M&A Report – Delaware Decision Highlights Practical Difficulties in Seeking Indemnification for Third Party Claims in M&A Agreements

April 8, 2014

On March 27, 2014, Vice Chancellor Parsons of the Delaware Court of Chancery issued an opinion that provides valuable guidance for M&A practitioners drafting or complying with contractual provisions governing indemnification for third party claims.  In I/M^X Information Management Solutions, Inc. v. Multiplan, Inc. and HMA Acquisition Corp.,[1] the Vice Chancellor held that correspondence concerning a potential dispute from a third party to a party indemnified under a stock purchase agreement (the "SPA") and the indemnified party’s broad notice of claims to the indemnifying party were, in each case, insufficient to permit the claim to survive the claims survival provisions of the SPA.  The opinion highlights the importance of provisions in M&A agreements regarding potential third party claims and the requisite notice for triggering an indemnification obligation.

Background

In April 2011, HMA Acquisition Corporation ("Buyer") purchased several subsidiaries of I/M^X Information Management Solutions, Inc. ("Seller") pursuant to the SPA.  Multiplan, Inc. ("Multiplan"), an affiliate of Buyer, operated the purchased subsidiaries.  The SPA contained representations and warranties, including representations and warranties concerning material contracts involving the purchased subsidiaries.  The SPA also outlined the procedures the parties were required to follow to make an indemnification claim.  The SPA provided "[i]f any Action is commenced or threatened that may give rise to a claim for indemnification by any Indemnified Party, then such Indemnified Party will promptly give notice to the Indemnifying Party."  The SPA defined an "Action" as "any claim, action, or suit, or any proceeding or investigation, by or before any Governmental Authority or any arbitration or mediation before any third party."  It also provided a claims survival period, stating that no claim for a breach of representation or warranty of the SPA could be asserted unless such claim was asserted during the period ending on July 29, 2012 (the "Survival Period").  Finally, the SPA allowed an indemnifying party to assume the defense of a third party claim against the indemnified party.  To facilitate this right to defend, the SPA required that the indemnified party give notice of any such claim, but that failure to provide this notice would not relieve the indemnifying party from liability except to the extent that the indemnified party was materially and irrevocably prejudiced by such failure.  The parties also entered into an escrow agreement providing that the funds in escrow would be released at the end of the Survival Period unless there was a claim that had been properly asserted during the Survival Period which remained pending.

One of the purchased subsidiaries, Health Management Network, Inc. ("HMN") was a party to a Participating Hospital Agreement with Queens Medical Center ("Queens"), which allowed HMN to offer discounted rates to clients that HMN directed to Queens for medical services.  This contract was a material contract under the SPA.  Prior to May 2012, Queens informed Buyer that HMN might be in breach of this contract by providing certain discounted rates to the Veterans Administration to which it was not entitled.  Further, on May 31, 2012, Queens sent a letter to Multiplan stating that Kaiser Foundation Hospitals ("Kaiser") had improperly accessed the discounted rates and referring to language in the contract requiring the parties to negotiate a resolution.  In July 2012, Queens sent another letter to Multiplan, discussing only the Veterans Administration matter and requesting that HMN stop providing discounted rates to "third parties" not covered under the contract.  The letter noted that "[Queens] reserves the right to pursue all legal remedies if this matter is not resolved by July 17, 2012."  In September, Queens sent another letter asking to work with Multiplan to resolve the Kaiser issue.  This letter did not suggest that a lawsuit was threatened.

Prior to the end of the Survival Period, Multiplan and Buyer informed Seller about the issues under the Queens contract and claimed that they were entitled to indemnification under the SPA.  Seller claimed that Multiplan and Buyer failed to specify sufficiently the basis for their indemnification demand, and on July 26, 2012, Multiplan and Buyer provided additional information concerning the claim.  After the Survival Period expired, Seller demanded that funds remaining in escrow be released and sued Multiplan and Buyer to cause them to release the funds.

The Chancery Court Analysis

The Court of Chancery examined (i) whether Queens’ communications with Multiplan concerning Kaiser constituted a threatened third party claim under the SPA that gave rise to a claim for indemnification and (ii) if there was a valid claim for indemnification, whether Multiplan and Buyer provided sufficient notice of the claim under the SPA to Seller before the end of the Survival Period.  The Vice Chancellor answered each of these in the negative and granted partial summary judgment in favor of Seller.  Whether Buyer was entitled to indemnification in respect of the Veterans Administration issue was not the subject of the Vice Chancellor’s opinion.

First, the Vice Chancellor examined whether Queens had threatened to make a claim within the Survival Period.  Looking to the dictionary definition of "threatened," the Vice Chancellor determined that "the relevant inquiry . . . is whether [Queens] ‘gave signs or warnings’ to Multiplan that it was going to [make a claim] regarding the Kaiser issue or announced to Multiplan that it intended to, or that it was possible that it would, commence [a claim] regarding the Kaiser issue."  The Vice Chancellor noted that this required more than the simple notification of a problem; rather, Queens "also must have expressed that it was going to do something about that problem, in such a way that a reasonable person would understand that [Queens] was intending to press the issue through a proceeding before a third party." 

The Vice Chancellor found that Queens’ first correspondence to Multiplan concerning the Kaiser matter did not meet this standard.  He noted that Queens informed Multiplan of a problem concerning Kaiser’s access to preferential rates and provided written notification of its position in accordance with a provision of the contract between Queens and HMN.  This provision stated that, upon this notice, Queens and HMN would "work in cooperation"[2] to resolve the issue.  The Vice Chancellor found that a reference to this provision, and a lack of any reference to the provisions of the contract governing dispute resolution, did not evidence any intent on behalf of Queens to bring a suit against HMN.  The Vice Chancellor further bolstered his argument by noting that Queens contacted HMN concerning the Kaiser matter after the expiration of the Survival Period and requested that the parties work together to resolve the issue without threatening to bring suit.  The Vice Chancellor found that Queens had not threatened to bring a suit during the Survival Period, basing his conclusion on four grounds, namely that Queens’ communication of a potential dispute (i) was followed with additional, non-threatening communication; (ii) was not preceded by other communication between the parties; (iii) invoked a clause of the relevant agreement calling for cooperation; and (iv) lacked a deadline for response.

Multiplan argued that July correspondence between Queens and Multiplan showed that Queens had threatened to bring a suit in connection with the Kaiser matter.  In July, prior to the end of the Survival Period, Queens had written to Multiplan about the parties’ dispute concerning the Veterans Administration.  Queens ended this letter with a paragraph demanding that HMN "stop providing network access to third parties" and reserving Queens’ "right to pursue all legal remedies if this matter is not resolved by July 17, 2012."  The Vice Chancellor rejected this argument, stating that the relevant inquiry was whether a reasonable person would understand the "third parties" referred to in the Queens letter to include Kaiser or if the reference was limited to the Veterans Administration.  Because the letter made no reference to any party other than the Veterans Administration, and because Queens would consider such agency to be a third party, the Vice Chancellor found that an objective reader reasonably would have understood the term "third parties" to refer solely to the Veterans Administration.  As a result, the Vice Chancellor concluded that, although there may have been an issue with the Queens contract relating to Kaiser, a mere issue, standing alone, did not trigger indemnification rights under the SPA.  Instead, Queens also had to commence or threaten to commence an action in order for an indemnification obligation to arise under the SPA.

The Vice Chancellor went on to find that, even if Queens had threatened to bring a suit based on the Kaiser issue during the Survival Period, Seller would not be required to indemnify Multiplan for the suit because Multiplan failed to provide proper notice of the claim to Seller prior to the termination of the Survival Period.  Multiplan had provided notice to Seller about a possible breach of the relevant material contract, but nothing in the notice identified the Kaiser matter or differentiated it from the Veterans Administration matter.  Notably, the SPA gave Seller a twenty-day window from the time it received notice of a third party claim in which to determine whether it would assume the defense.  In order for Seller to make an informed decision about whether it would assume the defense of any claims related to the Kaiser matter, it would need at least "minimal information about the differences between the [Veterans Administration] and Kaiser issues."  Because Multiplan’s notice to Seller failed to identify the Kaiser matter or distinguish it from the Veterans Administration matter, the Vice Chancellor found that it was not sufficient notice under the SPA.

Multiplan argued that pursuant to the terms of the SPA, any failure to give notice to Seller did not negate Seller’s indemnification obligations except to the extent that Seller was prejudiced by such failure.  The Vice Chancellor rejected this argument, finding that the referenced provisions of the SPA did not absolve Multiplan from giving notice of threatened claims prior to the end of the Survival Period.  The Vice Chancellor found that this argument would render the provisions of the SPA that required that claims for breaches of representations and warranties be brought before the end of the Survival Period meaningless.  Finding that the SPA required that Multiplan bring claims, including claims involving threatened third party claims, prior to the end of the Survival Period, the Vice Chancellor rejected the use of what he referred to as "’placeholder’ language" in the notice to Seller.  If a broad notice that Queens had threatened to bring a claim based on a certain contract was sufficient, Multiplan could give this broad notice to Seller and then look back, after the end of the Survival Period, to find any possible claims fitting this broad description and attempt to include such claims in its claim for indemnification.  Accordingly, the Vice Chancellor found that Multiplan failed to give Seller appropriate notice under the SPA of the claims relating to the Kaiser matter.

Multiplan also argued that notification of the specific Kaiser issue was unnecessary because its sole notice obligation to obtain indemnification under the SPA was to notify Seller that Multiplan had a claim for breach of the material contracts representation and warranty in the SPA with respect to the Queens contract.  In other words, once Multiplan informed Seller that Queens had accused HMN of being in breach of the material contract, Multiplan had satisfied its claims notice requirement.  The Vice Chancellor was unpersuaded and seemed to focus on the nature of the claim as a third party claim, as opposed to a direct claim for breach of representation and warranty.  Again, the Vice Chancellor emphasized that Multiplan’s interpretation of the notice requirement as permitting a general reference to a breach would "undermine substantially" Seller’s right to decide whether to assume the defense of the third party claim.  The Vice Chancellor considered Multiplan’s concept of acceptable notice as akin to "placeholder" language that would impermissibly allow Multiplan to count the Kaiser issue as an indemnification claim after the expiration of the Survival Period.

Lessons Learned

This case highlights several issues pertinent to how M&A agreements treat indemnification obligations triggered by third party claims.  It is critical that an agreement clearly define what constitutes an indemnifiable third party claim, especially in light of claims survival provisions that might terminate claims not made on or before a certain date.  If an indemnifiable third party claim only arises when legal action is threatened or commenced by a third party, an indemnified party may find itself in the position of being aware of a possible claim but unable to seek indemnity during the claims survival period because the claim has not been threatened or commenced.  In particular, that the Vice Chancellor analyzed whether a claim had been threatened in light of correspondence occurring after the claimed threat highlights the risks of relying on language allowing indemnification only for "threatened" or actual claims.  Parties should carefully consider whether it is appropriate to allow an indemnified party to make a claim for indemnification, and thus preserve a claim beyond the claims survival period, when the party becomes aware of a potential third party claim even if such claim has not yet been threatened or commenced.  Relatedly, parties should carefully consider when it is appropriate to release funds from escrow.  Clear standards identifying whether a claim is "pending" on the escrow release date, and therefore permitting the indemnified party to keep funds in the escrow account, can help minimize disputes when a party is aware of potential third party claims, but such claims have not been threatened or commenced, on the release date.   Finally, parties aware of a potential third party claim arising near the end of any claims survival period should consider whether they can bring a claim directly against the indemnifying party for a breach of the underlying representation or warranty.

Further, parties to an M&A agreement should be mindful of any contractual claims survival periods as well as any applicable statutes of limitations.  Parties should review any indemnifiable claims, including claims on account of third party claims, that they might have during these periods and make sure that they have taken any necessary action to preserve these claims prior to the expiration of the relevant survival period.  These parties should further review the relevant M&A agreement to determine the specified requirements of any notice needed to preserve a claim and should make sure that any notice provided will allow the noticed party to make an informed decision concerning its rights, if any, with regards to such claims, including whether to exercise any right to assume the defense.  Specifying exactly what a notice of a claim for indemnification must contain in an M&A agreement can help provide certainty as to whether a notice is sufficient to preserve a claim.  Finally, parties seeking indemnification should make sure their notice identifies specific claims and does not rely solely on broad "placeholder language," which might not be effective to preserve their claims.

Conclusion

This decision highlights the importance of carefully considering the interactions between indemnification provisions and claims survival provisions in M&A agreements, particularly as they relate to third party claims.  Failure to address the interaction of these provisions can leave a party in a position where it is aware of a potential claim but unable to seek indemnification prior to the end of the claims survival period. 

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