Warranties and Indemnities

WARRANTIES & INDEMNITIES

WARRANTY

In a transaction involving sale and purchase of a business or shares, the parties agree to the main terms of the contract and after it the buyer starts its thorough investigation carrying out its due diligence exercise. The buyer puts forth queries regarding the busines to the seller and the seller responds by providing information about the business, which is usually supported by accompanying documentation. 

This information will, generally, include relevant facts and matters about the business that will enable the buyer to analyse the scope of the risk involved and help in preparing the sale contract. A key part of this document is the warranty schedule. Warranties are promises or statements of facts about the business being sold by the seller to the buyer. It does have other definitions under contract law, but we are going to look at it from an SPA perspective. Share purchase agreement or a Sale Purchase Agreement (SPA) is typically the main document which is required as part of the legal process of acquiring or disposing of the share capital/assets of a private company. The use of the term warranty in this context should not be confused with the more generic business use which is more like a product guarantee.

Warranties cover a broad range of topics from promises confirming that accounts of the business are accurate, to promises that there are no current or anticipated disputes involving the business. They range from general to specific topics such as – Title, Capacity to sell, IP, IT, Tax, Litigation, Accounts etc.

A breach of warranty is a breach of contract. If a warranty is breached (that is, if it is discovered to be untrue), then the injured party can claim damages from the warranting party. The aim of these damages is to place the injured party back in the same position that they would be in, had the breach of warranty not occurred. They are calculated on what the party expected to get out of the deal and what it did get – that is why it is also called loss of bargain. The specific calculation of damages and the factors taken into consideration will vary depending on the nature of the contract and the nature of the warranty that has been breached.

An example of a typical warranty would be: 

"Neither the Company, nor any of its Directors nor any person for whose acts the Company may be vicariously liable, is engaged or involved in any of the following matters, done in the course of employment for the Company: 

(a) any litigation, or any administrative, arbitration or other proceedings, claims, actions, 

or 

(b) any dispute with, or any investigation, inquiry or enforcement proceedings by, any governmental, regulatory or similar body." 

It is important that the seller only gives these warranties after careful analysis of them, making sure they are accurate and true.  After completion of the sale if any of these statements prove untrue the buyer will be able to bring a claim for it and recover part or all of the overall purchase price paid for the business.

Although it is quite rare that a claim for breach of warranty in a share purchase agreement results in an award of damages for the entire purchase price paid and the buyer retaining the purchased shares. But this is what happened in this case 116 Cardamon Ltd v MacAlister and another (2019).

The dispute centered around the company’s accounts and the warranties it had given for them. The sellers warranted the truth, fairness, accuracy and proper preparation of these accounts. Despite what was reflected in the year-end accounts and subsequent management accounts, it was alleged that the company was effectively insolvent at completion. Albeit, the buyer did not conduct a thorough due diligence exercise still was able to recover full price paid in damages due to breach of accounts warranty as stated by the seller in the SPA. 

I regard this an important case which teaches the seller these cardinal points:

·      Verify the accuracy of the accounts and financial information of the company being sold;

·      Provide fair disclosure;

·      Provide well-drafted warranties; and

·      Include limitation clauses to protect their interests.

Purpose of Warranties 

There are mainly two reasons behind the buyer asking for warranties from a seller:

Allocate Risk:

The warranting party gives an assurance that the information set out in the warranty schedule is true and verifies this by assuming responsibility for the damages if that warranty is (or becomes) untrue. 

The underlying principle of caveat emptor “let the buyer beware" applies to the sale of shares or business. That is if there does arise some liability post completion it will be the company itself, and not the previous owner, which shall be liable for it. This requirement of giving warranties on various aspects of the business means if there is any breach which arises later the buyer will have the right to claim for damages, which in essence will aim to put the buyer in a position had the warranties been true. However, if the seller can prove that he made adequate and ‘fair’ disclosure regarding the particular warranty then the buyer shall not be able to claim back anything. The standard of what is ‘fair’ was set out in Infiniteland case - 2005, where the court held that “What is ‘fair’ is what has been agreed between the seller and the buyer in the Agreement and that is the standard”. So, basically giving warranties, according to the standard of disclosure as decided between the seller and the buyer, allocates risk between them. 

Elicit Information:

This one is a more important reason in some ways, as it is for the buyer to elicit information about the company's business from the seller before it completes the acquisition. If a seller is reluctant to give a particular warranty then this might indicate a potential problem with that aspect of the target business. The sellers will generally also provide a draft disclosure letter which sits alongside the SPA and sets out areas of inconsistency between the commercial warranties and the target business. This information (which will be made available prior to completion of the transaction), along with the results of the buyer's due diligence enquiries, gives the buyer the choice of whether to proceed with the purchase, or alternatively to revisit the deal terms (i.e. price and risk allocation — for example by insisting upon specific indemnities which would result in the seller being liable to compensate the buyer on a pound-for-pound basis if any loss is suffered after completion pertaining to such indemnified risk).

Warranties in certain specialist areas (such as IP or tax) may be ring-fenced or "boxed" so as to make them self–standing. This means that, for example, the general disputes and investigations warranty will not cover disputes and investigations in these areas. However, the trade-off may well be that the buyer also insists on disclosures being ring-fenced.

Warranties and Representations 

It is pertinent to mention here that warranties have to be distinguished from representations. A representation is a statement of fact which was actually relied upon by the buyer inducing it to enter into the deal. Sometimes both the warranties and representations are clubbed together – this scenario favours the buyer but not the seller – why? For the simple reason that if a representation turns out to be untrue it becomes a misrepresentation thereby causing loss to the other party, and the claim under it lies in the law of Tort.

This becomes an additional option available to the buyer. A successful misrepresentation claim may enable the wronged party to rescind the contract and also to recover damages. Rescission of a contract means cancelling a contract and unwinding it entirely. This would, undoubtedly, be a costly position for the unsuccessful party to find himself in. So, if the seller permits the word ‘representation’ to be used alongside ‘warranties’ it is allowing the buyer to have a different basis of claim if that statement turns out to be untrue. The best practice for the seller is to delete if he sees this word cropping anywhere in such a manner, and also to have an ‘Entire Agreement’ clause which not only specifies that everything in the Agreement constitutes the entire Agreement but specifically rules out that no claim outside contract law can be made and expressly excludes misrepresentation.

The golden rule pertaining to warranties, for the seller is that everything relevant should be disclosed in detail. Revisions and updates should be made to the disclosure letter right up to the date of completion. As for the buyer he must raise enquiries to anything unclear and fully understand the consequences of accepting them. 

Ways for the Seller to protect against a claim for breach of warranty? 

A seller can protect itself via various ways against a claim for breach of warranty, some of the main ones are: 

1. Negotiation

The warranties, contained in the SPA, which seem open-ended or forward-looking should either be deleted or reduced in scope to a level whereby the seller feels confident in giving them. The realm of warranties should always be qualified by the actual awareness of the seller or by setting materiality thresholds (although the reality is that the end position will always depend on the commercial bargaining strength of the respective parties). 

2. Limitation on Liability

By inserting limitation provisions in the SPA, such as time limits for bringing warranty claims and financial thresholds that need to be met in order to bring a claim or how a third-party claim, if it were to arise, shall be handled.

3.  Disclosure letter

This is the ultimate classic protection for the seller in the corporate context of the SPA. The Disclosure letter is usually prepared by the seller’s lawyers, it takes the form of a letter containing two parts – general and specific. It records exceptions to warranties or qualifies them. It effectively contains a list of items that the buyer will not be able to bring a warranty claim in respect of. 

4. Insurance

Where the seller wishes to mitigate its liability, or where the seller is unable to give commercial warranties (e.g. where funds are distributing proceeds to investors immediately following the sale) warranty and indemnity insurance can be purchased to cover liability for a warranty claim.

INDEMNITIES

An indemnity is a legal protection against liabilities arising from one’s actions. That is, one party (Party 1) promises to another party (Party 2) to accept the risk of the loss that Party 2 might suffer in a particular situation. It is a promise to reimburse the buyer in the context of an SPA, in respect of a particular liability, should it arise due to seller’s act, omission, neglect or default. It is a guaranteed compensation – a dollar to a dollar. It basically shifts the financial risk from the buyer to the seller.

Indemnities are generally used by buyers to protect themselves against matters that are outside of their control. They are also commonly used to cover known risks (to be distinguished from warranties, which are commonly used to protect against unknown risks).

In the M&A context, indemnities will often be used to cover specific issues (e.g. environmental issues, litigation or tax) identified during the buyer's due diligence in order to allocate risk back to the seller against the known event, risk or liability. The scope of recovery under an indemnity claim is much broader, with the innocent party generally able to cover their whole loss, provided the loss is within the terms of the indemnity and the 'claims period' in the SPA has not expired. Importantly, the contractual rules of causation, remoteness and mitigation do not apply (unless the SPA expressly provides for this).

On a sale of a business the buyer may seek a warranty as to the conformity of a company's data protection policies and the resilience of its IT security. If after completion these are found to be inadequate, it may be argued that the value of the company will not have diminished, but costs may be incurred in rectifying the matter. If the buyer had obtained an indemnity from the seller in respect of this issue he would have been able to recover his costs under the indemnity. On the other hand, the buyer may seek a warranty as to the accuracy of the accounts of the company. If, after completion, it is found that the company had been making less profit than promised, then the value of the company would be likely to be significantly diminished and the level of damages for breach of such warranty would be significant, especially if the purchase price had been calculated on the basis of a multiple of annual profits.

An indemnity provides compensation for a specific demonstrated loss. If an indemnified event occurs, the indemnified party is reimbursed for all loss suffered by them as a result of that event. 

If the indemnified party invokes the indemnity, they are able to recover the value of their loss as a debt (rather than damages under breach of contract). This often simplifies the recovery process and makes it easier to obtain payment. 

To avoid disputes regarding the application or scope of an indemnity clause, it is important to be very clear in the drafting of indemnities. Indemnities should not be taken as boilerplate clauses as they need to be drafted carefully to cater specifically to the matter being indemnified and the circumstances of the respective parties to the indemnity. 

Key Ingredients:

Case law suggests that where an indemnity is unclear, it will be construed against the party seeking to rely upon it. Indemnities should include following specifications (without limitation): 

? who is protected; 

? who is liable for a breach of the indemnity;

? the extent of the loss that is covered;

? the event which triggers the actuator of the indemnity (such as a breach of the agreement, or destruction of the asset in question); 

? any specific exclusions or limitations; and

? whether the indemnity is in addition to or in replacement of other remedies that may be available to the injured party

If you are the indemnifying party, you may also wish to consider: 

? specifying that you are not providing indemnities for events outside of your control;

? carving out loss attributable to the actions or omissions of the indemnified party;

? inserting an obligation for the injured party to mitigate their loss; and

? including a limitation period in the indemnity.

Lawyers should take utmost care when drafting indemnities, as the courts will be focused on their interpretation. Recently, in  Dodika Ltd & others v United Luck Group Holdings Ltd, 2020, a sale and purchase agreement (SPA), disposing off the sellers' shares in a holding company, contained a tax covenant indemnifying the buyer for any undisclosed tax liabilities of the group companies. The buyer was required to give “written notice” to the sellers, in order to claim under the clause, stating in reasonable detail the matter which gave rise to such claim, the nature of such claim and (so far as reasonably practical) the amount claimed in respect thereof. 

At a later date, the buyer provided a notice which contained details of an investigation by the tax authority into transfer price practices, involving one of the group companies owned by the holding company disposed of under the SPA. While the notice did include details of how the investigation would work and a chronology of events, the court held that this did not qualify under the indemnity as it did not provide sufficient detail of the circumstances that the buyer was relying on to support its claim, and therefore did not give rise to a claim under the tax covenant.

This underlines the importance of strictly complying with the wordings of the indemnity clause in order to avail its benefit. 

Unlike a warranty, there is no automatic common law obligation for the indemnified party to mitigate its loss, as long as the loss suffered by it is a loss that comes within the terms of the indemnity. Because of this, indemnifying parties often insert a specific clause in their contracts requiring indemnified parties to mitigate their loss. 

The loss caused by a breach of an indemnity can often be easier to quantify than a loss caused by a breach of warranty as the counter arguments of mitigation and remoteness do not apply. The indemnified party can simply claim all of the loss actually suffered by it due to the indemnified event occurring. 

Parties commonly misuse or over-use indemnities. Many indemnities are unnecessary, inequitable or drafted heavily in favour of the party with the greater negotiating power or are simply copy pasted without putting much thought to it.

Conclusion

Whether you are a Buyer or Seller, the warranties and indemnities in the SPA will have a significant impact on your level of post-completion risk. It is therefore vital that you are aware of your obligations under the SPA and you ensure that the terms of the SPA reflect what you have agreed with the other party.

Some practical advise for the buyer would be to take care to ensure the seller will be able to be in a position to pay out indemnities for breach of warranty, e.g. by requiring bank/parent company guarantees. And, where more sellers are involved there should be clarity over who is going to be liable for which warranty/indemnity, e.g. joint and several liability.

Even though the commercials of a contract are often set out by the clients, while lawyers focus on negotiating the terms of such security. However, it is the lawyer’s job to negotiate the body of warranties, indemnities and warranty limitations, of course under instructions from clients, to ensure that they are well protected. Therefore, keeping the crucial nature of these provisions in mind and knowing how deeply they can affect the deal and the client, it is paramount for the lawyers to understand how to draft these clauses in the best interests of their clients.

In such times of increased instability and uncertainty, it is more imperative now than ever before to ensure that warranties and indemnities and other key share purchase agreement (SPA) provisions are drafted particularly precisely in order to ensure all clauses can be relied upon in the way that was intended by the parties to the transaction.

This article is only intended as an overview and should not replace seeking appropriate legal advise. 

(The author is legal manager at Sadeq Law chambers and also is the chief trainer for the British Legal Centre for GCC states)