Basket and Cap, explained

Limiting post-close liability: Understanding “baskets” and “caps”

A “basket” and “cap” refers to a limitation of liability, whereby the “basket” (sometimes referred to as the “floor”) is the threshold that a party must meet in order to bring a claim against an alleged breaching party, and the “cap” is the maximum amount of liability the alleged breaching party may be subject to for such breach. A basket and cap can be negotiated in any transactional agreement; however, in real estate, the concept is most often negotiated by a seller in a purchase agreement to limit the seller’s liability to the buyer with respect to a breach of its representation and warranties in the purchase agreement. The following is an example of a basket and cap from a purchase agreement (emphasis added):

Notwithstanding anything to the contrary contained in this Agreement:  (i) the maximum aggregate liability of Seller, and the maximum aggregate amount which may be awarded to and collected by Buyer for any and all breaches of representations or warranties under this Agreement shall not exceed an amount equal to [                                             ] (the “Cap Amount”); and (ii) no claim by Buyer alleging a breach by Seller of any representation or warranty of Seller contained herein may be made, unless and until such claim, either alone or together with any other claims by Buyer alleging a breach by Seller of any of its representations or warranties, is for an aggregate amount in excess of [                     ] (the “Basket Amount”), in which event Seller’s liability for such claim or claims shall be for the entire amount thereof, subject to the Cap Amount set forth in clause (i) above.

Negotiable Points

The basket and cap amounts are always negotiable, and the amount will often vary depending on the purchase price. Typically, the cap amount ranges from one to five percent of the purchase price, although, depending on the asset type, purchase price, market conditions, and relative leverage of each of the buyer and seller, the cap amount can vary greatly. Additionally, depending on the type of transaction, some buyers and sellers may negotiate different cap amounts with respect to different representations and warranties (i.e., no cap amount on “boilerplate” representations relating to the seller’s authority to enter into the sale).

Basket amounts oftentimes are dependent on the purchase price as well, although the range of variability is somewhat narrowed compared to cap amounts. Basket amounts typically fall between $15,000 to $100,000, regardless of purchase price. Of note, a buyer will want to ensure it includes language that states the Basket Amount is an aggregate amount for all claims (i.e., if two separate claims collectively meet the Basket Amount (but individually do not), then the Basket Amount is satisfied, and a claim can be brought). In the example provision above, this is achieved by the language “either alone or together with any other claims…is for an aggregate amount.”

Similarly, with respect to the Basket Amount, a seller and buyer will negotiate whether claims made in excess of the Basket Amount are for the entire amount of the claim, or only for the portion of the claim that exceeds the Basket Amount. A buyer should negotiate to be able to make a claim for the full amount, which is how the example provision above operates (i.e., “in which event Seller’s liability for such claim or claims shall be for the entire amount thereof”). This is known as the “first dollar” method since the claimant can make a claim for the “first dollar” it has lost, and is often referred to as a “tipping basket.” Buyers will argue this is a reasonable outcome because the intent of the Basket Amount is to pass a certain amount of risk to the buyer (i.e., if a buyer does not exceed the Basket Amount in any claim, then the buyer must assume such a loss), but not to be a “credit” to the seller for any seller defaults. In fact, the “first dollar” method is the most common approach used in real estate transactions. Nonetheless, a seller with a lot of leverage may be able to negotiate that only amounts in excess of the Basket Amount could be recovered, in which case, the buyer is effectively awarding the seller a “credit” in the amount of the Basket Amount.

Lastly, a buyer will want to explicitly negotiate that any fraud or intentional misrepresentation (and potentially gross negligence) by the seller is carved out from the cap requirements. The cap is not intended to protect the seller from bad acts, but rather unintentional misrepresentations.

Examples

Example 1:

Basket Amount: $25,000

Cap Amount: $1,000,000

Claim Amount: $10,000

No claim can be made, because the Claim Amount does not exceed the Basket Amount. The buyer is forced to absorb the $10,000 loss.

Example 2:

Basket Amount: $25,000

Cap Amount: $1,000,000

Claim Amount: $100,000

A claim can be made because the Claim Amount exceeds the Basket Amount.

If the first dollar method is being applied, a claim for the full Claim Amount ($100,000) can be made. Unlike Example 1, since the Claim Amount has now exceeded the Basket Amount, the buyer can recover the full amount of its claim (including the first $10,000 that were forfeited in Example 1).

If the first dollar method is not being applied, a claim in an amount equal to the Claim Amount minus the Basket Amount can be made ($100,000 – $25,000 = $75,000). Therefore, the buyer has essentially granted the seller a $25,000 credit, and must come out of pocket for such costs.

Example 3:

Basket Amount: $25,000

Cap Amount: $1,000,000

Claim Amount: $2,000,000

A claim can be made because the Claim Amount exceeds the Basket Amount. However, the Claim Amount exceeds the Cap Amount and, as a result, a claim for only $1,000,000 may be made, and the buyer is forced to absorb the losses in excess of the Cap Amount.  Provided however, that if the alleged breach is the result of fraud or intentional misrepresentation by the seller, and such acts are carved out from the Cap Amount in the purchase agreement, then buyer would be able to bring a claim to recover the entire $2,000,000.

Other Limitations on Liability

A basket and cap are just one method of limiting a party’s liability. A seller should also include a survival period and anti-sandbagging provisions to limit its potential liability.