February 22, 2012
Assuming Defense of Third-Party Claims: The Moral Hazard Problem
Here is another excerpt from Shareholder Representative Services’ new 3rd Edition of “Tales from the M&A Trenches“:
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 other similar terms are not fun to read but can be very important if problems do arise later. One particular issue worthy of special attention is which party controls the defense of third party claims. There are good arguments on each side for wanting this control. On the 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 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 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. It is certainly possible that the party with control of such matter will behave differently if it is not their own money 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.
If the party that controls the defense is not the party responsible for any related payments, there can be a moral hazard problem.