Elisa Escobar


Agency problems in corporate[1] and contract law have been widely studied among scholars and practitioners of the law. In the science of economic analysis of contract law, it is well known that private agreements that allocate risks between two or more parties can also create a set of incentives that, in the end, reflect an agency problem,[2] Usually, contracts rule the conduct of such parties after the execution of the agreement through a combination of positive and negative covenants and standards of conduct. Since the use of the language is limited, not all scenarios are foreseeable for the parties; thus, there can be hidden incentives in certain clauses that will only arise when the clause or contract is performed.[3]

In typical M&A contracts, such incentives can be identified and managed by means of arrangements between the parties. For instance, there is a common agency problem and adverse selection dilemma that arises whenever an earn-out provision is agreed upon in an acquisition agreement.[4] Such earn out provisions rule on the potential payment from buyer to seller after an acquisition is consummated. Simply put, if the seller continues to manage the business after closing, then the incentives of the seller and the buyer to have a well performing target are generally aligned. However, clauses should be drafted in a way that avoid the risk of the seller of being overly engaged in risky business to obtain short term results but harming the company’s performance in the long term.

Another example of these kind of clauses that present an agency problem. When  a buyer and a seller agree on a special indemnity regime within a purchase agreement, there are usually divergent interest. An example can illustrate this divergence.

Suppose that Buyer – “B”, buys a 100% of the stock that Seller – “S” has in a Company – “C.” In negotiating the stock purchase agreement, B and S agree that this latter will indemnify and hold B harmless on any and all losses incurred by B and/or C, in connection to an ongoing claim of a governmental authority against C (the “Claim”). Suppose that the corporate purpose of C is a highly regulated one, thus, the relationship with such authority will be a considerably long-lasting one.

Absent any other provision ordering B’s conduct, B would have incentives to quickly settle the Claim in the terms offered by the authority and cease to pursue the Claim, just to preserve a good relationship of C with the Authority. In the end, S must indemnify the Company for whatever amount C ends up liable for under the Claim. This is certainly different from what S would prefer. It is likely that S will prefer to pursue the Claim until the end, if S believes that it has reasonable arguments to avoid liability when a final judgment on the Claim is obtained. However, this can certainly affect C’s relationship with the Authority in the long term, if the Claim is a long lasting and burdensome one.

Now, note that the agreement could also provide that, since S could be held liable for the losses arising from the Claim, then S will act as an agent before the authority, solely in respect to the Claim. This appears logic considering, among others, that S has first-hand knowledge of the facts of the Claim, that existed prior to the closing of the transaction.  Yet, if the Agreement fails to include a provision regulating clear limitations to such mandate, the incentives described above persist. An example can be helpful.

If the Authority offered a settlement to S,  then at least two could be the outcomes. S could agree to settle and finalize any dispute related to the Claim, in exchange of an amount of, say, $200. This means that S would have to pay or recognize the amount of $200 to B, for the loss of $200 incurred by C to settle with the authority. On the other hand, S could decide to move forward with the Claim and refuse to settle, as S considers that C has strong arguments to obtain more favorable conditions at a later stage of the Claim.

Suppose that S—a rational economic agent—decides to reject the settlement proposal and move forward with the Claim. This, as explained, S considers that a better settlement could be reached at a later stage. Contrarily, B  believes that it is safer to settle and that C assumes a liability of $200, for the sake of preserving a good relationship with the authority hereafter. B values its relationship with the authority in more than $200. In other words, B would have been willing to settle while S not. Their interests therefore diverge. This is where a boilerplate indemnity clause could fail. There are opposing interests between S and B, as the first will act seeking to reduce its liability to the least possible. Rather, B attributes a higher value to its long-term relationship with the authority, that could be disturbed as a result of the outcome of the Claim.

A well drafted indemnity clause should foresee challenges as the described. Since S is acting on its own benefit but also holds the representation of C, these interests may diverge. An indemnity procedure clause could solve this issue, by restricting the acts of S and subjecting those to B’s will. However, this would eventually affect B’s right to assert its indemnity under the agreement. 

If the indemnity clause mandated for S and B to act in coordination in relation to the Claim, this could also create coordination costs as both S and B would be acting as agents on behalf of C, and the decision-making process could be hindered.  Also, under this scenario, S could be deemed as principal, since the outcome of its indemnity obligation and potential liability depends on its coordination with B.

The examples above illustrate how indemnity clauses, as indicated, can either create agency problems or aid in solving them. The drafting of indemnity clauses and indemnification proceedings is quite challenging in the practice of M&A. Yet, these clauses are frequently underestimated or quickly overlooked.



[1] For agency problems in business organizations and corporate law in general, see, for example: John Armour, Henry Hansmann; Reinier Kraakman, Agency Problems and Legal Strategies, The Anatomy of Corporate Law (Oxford University Press) 29–48 (2017); see also, Robert C. Clark, Agency Costs Versus Fiduciary Duties, Harv. Bus. Sch. Press. (1985); Ronald J. Gilson, Controlling Shareholders and Corporate Governance: Complicating the Comparative Taxonomy, 119 Harv. L. Rev. 1641, 1650 (2006). (2006).  Three typical agency problems have been identified in corporate governance. Firstly, the agency problem between a controlling shareholder and the minority shareholders. See Mariana Pargendler, Controlling Shareholders in the Twenty-First Century: Complicating Corporate Governance Beyond Agency Costs (45 J., of Corp. L., Working Paper No. 483, 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474555. There is also an agency problem between shareholders, as the owners of the enterprise, and its management, as the agent. Finally, a very common agency problem has been identified as arising between the company and other stakeholders, mainly its creditors. This latter, being more latent in companies in financial distress. Sarah Paterson, The Paradox of Alignment: Agency Problems and Debt Restructuring, 17 Eur. Bus. Org. L. Rev., 497-521 (2016)

[2] Benjamin Bental, Bruno Deffains and Dominique Demougin, Interpreting Contracts: The Purposive Approach and Non-comprehensive Incentive Contracts, 50 Eur. J. of L. and Econ. 241, 265 (2020).

[3] Id.

[4] Srikant Datar, Richard Frankel, Mark Wolfson, Earnouts: The Effects of Adverse Selection and Agency Costs on Acquisition Techniques, 17 J. of L. Econ. and Org. 201,238 (2001) “Although earnout provisions may alleviate private information problems, these arrangements can also influence the incentives of the party managing the selling firm’s assets post-acquisition