Liability Cap

What is a liability cap?

Liability cap (German Haftungshöchstbetrag, also Haftungsobergrenze or indemnity cap) denotes the amount agreed in the company purchase agreement up to which the seller is liable in total. It covers claims of the buyer under warranties, that is, under assurances about the condition of the company, and, where agreed, under indemnities for individual assumed risks. Claims exceeding this amount are borne by the buyer.

The cap completes, at the upper end, the system of monetary liability limitations that begins with the de minimis threshold and the basket. It is negotiated together with limitation periods, security and knowledge rules and is often already outlined in the letter of intent (LOI). For sellers, it determines what part of the proceeds still remains economically at risk after closing (the transfer of the shares against payment).

Tiered liability caps

Company purchase agreements rarely work with a single cap. A tiering by type of claim is customary:

• Business warranties: for statements on contracts, employees, intellectual property rights or annual financial statements, the general cap applies. In practice it is often between 10% and 30% of the purchase price. In transactions with warranty insurance, which bears warranty losses in place of the seller, it is often significantly lower.
• Title warranties: for the existence and ownership of the shares, the seller is regularly liable up to the amount of the purchase price, because in the case of a defect in title the buyer loses the equivalent of its entire payment.
• Tax and special indemnities: these receive their own caps, often up to the purchase price or in the amount of the risk secured in each case.
• Overall limit: all claims together are as a rule limited to the purchase price that the seller has actually received.

In the contract, the clause reads in simplified form roughly: “The sellers' liability for claims for breach of business warranties is limited in total to 15% of the purchase price.” What counts as the purchase price must be set out in the contract: the amount at closing, the amount after purchase price adjustment, or additionally later payments from an earn-out. The reference figure is usually the purchase price for the shares (equity value), not the enterprise value including financial liabilities. It is also possible to reduce the general cap after a first period has expired, for example after the first audited annual financial statements under the new owner.

Statutory limits on limiting liability

Under Section 276(3) of the German Civil Code (BGB), liability for intent cannot be waived in advance for the debtor; this includes a monetary limitation. A second limit is set by Section 444 BGB. Under it, the seller cannot rely on an agreement that excludes or limits the buyer's rights to the extent that the seller fraudulently concealed a defect. The same applies to the extent that the seller has given a guarantee as to the quality.

Because of this second alternative, the warranties in company acquisitions are structured as independent guarantee promises and expressly not described as quality guarantees. According to the prevailing view, Section 444 BGB does not in any case cover limits that are part of the content of the guarantee from the outset; the clarification removes any remaining doubt.

Fraudulent intent (Arglist) does not require an intention to cause harm; conditional intent suffices: the seller considers an inaccuracy possible and accepts it. According to case law, a person who makes statements with no actual basis, at random, can also act fraudulently. If the seller has fraudulently deceived the buyer, the buyer can also rescind its declaration under Section 123 BGB. In German law, the dividing line runs between intent including fraudulent intent and negligence: liability for negligence, including gross negligence, can in principle be limited in an individually negotiated contract.

Special rules for defects in title and taxes

Title warranties concern defects in title in the narrower sense: the shares do not exist, do not belong to the seller or are encumbered with third-party rights. Because in these cases the buyer does not receive the core of the performance, a cap below the purchase price is unusual, and the limitation period runs considerably longer than for the business warranties. In an asset deal, the same applies to ownership of the assets transferred and title to the intellectual property rights transferred.

Tax risks are secured through the tax indemnity, which as a rule sits outside the general cap. Its own cap is often based on the purchase price, because the amount of possible additional claims from tax audits cannot be foreseen when the contract is signed. For special indemnities, by contrast, the cap is usually based on the risk known in each case.

Liability cap with several sellers

If several persons undertake by contract jointly to perform a divisible obligation, they are, in case of doubt, liable as joint and several debtors under Section 427 BGB. The buyer could then demand the entire amount from a single seller, who in turn must seek recourse from the others (Section 426 BGB). Sellers therefore generally agree on proportionate liability by shareholding, with a separate cap for each seller.

In addition, the warranties are often distributed by role. Financial investors, for example funds in private equity and venture capital, usually give only title warranties and limit their liability to their own proceeds. The business warranties are taken on by founders and managing directors, who know the company operationally. For these warranties the buyer then has access to only part of the proceeds, which is a frequent reason for warranty insurance.

Cap, security and warranty insurance

A retention in an escrow account secures claims but does not limit them. If justified claims exceed the escrow amount, the buyer can assert the remainder against the seller, unless the contract expressly declares the escrow amount to be the sole source of satisfaction. With warranty insurance, the seller's cap often falls to a part of the policy's retention, that is, the share of the loss that the insurer does not cover, or to a symbolic amount. For losses above this amount, the buyer turns to the insurer, limited by the limit of cover.

Worked example: liability cap in a sale by two founders

Two founders sell all shares of a GmbH (German limited liability company) for EUR 20 million; founder A holds 60%, founder B 40%. Agreed are a general cap of 15% of the purchase price for business warranties, a tax indemnity up to the amount of the purchase price and proportionate liability by shareholding. After closing, warranty claims of EUR 3.6 million are established after deduction of the basket. In addition there are additional taxes from a tax audit of EUR 0.8 million.

• General cap: 15% of EUR 20 million = EUR 3.0 million
• Warranty claims: of EUR 3.6 million, EUR 3.0 million is compensated, EUR 0.6 million is borne by the buyer.
• Tax indemnity outside the general cap: EUR 0.8 million in full
• Total payment: 3.0 plus 0.8 = EUR 3.8 million, far below the overall limit of EUR 20 million
• Share of founder A: 60% of EUR 3.8 million = EUR 2.28 million
• Share of founder B: 40% of EUR 3.8 million = EUR 1.52 million

Without an agreement on proportionate liability, the buyer could, for warranties given jointly, in case of doubt demand the entire amount of EUR 3.8 million from founder A under Section 427 BGB, for example if founder B has already committed the proceeds elsewhere. If a founder had fraudulently concealed the circumstance behind the warranty claims, all contractual limits would fall away as against that founder. The buyer could then also demand from that founder the uncompensated part of EUR 0.6 million and the basket deducted earlier.

Distinctions: liability cap, basket, escrow amount and limit of cover

• Indemnity cap: synonymous term from US usage, in which indemnification also covers compensation for breaches of warranty.
• Basket and de minimis threshold: determine from when the seller is liable; the cap determines up to what sum.
• Escrow amount: security for claims of the buyer; it limits liability only if the contract expressly provides so.
• Limit of cover: upper limit of the insurer's payment under the warranty insurance, independent of the seller's cap.

Common mistakes

• Open purchase price concept. If it remains unclear whether earn-out payments or purchase price adjustments change the cap, the upper limit itself is disputed.
• Exceptions that run wild. If further topics beyond title warranties and taxes are excluded from the cap across the board, the limitation loses its effect.
• Joint and several liability overlooked. Without an express rule, several sellers are in case of doubt each liable for the entire amount.
• Escrow amount misunderstood as a liability limit. Without an express agreement, the seller is also liable beyond the escrow amount.
• Fraud risk underestimated. Answers in due diligence that are given without sufficient basis can support an allegation of fraud, against which no cap protects.

Frequently asked questions

How high is the liability cap usually in a company sale?

As a rule of thumb 10% to 30% of the purchase price for the business warranties and up to the full purchase price for title warranties. If warranty insurance is taken out, the seller is often liable only with a small amount.

Does the liability cap also apply in the case of fraud?

No. Liability for intent cannot be limited in advance under Section 276(3) BGB. In the case of fraudulent concealment, the seller moreover cannot rely on liability limitations under Section 444 BGB.

Is each of several sellers liable for the entire amount?

In case of doubt yes, if they give the warranties jointly, because anyone who undertakes an obligation jointly is liable as a joint and several debtor under Section 427 BGB. Proportionate liability by shareholding is therefore generally agreed.

Is there a liability cap in other contracts too?

Yes. Liability limitations also appear in service, software and licence agreements and in some cases in non-disclosure agreements (NDAs). If they are pre-formulated, the law on general terms and conditions (Sections 305 et seq. BGB) sets narrower limits. Liability for gross negligence and for injury to life, body and health can then as a rule not be validly limited.

How long is the seller liable up to the cap?

That is determined not by the cap but by the contractual limitation period. It is tiered by type of claim; business warranties generally expire earlier than title warranties and tax indemnities.

The Roemer Capital view

For every seller, Roemer Capital calculates what part of the proceeds still remains at risk after closing. This includes the share in the general cap, the separately capped indemnities and the amount tied up in an escrow account. When comparing the offers of several bidders, this calculation is often more informative than the purchase price alone.

In the negotiation, Roemer Capital treats cap, limitation period and security as one package and pays particular attention to the allocation between the sellers. The legal drafting of the liability clauses is handled by the client's law firm.