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Warranties and indemnities: what you need to know

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, to what extent do you need to understand what warranties and indemnities mean and why they are needed, or is this something you can leave to the legal team?

Here, we explain why it is important to understand these mechanisms in the context of an acquisition of a private limited company.

Types of acquisitions: share sales and asset sales

First, let’s consider two common types of acquisition of a private limited company that can take place in the UK:

  • Share sale – in a share sale, all or part of the share capital of the limited company which runs the business (often referred to as the ‘target’) are sold to a third party (a ‘purchaser’). This means that the purchaser will then own all or part of the target company and its business, including (through its shareholding) having some exposure to the company’s existing and future liabilities and obligations. As a result, it is a well-practiced part of the sale process for the purchaser and its advisers to carry out detailed investigations into the company and business, in particular to make sure that it is aware of the existing, past or future liabilities, obligations or expenditures that company has or may have before it goes ahead and makes the purchase. This is called the due diligence process and limited information is typically made available by the seller or its advisers to the purchaser and its advisers.
  • Asset sale – in an asset sale, specific assets of the business are sold to, and chosen by, a purchaser. This results in the purchaser being able to cherry-pick the parts of the business that they want to acquire and gives the purchaser a certain level of control over which liabilities and obligations it takes on.

In English law, the principle of ‘let the buyer beware’ applies which means that a business purchaser will have no default protections under the law when making a commercial purchase. It is for the purchaser to decide whether the deal is a good one, so they often ask for certain protections from the seller in relation to the purchase. This is where warranties and indemnities come in.

What is a warranty?

A warranty is a contractual statement of fact about the state of the company and its business or assets, included in a 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 company is reduced, the purchaser will have a remedy against the seller for contractual damages. This means that to the extent that the seller gives an unqualified warranty, it will be forced to disclose any information to the purchaser that makes that warranty untrue or invalid. So asking the seller to give warranties about the company or its assets is a good way to flesh out any information that a purchaser wants to know and does not have access to from its due diligence process.

In a share sale, warranties can be extensive and are likely to cover all aspects of the company and business (but this really depends on the bargaining strength of the purchaser – if the seller has more leverage it may refuse to give a lot of detailed warranties). For example, there may be warranties on:

  • The legal structure and administration of the company
  • The accounts and finances of the company
  • Property owned by the company
  • Employees and their pensions
  • Environmental matters
  • Commercial contracts
  • Insurance
  • Intellectual property
  • IT
  • Tax

In an asset sale, the warranties will cover the assets being acquired.

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 and should ensure that you are happy to make those statements and that they are true and accurate. You may also want to think about whether you have any knowledge of any circumstances that might affect those statements and disclose the information as part of a separate disclosure letter that your corporate legal advisers can prepare. 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. For example, for any statements made about the company’s actual or potential litigation, these statements could be limited to only relate to litigation in the past five years.

Watch our video on warranty claims when buying a business below:

Disclosure

A seller is protected against a claim for a breach of warranty if the purchaser had knowledge of the situation before entering into the purchase agreement. As a result, the seller and its 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.

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 purchaser’s interests to require the seller to give unlimited and extensive warranties.

Remedy for a breach of warranty

A warranty which is thoughts to be untrue at the time that it was given may give the purchaser a claim against the seller for breach of contract. If the purchaser is successful in their claim, the seller may have to pay some contractual damages to the purchaser to put them in the position in which they would have been 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 purchaser 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 purchaser 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 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
  • No loss - if the purchaser cannot show that the breach of the warranty reduced the value of the company or business that was bought, then it could be difficult to claim for any meaningful amounts
  • 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. These limitations are likely to be expanded in the purchase agreement itself. 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 purchase 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.

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 purchaser when the purchase agreement is entered into but where the loss that the purchaser or the company might incur as a result of the liability has not been quantified at that time. For example, in a share sale 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 (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 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. A share purchase agreement would usually contain tax indemnities. As a purchaser, 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 parts of a purchase agreement, particularly in a share sale where the entire target company and its business is being acquired. As a purchaser, 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 the key commercial risks that become apparent through the disclosure and diligence processes can be apportioned. As a purchaser you might also need to make sure that you are operating at a level that is acceptable internally within your business group as well as externally with the seller. 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.

Our legal team will guide you every step of the way and provide experience, guidance and knowledge as to the most suitable warranties and indemnities that are right for you in your share or asset sale and purchase.


What next?

If you’re buying or selling a business and need legal advice on warranties and indemnities or other agreements and contracts relating to the transaction, our corporate solicitors can help. Contact us today on 0800 689 1700, email us at enquiries@hjsolicitors.co.uk or fill out the short form below with your enquiry.

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