The negotiation of the warranties and indemnities that are provided by a seller to a buyer in a sale of a business is an important as well as potentially risky part of the exit process if not controlled well.
To begin with, what are warranties and indemnities and why are they important?
Warranties (we look at indemnities later on) are contractual assurances given by sellers in the Sale and Purchase Agreement (“SPA”) about the condition of the business being sold and, in particular, any existing liabilities. For example, the seller may warrant that the business is not engaged in any litigation if it is not. These assurances are important to buyers since English law provides no generic protection for the buyer as to the business it is buying. Instead the legal principle is “caveat emptor” or “buyer beware!”. Therefore any buyer will seek warranties in order to get appropriate comfort over
any business it is acquiring.
More about warranties
Looking at warranties in more detail, they have two main purposes.
Firstly, warranties encourage “disclosure” by sellers of known issues and problems (e.g. ongoing litigation). This disclosure alerts buyers to potential problems before they incur any actual loss and at the point when they still have the option either to walk away or modify their offer.
Secondly, warranties provide buyers with a “remedy” following completion of the acquisition if the assurances made by the seller prove incorrect and, as a result, the buyer suffers a financial loss. Since a seller’s liability will be subject to various limitations and normally include a monetary cap on the amount that can be claimed, identification of the issues in advance of completion is preferable for buyers than suing sellers for breach of warranty following completion.
Damages for breach of warranty are calculated on a contractual basis and aim to put a buyer in the position it would have been in had the warranty been true. As claims are contractual, damages for breach of warranty will be reduced to the extent the buyer fails to mitigate its loss or where a loss is considered to be too remote.
Common areas for warranties
The scope of warranties and the areas that they cover should be tailored for each specific sale.
However, it is common for buyers to seek to cover the following main areas:
- Accounts, finance and banking arrangements
- Transactions with connected parties (e.g. associates, directors and employees)
- Commercial contracts
- Employees and pensions
- Intellectual property
- Information technology
- Compliance with law
- Constitutional matters (memorandum, articles of association and statutory books)
- Title to shares (if a share sale)
Disclosure and other limitations of a seller’s warranty liability
Sellers normally seek to limit their liability under the warranties that they give to buyers. Such limitations act as a “shield” for the seller to defend against or mitigate claims for breach of warranty. Moreover, a seller will not be liable under the warranties to the extent that they fairly disclosed any relevant matters in a document called the “Disclosure Letter”. For example, if the seller was aware of some ongoing litigation then it should disclose the details of this to the buyer in the Disclosure Letter. Whilst the buyer may seek a revision to the deal or an indemnity (see below) to cover the
identified risk, generally speaking if included in the Disclosure Letter there can be no claim for breach of warranty.
It is also important for sellers to negotiate a limitation on the time period during which a buyer may bring a claim for breach of warranty, since in the absence of any express agreement in the SPA statutory limitation periods will apply and buyers will have 6 years following completion of the transaction to bring a warranty claim under a simple contract or 12 years under a deed. Negotiated time limitation periods are normally anything between 12 months to 3 years (18 to 24 months being the most common).
Sellers should also ensure that they negotiate financial limitations on warranty claims. Warranties should be subject to both a minimum threshold and a maximum cap (often limited at the purchase price).
Indemnities are promises by the seller to reimburse the buyer for the exact amount suffered in respect of a specific liability. They differ to warranties in that they offer a guaranteed pound-for-pound remedy for a specific loss. Additionally, there is no obligation on the buyer to prove that any loss has occurred as a result of any inaccuracy in the information provided or statements given by a seller.
For this reason sellers should be careful to ensure any indemnities given are specific and limited in scope. Indemnities are often used where a material specific issue arises in due diligence (e.g. in relation to ongoing litigation with a dissatisfied client). It is also normal for tax liabilities relating to the seller’s period of ownership to be dealt with through a tax deed of indemnity.
The UK has so far resisted the buyer-friendly approach common in US M&A transactions under which all warranties are given “on an indemnity basis”. The UK practice is for sellers to only give indemnities in respect of specifically identified risks.
Payment of warranty and indemnity claims
Since any claim for breach of a warranty is only as good as the creditworthiness of the seller, there are a variety of measures with which buyers may try to ensure the seller retains sufficient funds to pay for any potential warranty claim. A common measure requires the depositing of part of the purchase price in a joint escrow bank account until expiration of the agreed warranty claim time period.
The negotiation of warranties and indemnities is often the most hotly contested part of the legal process of a sale transaction. Warranties and indemnities can also have a major impact on factors such as the timing of payment of proceeds and even the purchase price, and as such often play a part in the structuring of deals. For this reason, it is important for sellers to have expert legal M&A advice when offering and negotiating warranties and indemnities, and to ensure that a thorough disclosure process in undertaken.
Written by Charles Russell LLP for Boxington
This publication is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specific issues or transactions.
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