M&A Liability Caps on Indemnity Provisions in Light of Canada’s Elevated Interest Rate Environment

Until recently, Canada’s historically low interest rates, set by Canada’s central bank (the Bank of Canada), have provided ideal conditions for high levels of growth and business activity. However, since early 2022, growing fears of a global recession have spurred the Bank of Canada to double down on its policy of quantitative tightening, and to increase its interest rates for the eighth time in less than a year (at the time of writing), beginning in March 2022. As a result, Canada now has one of the highest policy interest rates among the G7 countries, second only to the United States.

As one might expect, these interest rate hikes are having a significant impact on the nature and requirements of many corporate and commercial deals.

While the appetite for transactions in Canada remains strong, particularly on the part of sellers wishing to exit markets, rising interest rates mean that the cost of borrowing has skyrocketed. Today, the leverage available to buyers is unfortunately much more costly, and carries greater risk than it did in 2021. The metrics used in calculating a buyer’s leverage have not changed, but the rapid rise in interest rates means that more consideration needs to be given to the liability and level of repayments that are interest vis-à-vis principal.

One of the most important considerations as part of an M&A deal involving any amount of risk should be the extent to which the seller’s indemnity obligations protect the buyer. Most transactions include indemnity clauses and provisions as part of the purchase agreement, helping to provide the buyer with security, recourse and recovery in the event of a default under the purchase agreement. In certain instances, the recourse or recovery amounts may include an agreed upper limit or “cap”, should the deal result in losses or harm to the purchaser (ie, breaches of the seller’s representations and warranties or non-compliance with covenants).

However, time and effort should be spent – by both the buyer and the seller – to understand exactly and how much any such indemnification will cover, especially when higher interest rates are involved. In this elevated interest rate environment, buyers need to make sure they are aware of whether their indemnity provisions will cover the cost of borrowing – in addition to any costs incurred through things like “break-up”/“breakage” fees and penalties if the deal turns sour.

In essence, a smooth transaction now requires greater awareness and consideration of the exposures that the higher cost of borrowing brings with it.

In times of lower interest rates, indemnity provisions can be capped at anything up to 100% of the transaction value, without having to allocate the risk of the higher cost of borrowing. When it comes to deciding the “ideal” cap to put in place, the view of one party may be wildly different from another’s. However, in light of higher interest rates and the aforementioned risks that come with them, a cap covering 100% of the purchase price may no longer be enough.

Indemnity provisions without caps can often provide adequate protection and recourse for the parties involved, especially when the risks and exposures are greater.

However, inherent to higher liability caps is the need for buyers, sellers and lenders to come to an agreement and understanding as to what is an acceptable level of risk versus compensation for everyone involved. As one might expect, it is often in the best interest of a seller to negotiate a lower liability cap, while it is often in the best interest of a buyer to negotiate a high liability cap. Indemnity caps have come to the forefront of many an agreement, and effective negotiation – specifically addressing liability limits – has never been more important.

In light of elevated interest rates, legal advisers now need to factor in a strong ability to work with their clients and/or the parties involved in any transaction, to manage expectations and help formulate new and alternative plans towards a successful deal. In any deal you approach, after considering the breakage fees that may be associated with any acquisition financing being used for the transaction, make sure that you and/or your clients have carefully considered and understand what liability and indemnification caps are included, and whether they provide you with the scope of protection, security and options that you are looking for.