When drafting a business sale and purchase agreement, warranties and indemnities are terms which corporate solicitors often get excited about and may spend a long time negotiating. Essentially, warranties and indemnities work as a tool to allocate risk between the buyer and seller of a business.
As a buyer or seller, do you need to concern yourself with warranties and indemnities or is this something you can leave to your legal team?
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Share or Asset Sale?
The acquisition of a business is most commonly structured in one of two ways: a share sale or an asset sale.
- Share sale – this is where all or a majority of the shares of a company (often referred to as the ‘target’) are sold to a buyer. This means that ownership of the company itself is transferred to the buyer which will include exposure to the company’s existing and future liabilities. All assets, liabilities, rights and obligations of the target company will transfer across to the buyer.
- Asset sale – this is where the buyer chooses or ‘cherry-picks’ specific assets of the business to buy. Liabilities for debts and obligations remain with the target company unless the buyer agrees to assume and release the seller from certain liabilities in the sale and purchase agreement.
In English law, the principle of ‘buyer beware’ applies which means that a buyer of a business will have no default protections under the law when making a commercial purchase. It is for the buyer to decide whether the deal is a good one, so they often ask for certain protections from the seller in relation to the purchase. As a seller of a business, you will want to limit these protections wherever possible and this is where the negotiation of the warranties and indemnities come in.
What is a warranty?
A warranty is a contractual statement of fact about the company, its business or assets, included in a sale and purchase agreement. If it subsequently comes to light that a warranty was untrue (at the time that it was given) and the value of the shares or assets is reduced, the buyer may have a remedy against the seller for contractual damages.
In a share sale, warranties tend to be extensive and are likely to cover all aspects of the company and business (depending on the bargaining strength of the buyer– if the seller has more leverage, it may refuse to give a lot of detailed warranties). For example, the agreement may include warranties about:
- Shares in the company
- Legal structure and administration
- Accounts and finances
- Property owned by the company
- Employees and pensions
- Disputes and investigations
- Environmental matters
- Commercial contracts
- Insurance
- Intellectual property
- IT
- Tax
In an asset sale, the warranties will cover the assets (and liabilities, if any) being acquired and may cover:
- Plant and machinery
- Stock and work in progress
- Contracts
- Goodwill and name of the business
- Debtors and creditors
- Employees and TUPE (Transfer of Undertakings (Protection of Employment) Regulations 2006), where relevant.
Limiting the warranties
The seller can seek to limit its liability under the warranties in a variety of ways in the sale and purchase agreement. Limiting the warranties to the seller’s awareness or inserting specific time limits into the warranties may provide comfort to the seller, particularly in relation to potentially far-reaching warranties.
- Time limits – for example 12 months, after which the buyer can no longer claim for any breach of warranty or specific time limits, for example, any warranties given about the company’s actual or potential litigation, could be limited to only relate to litigation in the past five years.
- Thresholds - a de minimis threshold amount, say for example £100, if the value of the shares or assets were reduced as a result of a warranty being inaccurate but only by £50, this wouldn’t give the buyer a right to claim for the breach. There is also usually an aggregate claim threshold (known as a basket). Say the basket threshold was £250, then each claim would have to exceed the de minimis of £100 but also in aggregate exceed the basket threshold of £250 before a claim could be made.
- Awareness - the warranties can be limited by the seller’s awareness. For example, warranties relating to potential litigation could be limited to only that of which the seller is aware.
- Disclosure - the main way for the seller to limit liability under the warranties is by means of disclosure, as discussed in more detail below.
Disclosure is the process by which the seller discloses to the buyer any information which renders the warranties untrue or inaccurate. A seller is protected against a claim for a breach of warranty if the buyer had knowledge of the facts rendering the warranty untrue before entering into the sale and purchase agreement. Asking the seller to give warranties about its business or assets is a good way to flush out any information that has not already been disclosed by the seller.
If you are a seller, in conjunction with your legal team, you will need to carefully think about the warranties that you (as a shareholder) and the other shareholders of your company are prepared to give in the sale and purchase agreement and should ensure that you are happy to make those statements and that they are true and accurate.
You will also need to consider whether you have knowledge of any circumstances that might affect those statements and disclose such information as part of the disclosure exercise, which will be presented to the buyer in a separate document called a disclosure letter that your corporate legal advisers can prepare.
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 buyer 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. Obviously, such disclosures opens up other risks for the seller such as the buyer requiring an indemnity to cover that particular issue (as discussed below), a renegotiation of the purchase price or in the extreme, the buyer pulling out of the deal.
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. 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. It is in the seller’s interests to be as detailed in the disclosures as possible just as it is in the buyer’s interests to require the seller to give unlimited and extensive warranties to minimise their risks.
Remedy for a breach of warranty
A warranty which is untrue at the time that it was given may give the buyer a claim against the seller for breach of contract. If the buyer is successful in their claim, the seller may have to pay contractual damages to the buyer to put them in the position they would have been in, had the warranty been true. For example, if the valuation of the company or asset is reduced as a result of the untrue warranty, the buyer may be able to claim the difference between the amount it paid for the company or asset and the actual value of the company or asset. However, there are several reasons as to why the full amount of a claim may not be payable by the seller:
- Knowledge – if the buyer has knowledge that the warranty is untrue at the time that it is given, a seller will not be able to bring a claim.
- Mitigation – the buyer 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 buyer is too remote (disconnected) from the breach of warranty, then the amount of damages awarded by the court will be affected and the claim could even fail.
- No loss - if the buyer cannot show that the breach of the warranty reduced the value of the company, business or asset that was bought, then it could be difficult to claim for any meaningful amounts.
- Limitations of liability – 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. These limitations are likely to be expanded in the sale and purchase agreement itself, as set out above. Sale and purchase agreements usually include various limitations of liability for the seller in relation to the warranties given, including, the period of time in which a claim under the agreement can be brought, the minimum amount for a claim, the maximum amount for a claim, and so on including an overall financial cap on the seller’s liability.
Watch our video on warranty claims when buying a business below:
What is an indemnity?
An indemnity is a promise given by a party to reimburse another party, pound for pound, for a specific loss. In a sale and purchase of shares or assets, it covers specific liabilities which are known to the buyer when the sale and purchase agreement is entered into but where any resulting loss has not yet been quantified.
For example, in a share sale if the company is in litigation at the point of sale, the buyer may require an indemnity from the seller that the seller will compensate the buyer (or the company) 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 buyer is acquiring the company and everything in it, including the liabilities. In an asset sale, the buyer 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 buyer does not affect the claim; in fact, it is usually because the buyer has knowledge of the issue that an indemnity is required.
A share purchase agreement would usually contain tax indemnities as standard. As a buyer, you should always seek tax advice from legal tax professionals on the scope of indemnities required for suitable protection against tax matters that are known or likely to arise in connection with the target company, its operations or its corporate structure.
Indemnities are also common for employment matters too and again, in both a share and asset sale, you should look to employment legal experts to advise you on how best to protect yourself against employment issues that might exist in the company or that might arise due to the sale of the assets or business. 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.
To what extent should you be aware of warranties and indemnities?
Clearly warranties and indemnities are extremely important areas of a sale and purchase agreement, particularly in a share sale where the entire target company and its business is being acquired. As a buyer, it makes sense that your commercial project team has an active role in negotiating and reviewing warranties and indemnities along with your advisers so that you can effectively manage to what extent key commercial risks can be apportioned.
As a seller, it is imperative that you are considering the warranties carefully along with your advisers and that all disclosures against them are fully made to avoid any claims for breach of contract in the future. Preparing your business for sale is essential to ensure all your ducks are in a row before the warranties are even drafted. For example, ensuring documents, licences and accounts are accurate and up to date will make the disclosure process go smoother and help to minimise your liability under the warranties.
What next?
Our corporate team will be able to guide you every step of the way from preparing for sale or purchase to the post-acquisition filings and obligations. We can provide experience, guidance and knowledge on the negotiation of the warranties and indemnities and the detailed disclosure process to ensure you are making the best choices for you and your business. Call us on 0800 689 1700 or fill out the short enquiry form below and one of our team will be in contact.
