Survival, explained

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

In a written agreement, survival refers to the concept that certain provisions of the agreement remain effective (i.e., they “survive”) after termination, expiration, or “completion” of the agreement. For example, once a consulting agreement is terminated, a consultant is no longer bound by the terms of the agreement. But what if the consulting agreement included a provision that stated that, for a period of one year after termination of the agreement, the consultant could not poach any of the client’s employees. Surely, such a provision is enforceable after the termination of the agreement.

Or, in a purchase agreement for a real estate asset, a seller has represented and warranted to the buyer that there are no ongoing condemnation proceedings with respect to the subject property. Two months after closing, the buyer discovers that condemnation proceedings had been commenced prior to the buyer acquiring the property, and therefore the seller’s representation and warranty was incorrect when the purchase agreement was signed. The buyer relied on such representation and warranty, and now the property is being seized by the government. However, the purchase agreement expired at closing by virtue of the completion of the transaction. Can the buyer sue the seller for a breach of a representation and warranty?

This is the purpose of a survival provision in an agreement. A survival provision is included to protect a party to an agreement from having no recourse against the other party once an agreement is no longer effective. Typically, a party will negotiate that certain provisions “survive” termination, expiration, or closing, simply by inserting the following (or similar) language: “this Section shall survive the earlier of termination and expiration of the Agreement, and Closing.” If the client or buyer in our examples above included such language, they are in luck, and can make a claim against the consultant or the seller, as applicable.

Therefore, the client and the buyer are covered, but what about the consultant and the seller? How can they protect themselves from future claims? Do these provisions now “survive” forever? That is why it is important to specifically negotiate survival periods to limit the consultant and the seller’s potential future liability.

Survival Periods

Similar to basket and cap and “anti-sandbagging” provisions, a survival period (or “tail” period) is used to limit a party’s liability by limiting the period of time during which a claim can be brought with respect to certain provisions that survive termination or expiration of an agreement. In a real estate transaction, the survival period typically limits the period of time during which a claim can be brought for a breach of a representation or warranty. Essentially, a seller wants to ensure that at some point it is truly free of any liability relating to the property it sold, and therefore that the buyer cannot sue the seller for any breach of the representations and warranties the seller made in the purchase agreement.

Depending on the type of transaction, the market conditions, and the relative leverage of the parties, a typical survival period is between three and eighteen months. Additionally, depending on the type of transaction, some buyers and sellers may negotiate different survival periods with respect to different representations and warranties (i.e., in a REIT deal, representations and warranties with respect to taxes will often have a longer survival period since tax considerations are of such value in a REIT deal).

In addition to the survival period, it’s important to negotiate the terms regarding when a buyer can bring a claim. A seller should require that a claim be filed within a certain period of time after the expiration of the survival period. Some sellers may also require that the seller receives notice of the claim prior to the expiration of the survival period. The following is an example of a “pro-seller” survival provision:

The representations and warranties by Seller in this Agreement shall survive Closing and not be merged therein for a period of three (3) months (the “Survival Period”), and Seller shall only be liable to Buyer hereunder for a breach thereof if (i) Seller receives a written notice of a claim from Buyer on or before the expiration of the Survival Period, and (ii) Buyer has commenced an action in court on or before the date which is thirty (30) days following the expiration of the Survival Period.

A buyer should try to negotiate that such requirements be (1) removed entirely, or (2) softened by extending the periods of time during which the buyer can bring such notice or file such a claim.

(Click here to read about basket and cap and “anti-sandbagging” provisions.)

Credit-worthiness, Holdback and Backstop Agreements

Negotiating for the survival of certain provisions of an agreement is a good start, but it does not fully protect the party seeking to make a claim (i.e., the buyer) after the termination or expiration of an agreement. A buyer needs to ensure that if it makes a claim, a credit-worthy party exists against whom it can make such a claim.  In a commercial real estate transaction, a property is often owned by a “special purpose entity” or “single purpose entity” (SPE) (oftentimes an LLC), whose only asset is the property it owns. Therefore, once the property is sold, the entity has no assets. So, while a buyer may timely make a claim against the seller during the survival period and win, the buyer may have no means to actually enforce its judgement and recover its losses because the seller may have no assets.

In order to avoid such a situation, a buyer should negotiate that, until the expiration of the survival period (and until the resolution of any timely brought claim), the seller (or its affiliate) will maintain sufficient funds necessary to satisfy any potential post-closing liability. This is typically achieved in one of the three following ways (arranged from most buyer-friendly to least buyer-friendly):

First, a buyer can require that the seller deposit funds in escrow with the escrow company in an amount necessary to satisfy any post-closing liability (i.e., in an amount equal to the cap amount). Such funds will be held by the escrow company pursuant to an “escrow holdback agreement” until the expiration of survival period. If no claim is made during the survival period, the escrow company releases the funds to the seller. If a claim is brought during the survival period, the funds are frozen until the claim is resolved, and if the claim is successful, funds are distributed by the escrow company from the escrow account to buyer in order to satisfy such claims (and any remaining balance is returned to the seller). This is most favorable to the buyer because it guarantees funds are available for any claims it makes, and least favorable to seller since it denies access to sales proceeds for the duration of the survival period.

Second, a buyer can require that a “credit-worthy” entity “backstop” or guarantee the seller’s surviving obligations by entering into a backstop, indemnity, guarantee, or joinder to the purchase agreement. For example, if a seller is a “SPE,” but the SPE is owned by a multi-million dollar company (such as a real estate private equity fund) or individual, the buyer can require that such credit-worthy entity or individual guarantee the seller’s surviving obligations (much the way a credit-worthy party guarantees a loan or a lease). Therefore, if a claim is made and the seller has no assets, the buyer can make a claim against the credit-worthy entity and recover its losses. This is still favorable to the buyer, but less than option 1, since the funds are not readily available.

Third, a buyer can require that, until the expiration of the survival period, the seller retain assets necessary to satisfy any post-closing liability (i.e., in an amount equal to the cap amount). However, this is a much less secure option for the buyer than option 1 because, unlike in option 1, the assets are not funded into an escrow account controlled by an independent third-party, which leaves opens the possibility of abuse by the seller. The seller could breach this requirement (i.e., retain no assets), and the buyer would be hard-pressed to have any further recourse. In option 1, the escrow company serves as an independent third party who ensures that the required funds are held back; no such assurance is delivered here. Therefore, this is the least favorable mechanism a buyer can deploy, and the most favorable to a seller since the seller is given the flexibility to control the assets that it must retain in order to satisfy its obligations.

Other Limitations on Liability

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