The parties to a share or asset purchase agreement will usually agree certain limits to a seller’s liability in the event of a claim under any of the warranties. Although the inclusion of limits is not particularly contentious, the specifics can be heavily negotiated and whether you are a seller or a purchaser, it is important that you are aware of the various options and how these may affect you in the event of a claim.
Note: we cover the reasons for limiting the seller’s liability, the various ways in which liability may be limited, the assignment of the benefit of warranties, and how a purchaser might ensure that the seller is, financially, able to meet a warranty claim.
- Why are limitations of liability included in a purchase agreement?
- What liability is to be included?
- Types of liability limitation
- Financial limits on liability
- Time limits on liability
- Seller’s ownership
- Double recovery
- Pre-completion issues
- Legislation changes
- Conduct of claims
- Buyer protection
Why are limitations of liability included in a purchase agreement?
Limitations of liability are included in a purchase agreement to provide some protection and certainty to the seller. By including specific limits, a seller knows that a purchaser is only able to bring a breach of warranty claim during a certain time period and that it will be capped at a certain amount.
Warranties are statements of fact about the target company and its business (in a share sale) or about the assets (in an asset sale) given by the seller to the purchaser in the purchase agreement. If any of these prove to be untrue following completion, the purchaser can bring a claim against the seller for breach of contract. As a result, warranties provide protection to the purchaser. In addition, warranties can, through the disclosure exercise, result in information about the target company and its business, or the assets, being given to the purchaser that he would otherwise not have. Statute provides some limits for the seller, but it is usual for the purchase agreement to extend these.
The inclusion of certain limitations of liability in the purchase agreement by the seller’s legal advisers will come as no surprise to the purchaser’s legal team. Indeed, where the purchaser’s legal team has prepared a first draft of the purchase agreement, they are likely to incorporate some limitations themselves. That said, it is highly probable that the specifics of these limitations will then be heavily negotiated.
Although your legal team will have suggestions and be able to give you advice during these negotiations, based on their experience and market practice, the actual details will need to be finalised by the principals to the transaction, that is, the seller and the purchaser.
What liability is to be included?
Liability arising under a breach of warranty claim will be included in the various limits set out in the purchase agreement. However, the parties may negotiate that certain warranties will have different limits. For example, warranties that go to title (of the shares or assets) may have a different cap than the other general business warranties.
A seller is likely to want any indemnities (including tax) to be included in the limits although a purchaser should resist this on the basis that indemnities provide pound for pound compensation for a specific loss and as such, they should not be capped.
It is likely that a tax covenant (whether included in the purchase agreement or a separate agreement) will set out its own limitations and so will usually be excluded from the warranty limitations set out in the purchase agreement.
The disclosure exercise can be an integral part of the transaction and, if done adequately, can provide protection to the seller against warranty claims and ensure that the purchaser understands, and has full knowledge about, the target company and its business or the assets before purchasing them. Please see our note Disclosure in Acquisitions – Who Benefits? for a more detailed discussion about the disclosure process.
Types of liability limitation
There are various types of limitation which can be included in a purchase agreement, some of which will result in more negotiation than others. These will be discussed in more detail below.
Generally, a purchaser’s and seller’s legal team will require instructions from you, the client, in relation to:
Other limitations include:
Financial limits on liability
The financial limits are often split into the following categories:
- De minimis – this is the minimum limit for any one claim. If an individual claim is less than the agreed amount, the purchaser will be unable to make the claim. It prevents the purchaser from bringing spurious or ‘nuisance’ claims. As a result, the figure is usually very low.
- Basket / threshold – this is the minimum limit for claims in aggregate, or an amount which must be reached before any claims can be made by the purchaser. Again, it seeks to prevent time-wasting in the bringing of claims. The figure will often depend on the purchase price; 1% of the purchase price is quite standard but this may not be satisfactory to the purchaser if the purchase price is large. From a purchaser’s point of view, it is important that the purchase agreement stipulates that once this threshold has been reached, the entire amount can be claimed, not just the surplus above the agreed figure.
- Maximum cap – this is the total amount that the seller can be liable for in respect of breaches of warranty. It provides certainty to the seller as to the total amount that he could be made to pay. As such, the seller will usually seek to limit his aggregate liability to the purchase price received. This may be too low for the purchaser, for example, if there is a low purchase price, if part of the purchase price is not in cash, or if the purchaser has not been able to complete adequate due diligence. In some transactions, there may be separate caps for different warranties.
Both the purchaser and the seller will require certainty as to who is liable to pay for any claim. This could be an issue where there is more than one seller. For example, should the sellers share the cost of any claim equally, in proportion to the amount of the purchase price received by them, or will it depend on their input to the business? A purchaser will want the sellers’ liability to be joint and several, which will allow the purchaser to pursue a claim against any of the sellers and if successful, be paid the full amount by that seller. Although the relevant seller can then seek a contribution from the other sellers under the Civil Liability (Contribution) Act 1978, it is advisable for the sellers to agree how any liability will be split between them as part of the transaction, rather than leaving it to the court to decide under the Act.
Time limits on liability
Under the Limitation Act 1980, a purchaser may bring a contractual claim within six years of the breach. If the contract has been signed as a deed, this increases to 12 years. It is standard to reduce this time period in the purchase agreement.
Often, a purchase agreement will provide that a claim (other than a tax claim) must be brought within two to three years of completion. In relation to tax claims, HMRC is entitled to investigate the tax position up to six years after the end of the relevant accounting period, and so purchase agreements often provide that tax claims must be brought within six to seven years of completion. The seller may not agree to this if he has only owned the shares or assets for a short time.
The purchase agreement will also include a time period in which the purchaser has to bring proceedings for any warranty claim upon becoming aware of the breach. This is to prevent the purchaser from sitting on a claim and provides certainty for the seller. It is important to note that case law has shown that these notification periods are viewed strictly by the courts.
A seller is likely to argue that his liability should be limited only to matters which arose during his ownership of the shares or assets. This may be acceptable especially where the seller has run the target business for a long period. However, it is more likely to be a factor for the seller where he has only owned the shares or assets for a short period and in such cases, this limitation is unlikely to be agreed by the purchaser as it does not provide sufficient comfort.
A warranty may be limited by couching it in terms of the seller’s awareness. A claim in relation to that warranty will then only be successful if it can be shown that the seller was aware of the circumstances.
A seller is unlikely to agree to a generically worded warranty if it relates to something of which he has no knowledge. This could be, for example, because the warranty refers to or includes a period prior to the seller’s ownership of the shares or assets. In this instance, such warranties may be limited to the seller’s awareness.
It is a good idea to define the term ‘awareness’ in the purchase agreement, especially if the seller is not an individual or is not particularly involved in the target business. In these cases, the seller may need to make clear that ‘awareness’ refers to the knowledge of certain members of management or specific directors.
A purchase agreement will usually include a clause to prevent the purchaser from bringing a warranty claim against the seller if he could recover the loss elsewhere. This may still affect the seller as it would include being able to recover under an indemnity in the purchase agreement, but it may also include recovery under an insurance policy or from another third party.
It is important for the seller that the purchase agreement includes wording that a purchaser may not bring a claim for issues which arise as a result of the purchaser’s acts following completion of the transaction. A purchaser may be happy with this but should be careful that the seller’s liability is not too limited by this provision. It is possible, for example, that the seller’s actions (as well as the purchaser’s) may have partly caused the breach.
A seller will not want to be liable for a breach of warranty which arises as a result of changes to legislation which occur post-completion. This is usually not an issue for the purchaser.
Conduct of claims
Where a breach of warranty claim involves a dispute with a third party, a seller is likely to want to be involved in the conduct of that claim. This is not an unusual clause in a purchase agreement but the wording needs to be clear and fair to each of the seller and the purchaser as they will have different interests; the seller will want to minimise his liability in respect of the claim, whereas the purchaser may be more concerned to protect goodwill and maintain a good relationship with the third party.
A purchaser will be expected to mitigate the effects of any breach and failure to do so may affect the success of any breach of warranty claim. So, for example, if a property owned by the business has faulty plumbing and water begins to flood the property, the purchaser would be expected to turn the water off as soon as he became aware of the issue. If the purchaser does not mitigate the loss, then his claim for damages may be reduced accordingly.
What is the position in relation to warranty claims if a purchaser wants to be able to transfer the target company or any of the acquired assets to a third party or to a company in its group post-completion? If agreed by the seller, the benefit of the warranties can be assigned to the relevant third party or company. In practice, a seller will usually accept assignment to a group company but not to a third party.
It is important that assignment provisions are drafted correctly, and your legal team will be able to deal with this and advise on the process.
It is all well and good for the purchaser to have the benefit of warranty protection, notwithstanding the limitations which are agreed in the purchase agreement, but the practical issue of whether the seller has the funds to pay any claim is a different matter. A seller which is a company or other corporate entity could, for example, pay out the purchase price received as a dividend and then be wound up, while an individual seller could leave the country or spend the proceeds of sale and be left without any funds to meet any warranty claims. This could make the warranties worthless and leave the purchaser financially at risk. How then can a purchaser protect himself in the purchase agreement from such a scenario?
There are several methods which can protect the purchaser from the situations described above, including:
- Warranty and indemnity insurance
- Retention provisions
- Set-off provisions
- Escrow agreement
Let’s look at each of these in turn:
|Warranty and indemnity insurance||Insurance cover can be taken out by either the purchaser or the seller. If the policy is in the seller’s name, it will cover the seller for the amount of any warranty or indemnity claim successfully brought by the purchaser under the purchase agreement. If the purchaser takes out the policy, it will cover the purchaser for any loss he suffers in relation to a breach of warranty or in the event that he cannot recover the full amount under an indemnity provision. In some cases, purchaser insurance can negate the need for any warranty claim against the seller whereas in others it provides cover where the seller’s liability exceeds the maximum cap agreed in the purchase agreement. The insurance policy will usually run for as long as a claim can be brought under the purchase agreement and the premium will vary depending on the cover required. If you think that insurance may be advantageous (whether you are a seller or a purchaser) it is advisable to discuss this with your legal team as soon as possible in the transaction.|
|Retention provisions||The parties may agree that a certain amount of the purchase price be retained for a specified period following completion to cover, or partly cover, any claim under the warranties or indemnities.|
|Set-off||If the purchase price is to be paid in instalments, set-off provisions can be included in the purchase agreement. In the event of a warranty claim, the purchaser can then set-off payment against the claim.|
|Escrow agreement||The parties can agree that a certain amount of the purchase price is held in a separate escrow account for a period of time to cover or partly cover any potential claims.|
|Bank guarantee||Although not as common as the other options mentioned above, the purchaser could request a bank guarantee from the seller (if an individual) or the seller’s parent company (if a corporate entity). These can be expensive, and the bank will require the seller to provide some form of security.|
The limitations of liability included in the purchase agreement will depend on the nature of the transaction, the warranties which have been negotiated, the nature of the target business or assets being acquired, and the bargaining position of the parties. Market practice will also often affect the extent of the limitations. Your legal team will be able to advise you about the provisions that you should expect and what is reasonable in the circumstances. Harper James has plenty of experience with these transactions and will provide comprehensive and commercial advice regarding these terms as part of the acquisition process.