Warranties and indemnities are terms which corporate and M&A solicitors often get rather excited about. However, as a seller or purchaser of a company or business, do you need to understand exactly what these terms mean and why they are needed, or are they something you can leave to the legal team?
Here, we explain why these terms are necessary in the context of an acquisition of a limited company.
Types of acquisitions: share sales and asset sales
First, we need to consider the two main types of acquisition of a limited company:
- Share sale – in a share sale, the shares of the limited company which runs the business are sold to a third party (a purchaser). This results in the purchaser acquiring the entire company and the business, i.e. all assets, liabilities and obligations. The only thing that changes on the face of it, is the shareholders. As part of the sale process, the purchaser and his advisers will carry out detailed investigations into the company and business; the due diligence process.
- Asset sale – in an asset sale, specific assets of the business are sold to a purchaser. This results in the purchaser being able to cherry-pick the parts of the business that he wants to acquire.
In English law, ‘caveat emptor’ or ‘let the buyer beware’ applies. As a result, a purchaser will want certain protections from the seller in relation to the purchase and this is where warranties and indemnities come in.
What is a warranty?
A warranty is a contractual statement of fact about the company and/or business, included in a purchase agreement. If it subsequently comes to light that a warranty was untrue, the purchaser will have legal recourse against the seller for contractual damages.
In a share sale, warranties can be extensive and are likely to cover all aspects of the company and business. For example, there will be warranties on the legal structure and administration of the company, the finances of the company, the property owned by the company, the employees, any litigation and so on. In an asset sale, the warranties will only need to cover the assets being acquired and may well be very limited.
A seller, in conjunction with his legal team, will need to carefully read through the warranties and ensure that he is happy to make those statements. In some cases, limiting the warranties to the seller’s awareness or inserting specific dates into the warranties may provide comfort to the seller, particularly in relation to potentially far-reaching warranties, i.e. that there is no litigation in the pipeline.
Watch our video on warranty claims when buying a business below:
A seller is protected against a claim for a breach of warranty if the purchaser had knowledge of the situation prior to entering into the purchase agreement. As a result, the seller and his legal team will prepare a disclosure letter against the warranties. A disclosure letter sets out exceptions to the warranties. For example, a warranty may be given that the company being sold is not involved in any employee disputes. If, however, this is not true and the company is involved in an employee dispute, the disclosure letter will specify the details of this. The purchaser will then be unable to bring a claim against the seller for a breach of that particular warranty in relation to that particular employee dispute. However, it is possible that the purchaser will then require an indemnity to cover any loss which subsequently arises from that employee dispute post-sale.
As a result of the disclosure exercise, warranties also elicit information about the company and business being acquired for the purchaser. Some disclosures may not be surprising to the purchaser following the due diligence process but other disclosures may seriously affect the transaction.
In order to provide adequate disclosure, it is necessary for the legal team and the seller to go through the warranties carefully, particularly those relating to the running of the business. Depending on the size of the company being sold, different people may need to be involved in different parts of the disclosure exercise, for example, the Chief Finance Officer may need to deal with the finance warranties, the head of HR may need to deal with the employment warranties, and so on. It is in the seller’s interests to be as detailed in the disclosures as possible. Disclosure may seem like an onerous exercise but from the seller’s point of view, it can avoid potential warranty claims at a later date.
Remedy for a breach of warranty
A warranty which turns out to be untrue provides the purchaser with a claim against the seller for breach of contract. If the purchaser is successful in his claim, the seller will be obliged to pay contractual damages to him thereby restoring the purchaser to the position in which he would have been had the warranty been true. However, there are a number of reasons as to why the full amount may not be payable by the seller:
- Knowledge – if the purchaser has knowledge that the warranty is untrue, he will not be able to bring a claim (see Disclosure above).
- Mitigation – the purchaser has a duty to mitigate the damage done by the breach of warranty and a failure to mitigate may affect the amount of damages awarded by the court.
- Remoteness – if the loss suffered by the purchaser is too remote from the breach of warranty, then the amount of damages awarded by the court will be affected and the claim could even fail.
- Limitations of liability – under law, there are certain limitations which apply to a claim for breach of contract, for example, the time period in which a claim can be brought. However, these limitations are likely to be further curtailed in the contract itself. Purchase agreements usually include various limitations of liability, including, the period of time in which a claim under the contract can be brought, the minimum amount for a claim, the maximum amount for a claim, and so on.
What is an indemnity?
An indemnity is a promise given by the seller to reimburse the purchaser, pound for pound, for a specific loss. It therefore covers specific liabilities which are known to the purchaser when the purchase agreement is entered into but which cannot be quantified at that time. For example, if the company is in litigation at the point of sale, the purchaser may require an indemnity from the seller that the seller will compensate the purchaser for any amounts which the company is obliged to pay out in the future in relation to that litigation. As such, indemnities are more usual in a share sale where the purchaser is acquiring the company and everything in it. In an asset sale, the purchaser is less likely to take on the litigation and so will not require protection against it.
As an indemnity does not rely on a breach of contract and is a promise for specific compensation, knowledge of the purchaser does not affect the claim; in fact, it is usually because the purchaser has knowledge of the issue that an indemnity is required. There are fewer reasons why the compensation may be reduced than in the case of damages for a breach of warranty, although the law is not clear as to whether mitigation by the purchaser is required in an indemnity claim.
Are warranties and indemnities really necessary or just legalese?
Warranties and indemnities are extremely important parts of a purchase agreement, particularly in a share sale where the entire company and business are being acquired. As a purchaser, the main focus will be on any specific issues about which you are concerned as a result of the due diligence or disclosure exercises, which may require indemnities. However, as a seller, it is imperative that the warranties are considered carefully and that any and all disclosures against them are given in as much detail as possible to avoid any claims for breach of contract in the future.
Our legal team will guide you every step of the way and provide experience and knowledge as to which warranties you, as a seller, need to carefully consider and what information is required to make any necessary disclosures.