonably agree on the selection of counsel, the strategy and/or the budget. Sellers might argue that as long as the shareholders are responsible for the bill, the buyer arguably should be willing to give the sellers a say in such matters. There may need to be exceptions for matters such as equitable claims and sizeable third-party claims in excess of the escrow.

More typically, the buyer will agree to language clarifying the right of “the indemnifying parties, at their sole option and expense, to participate in, but not to determine or conduct, the defense of a third-party claim.” While not as favorable, this still gives sellers a seat at the table. A seller facing potential large third-party claims may address the moral hazard problem by crafting a provision by which the buyer has some responsibility for sharing the risk. One way to do this is limiting or eliminating the indemnifying party’s exposure for third-party claims after a certain dollar threshold, to give the buyer a financial incentive to settle or resolve claims cost-effectively. Buyers are often reluctant to allow sellers to assume the defense of third-party claims with any potential impact on the ongoing business or liability above the escrow.

The last thing either side to the merger wants is to resolve the third-party claim and then discover they now have to navigate a related dispute between the buyer and shareholder representative over the process of getting to that resolution. Addressing the moral hazard concerns early may help to avoid this.

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