Partner Piece – Greenwoods GRM LLP

August 28, 2019

Warranties and Indemnities – A Careful Balancing Act

By Dov Katz and Manasi Shah of Greenwoods GRM LLP

 

For many businesses, planning a corporate transaction can involve a lot of tough, timely and sometimes expensive, considerations. However, the decision to sell or purchase a company or business remains a significant one to make. Typically, the seller of a company knows the ins and outs of the operation of its business, but from a purchaser’s perspective, the law tends to provide little protection as to the nature or value of what is being bought. For example, how can a purchaser trust the information given to him by the seller in relation to, say, tax or employee information? This is where warranties, indemnities and the disclosure letter play a vital role in a transaction.

This article focuses predominantly on the use of warranties and indemnities in a corporate transaction, the key aspects to consider and briefly touches on a seller’s disclosure obligations.

 

What are warranties and indemnities?

Warranties are contractual statements made by the seller about the state of the seller’s business when it is purchased. The purchaser relies on these statements in entering into an agreement and if any of the statements are later discovered to be untrue, the purchaser may bring a contractual claim against the seller, entitling the purchaser to damages – by this, we mean the purchaser will be compensated for the loss by being placed in the financial position he would have been in had the warranty been true. However, the onus here lies heavily on the purchaser and making a claim on this basis is not straightforward. The purchaser will be required to prove that he has suffered loss, the loss was caused by the breach, the loss is not too remote and that he has taken reasonable steps to mitigate that loss.

In comparison, indemnities are promises made by the seller to reimburse the purchaser, on a pound for pound basis, in respect of a specific type of liability should it arise in the future. They generally cover liabilities which are known to the purchaser when the agreement is entered into, but which cannot be quantified at that time. A common scenario is if the company is subject to litigation proceedings at the point of sale; in this instance, a purchaser may require an indemnity from the seller to compensate for any future liabilities of the company in relation to the litigation. The reason why an indemnity is usually required is because the purchaser has knowledge of a particular issue in relation to the company.

 

Are warranties and indemnities necessary in a corporate transaction or can they be avoided?

The starting point in any transaction is the principle of “caveat emptor” which is interpreted as “let the buyer beware”. The purchaser will carry out due diligence on the company or business but, as highlighted above, will the purchaser really trust the information provided to him by the seller and enter into an agreement on this basis? It is unlikely that the purchaser will have full knowledge of the company or the business before entering into an agreement. A purchaser will therefore seek to include warranties and indemnities in the agreement, as a necessity, as protection for the purchaser against the unknown and the indemnities shall allocate risk in respect of liability. It is highly improbable that these can be avoided by the seller. A seller may push back on the warranties and indemnities; however, it should be noted that a transaction may fall through because of this.

So, what purpose do warranties and indemnities actually serve?

Put simply, they minimise a purchaser’s risk, provide protection, provide information and, in some ways, offer comfort to the purchaser as to what is being acquired. From a seller’s perspective, warranties and indemnities may be viewed as “price adjusters” because a purchaser may be inclined to offer a higher price for the transaction if there are warranties and indemnities in place.

 

What is a disclosure letter?

While warranties and indemnities provide purchaser protection, a disclosure letter is a key document in a corporate transaction that offers the seller protection. It is provided by the seller to the purchaser and sets out exceptions to the warranties included in an agreement. Taking the example above, an agreement will usually include a warranty which states that the target company or business is not involved in litigation at the point of sale. If, however, this statement is not true, and the company or business is involved in litigation, the disclosure letter should set out the relevant details. Provided a disclosure has been made against this warranty – and accepted by the purchaser, the purchaser will not be able to bring a claim against the seller for a breach of that warranty and the seller’s risk is reduced.

It is therefore key for a seller to ensure that the appropriate disclosures are made in relation to the warranties that are not true in all respects. Equally, a purchaser should ensure that the disclosure letter is reviewed and assessed thoroughly to ensure it is prepared to go ahead in the light of the matters disclosed.

 

Practical points on warranties and indemnities

  • Multiple sellers in a transaction – where the transaction involves more than one seller, the agreement should clarify who is liable for which warranties and/or indemnities and how liability will be shared between them.
  • Delay between exchange and completion of the transaction – where this is the case, the purchaser may insist on the warranties being repeated to ensure that they are effective. This is because warranties are only true at the moment they are given.
  • Security for warranty and indemnity claims and set-off – the purchaser will usually ensure that the seller will be able to pay out any indemnity and/or for breach of a warranty. This may involve obtaining a bank guarantee or setting off any claims against deferred consideration (if applicable).
  • Limitation on liability – the seller should seek to limit its liability in respect of any warranty and indemnity claims. It is usually a fair compromise to limit the liability to the purchase price.

Warranties and indemnities therefore play a fundamental role in a corporate transaction for both seller and purchaser. The seller on the one hand needs to be wary of providing inappropriate warranties and indemnities just to get the deal over the line. If warranties have to be given, in order to avoid future liabilities and to sleep at night, the seller would be advised to make full and fair disclosure of all relevant issues. The purchaser on the other hand will want to ensure that it has the protection of its purchase with appropriate warranties and indemnities which it can rely on to bring a claim, if necessary, against the seller. Finding a fair position is often a careful balancing act.

This document is for information purposes only and does not constitute legal advice. It is recommended that specific professional advice is sought before acting on any of the information given.

 

Dov Katz (Partner) Greenwoods GRM LLP 1 Bedford Row London WC1R 4BZ Email: dgkatz@greenwoodsgrm.co.uk Tel: +44 (0)20 7504 1153 Mob: +44 (0)7958 306451

Manasi Shah (Solicitor) Greenwoods GRM LLP 1 Bedford Row London WC1R 4BZ Email: mshah@greenwoodsgrm.co.uk Tel: +44 (0)20 3691 2065 Mob: +44 (0)7970 293912

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