In any share or asset purchase transaction, invariably a lot of time is spent discussing warranties and indemnities. Sellers and buyers often have questions about the difference between the two. This blog looks at:
• The purpose of warranties and indemnities
• How they differ
• How they fit in with the overall transaction process
What is the purpose of warranties and indemnities?
Where shares or business assets are being sold, there is no automatic protection for the buyer as to the extent, nature, quality, etc. of the things it will acquire. The only protections a buyer will have will be those that are included within the sale contract.
Warranties and indemnities are each forms of contractual protection for the buyer. They are used in both share and asset sales.
What is a warranty?
A warranty is a contractual statement as to the condition or state of affairs of the company or business being acquired at a particular point in time. The seller gives warranties to the buyer.
For example, the seller might give a warranty that it is not aware of any current or pending litigation against the company being sold. This would be an important assurance for a buyer.
Another example might be a warranty that the target company has not received any notice of termination of any of the company’s material contracts, and there are no grounds for those contracts to be terminated. Again, this could be an important matter for the buyer who may be valuing the target company on the basis that its key contracts would continue in force after the purchase.
What remedy does the buyer have if a warranty turns out to be untrue?
A buyer will be able to claim damages for a breach of warranty if it can show that the warranty was untrue when given and that the breach caused a reduction in the value of the company at that time.
Where a warranty has been breached, the buyer is under a duty to mitigate its loss. If it unreasonably fails to take steps to avoid or reduce its loss, the amount of damages it can claim from the seller may be reduced accordingly.
So there are a number of hurdles for a buyer to overcome to succeed in a damages claim for a warranty breach. In particular, it may be difficult to establish that the breach has reduced the value of the company.
What is an indemnity?
An indemnity is a contractual promise by the seller to the buyer that it will reimburse the buyer, typically on a pound for pound basis, in respect of a particular type of liability should it arise.
For example, if there is a known environmental issue for which the target could be liable prior to completion, the buyer might negotiate an indemnity to be given by the seller. If the liability does in fact come to light after the purchase completes, the seller would have to reimburse the buyer in respect of that liability.
An indemnity seeks to place the risk of the liability arising entirely with the seller. Unlike warranties, there is no requirement for the buyer to prove that the company’s value has reduced as a result of the liability having arisen.
Buyers sometimes ask us whether the sale agreement can just contain indemnities rather than warranties. This is not the norm in UK sale agreements. Sellers are often not willing to accept an increased level of potential risk.
In practice, indemnities are used to cover a limited number of specific risks which are of particular concern to the buyer, such as an environmental or tax liability.
Where does “due diligence” fit in to all this?
Part of the sale process involves the buyer carrying out “due diligence” on the target company or business. The buyer will typically investigate all aspects of the target including commercial, financial, legal, and environmental matters.
Due diligence will seek to flush out any issues of concern to the buyer and identify appropriate areas to be covered by warranties or indemnities. These will be tailored depending on the nature of the target company or assets being sold, and the issues which are identified.
“Disclosure” by seller
A seller will seek to limit its potential liability for breach of warranty through “disclosure”. A buyer will not have a claim for breach of warranty to the extent that the facts which give rise to the breach are disclosed.
Disclosures are negotiated in a disclosure letter that is separate from the main agreement.
For example, a sale agreement might contain a warranty that there is no litigation against the target company. If, in fact, a personal injury claim has been brought against the company, details would be disclosed in the disclosure letter. The seller would not be liable to the buyer for breach of warranty in relation to that personal injury claim, to the extent of the disclosure.
Other limitations of liability
The sale agreement will almost always limit the seller’s liability for breach of warranty in some manner.
Common limitations include monetary caps and a time limit within which any claims can be brought.
Whether or not the seller will be able to limit its liability under the indemnities will be a matter of negotiation. The buyer will obviously wish to resist any such limitations.
Interaction of warranties, indemnities, due diligence and disclosure
Warranties, indemnities, due diligence and disclosure operate in conjunction with each other. They help a buyer to find out, before the sale completes, what potential issues there might be with the company or business that it is acquiring.
Where issues are identified, the buyer can then decide whether to:
• seek a price reduction;
• require something to be remedied as a condition of the sale completing;
• negotiate an indemnity rather than a warranty for a particular issue;
• walk away from the deal.
The above options are likely to be preferable to completing the sale and relying on a warranty claim to recover any loss further down the line.
How Brodies can help
Negotiating warranties and indemnities is an important process and can be complicated.
It is important that you take expert legal advice if you are buying or selling a business to ensure that the contractual protections are dealt with properly.
Brodies lawyers have significant experience of advising on, negotiating and drafting share and asset sale agreements and would be delighted to assist you.
For general information that you should consider when buying a business check out our handy guide.
On September 25, 2018