If you’re considering buying a company – whether or not you’re acquiring share capital or assets, the position that you will find yourself in is one of caveat emptor, which loosely translates as ‘buyer beware’. Because of this, you will want the comfort and assurance of knowing that you’ve acquired what you thought you were buying, which is where the issue of warranties comes in.
In this article, we explain how and why warranties are used when buying a company. They explain in more detail how and why warranty claims arise, how they can be avoided, and what limitations and protection may be afforded by particular agreements and documents.
If you’re buying a business and want advice on warranties, or you’re facing a potential warranty claim, get in touch with our experienced business dispute solicitors. We’ll help you understand your position, review the relevant agreements, and guide you through the process to protect your interests.
Jump to:
- What is a warranty?
- When are warranties likely to be necessary?
- What happens when a warranty is breached?
- Why do warranty claims arise?
- What’s the difference between warranty claims and indemnity claims?
- Does the buyer have to prove a breach of warranty?
- What evidence do you need to have to make a breach of warranty claim?
- How to make a breach of warranty claim
- Remedies if your warranty claim is successful
- How can warranty claims be avoided?
- What are Vendor Protection Provisions?
- What other considerations are important?
- Summary
What is a warranty?
Put simply, a warranty is a written statement (or a series of statements) that backs up claims the seller has made about the business in the process of selling it to you. The purpose of any warranty is to provide you with some security regarding the future, not all potential issues with the business will materialise during the due diligence process. On that note, it’s important to point out that the purpose of warranties is to complement the due diligence process, not to be separate from it.
When are warranties likely to be necessary?
Broadly speaking, there are likely to be several types of warranties that can be given. Some examples include accounting issues, employment issues, commercial contracts, environmental matters, legal disputes, machinery and tax matters, to name but a few.
What happens when a warranty is breached?
When a warranty is breached, it gives rise to a claim for breach of contract, and this means that the party claiming there’s been a breach has to prove their loss. If proven, the party who has breached the warranty is only responsible for the loss and damage that’s foreseeable as a direct result of the breach. Limits on what can be claimed may also be in the Sale and Purchase Agreement (SPA).
Why do warranty claims arise?
The main reason why warranty claims arise is because the buyer hasn’t got what they thought they were buying in the first instance. If this happens to you, you will ultimately look to the warranties given by the seller when the purchase of the business was being finalised under the SPA in order to see whether or not you have any right to either unravel the purchase or any grounds to sue the seller for damages.
What’s the difference between warranty claims and indemnity claims?
An indemnity is different in its nature to a warranty. Put simply, an indemnity is an enforceable promise, as opposed to a statement of fact (a warranty). It’s a promise by the seller to reimburse the buyer for any loss suffered for specified events subject to defined conditions.
The main difference between the two types of claims is that in a warranty claim, the buyer will need to prove that the warranty wasn’t true at the date it was given: this is usually the sale completion date of the SPA. With an indemnity claim, these are typically losses suffered by the buyer after completion of the sale for particular agreed circumstances and matters. These will be set out in the indemnity itself.
Does the buyer have to prove a breach of warranty?
It is up to the buyer to prove that the warranty was untrue when it was made and also, that the breach caused a reduction in value of the company at that time when compared with what the buyer paid for it.
It’s worth highlighting here that any warranties will most likely exclude any facts and issues that the buyer is aware of before the completion of the sale because these will have arisen and been disclosed in the due diligence process undertaken beforehand.
What evidence do you need to have to make a breach of warranty claim?
As with any type of claim, the fundamentals of making a successful breach of warranty claim are largely based on the quality of the evidence that’s available in support of it. Some of the following factors require consideration in the gathering of evidence, so you should be prepared to think about these points carefully:
- Proving the breach: In order to prove a breach, you should begin by looking through documents such as correspondence between you and the seller and their legal representatives which now suggest with hindsight that a breach has occurred; likewise with collating any reports or other relevant data that bolsters your claim that there has been a breach.
- Engaging experts and other witnesses: It’s possible that you’ll also need to seek help from an expert to assess whether there was a breach of warranty and a financial loss arising from it, especially in particularly complex or technical industries. An expert can provide detailed reports of their findings and if the matter goes to trial, potentially give oral evidence if permitted by the court. It is wise to take detailed witness statements from anyone within your organisation who has been directly involved with the mechanics of the sale, or has been affected by the breach.
- Demonstrating how the breach has caused your business a loss: You must be able to show that your business has suffered a loss as a direct result of the breach of warranty. To do this, it’s advisable to pull together any financial records such as bank statements, invoices and receipts to use as vital evidence.
- Calculating the loss: For breach of warranty claims, calculating the loss is generally done by looking at the difference between the position you would have been in if the warranties had been true (this is usually the value of the company you’ve bought) and the position that you’re actually in as a direct result of the breach of warranty. As we’ve mentioned, this is likely to be where expert evidence comes into play.
How to make a breach of warranty claim
Along with identifying the breach and beginning to gather evidence, the first thing to focus on when thinking about making a breach of warranty claim is the contents of the share purchase agreement (SPA), because this forms the basis of the contract between you and the seller. Within the SPA itself, it’s common to find time limits for notifying the seller of the potential claim and also how long you have to formally issue and serve it, these would override any general statutory limitation periods if present.
There could also be a minimum financial threshold for bringing a claim specified in the SPA, along with a maximum liability of the seller relating to the particular warranty or warranties that you believe there have been breaches in relation to, so these key factors arising from the SPA must be addressed first.
Another important clause that the SPA might contain is around whether any means of alternative dispute resolution (ADR) ought to be explored before a formal claim is brought, as we’ll discuss further on in this article, or it may specify that this is a step to potentially be considered further along the line.
Taking everything into account, it’s definitely advisable to seek legal advice at this early stage. Because the requirements of the SPA will be so precise and because you’re legally bound by them, it’s vital not to take any action which could jeopardise your chances of bringing a successful claim if this is the route that you need to take. It might be the case that you’re recommended to try and resolve the issue by way of a more informal discussion initially, if there’s cause to believe that the other party would be open to this. Either way, it’s a good idea to try and establish the likely costs of pursuing a claim at this point too so that you’re fully aware of the extent of what these are likely to be, especially as they could include some or all of the seller’s costs if you’re unsuccessful.
Mitigating loss
Ensuring that you’ve taken reasonable steps to mitigate any loss you’ve suffered as a direct result of the breach of warranty is also important in the early stages ahead of bringing a formal claim. What you’ll be expected to do in order to action this will depend on the nature of your business but ultimately, it should involve minimising your financial and other losses as far as possible within your control. This will in turn play a part in the level of damages you’re awarded if you’re successful with a claim.
Notifying the other party of the claim
As we’ve mentioned above, the SPA will state a time limit for notifying the seller of any breach of warranty claims and this is typically much shorter than any statutory limitation periods. The SPA will specify what you need to do to put the seller on notice of the claim and this usually includes providing them with a reasonable level of detail around the warranty in question, along with reasons why you say there has been a breach.
When it comes to providing this notification, you’ll also be expected to serve the written notice by using the method dictated by the SPA for example, this may be by first class post. Using this specific method, the notice must be sent to the correct person at the correct registered address for the company.
What happens next: settlement, ADR/arbitration or formally bringing a claim
Once the seller has been validly notified of the claim, they may respond within the time limits determined by the SPA with an admission of liability or a denial, either of which may come along with an offer of settlement on a 'without prejudice' basis (or possibly not, in the case of a denial) or a proposal to negotiate with a view to settling. It will be a matter for you and your legal advisor to think about whether the settlement is reasonable in all the circumstances, both commercially and taking into account the financial costs and risks associated with litigation and a trial. This will be similar if negotiation becomes an option: you must have a clear idea of what your ideal outcome would be from this and what your fallback position would be if it doesn’t go in your favour.
If the matter can’t be resolved more informally at this stage, and if, after taking legal advice, you believe you have a realistic prospect of success, then the next step is to formally bring a claim. Again, the SPA must be reviewed to ensure that the correct procedures for doing this are strictly adhered to. There may also be a mechanism in the SPA around engaging in ADR before this happens, for example, this could be in the form of mediation. Alternatively, there could be a requirement for compulsory arbitration in the SPA, so again, this must be taken on board and complied with if so.
If bringing a formal litigated claim is, or becomes, the only option, there will be another set timeframe for doing this in the SPA to keep to. Make sure you think about where the seller is based when you reach this point because if they’re outside of the jurisdiction, you’re likely to need permission from the court to serve the claim on them and will need to factor in time for obtaining this and then serving the claim on them.
It’s worth mentioning that before you formally bring a claim for a breach of warranty, you should investigate as far as is possible whether the claim is likely to be commercially beneficial to you across the board. This includes checking whether the seller will actually have the financial means to pay the damages owing to you if you’re successful, as well as being aware of the harm a claim could bring to the business relationship between the two companies – and possibly other businesses who are also connected to you both in some way.
Remedies if your warranty claim is successful
If as the buyer, your claim for breach of a warranty is valid, you can make a claim for damages against the seller. Damages will take the form of financial compensation for the loss suffered. They will be the difference between the value of the company as warranted (generally taken to be the purchase price paid for the company) and the ‘true’ value of the company, had the buyer known that the warranties were incorrect.
How can warranty claims be avoided?
The most crucial point to be aware of when it comes to avoiding warranty claims as a buyer is to ensure that sufficient time and credence are given to the due diligence process, making certain that you or your solicitor have rigorously checked through all the warranty claims made by the seller, which will include making sure they’ve disclosed against everything possible in the disclosure letter.
What are Vendor Protection Provisions?
Something that both parties in the sale process need to give due consideration to are any vendor protection provisions in the agreement. The vendor protection provisions will govern how any claim in respect of a warranty is dealt with. Quite often, there will be specific procedures embedded in the SPA: these procedures will include and encapsulate specific time limits and, more often than not, there will be explicit monetary limits in respect of a particular head of warranty claim, or composite limits in respect of warranty claims in general. It’s quite common to find what are termed de minimis limits; in other words, minimum thresholds for bringing a warranty claim (for example, £5,000 or £10,000 for each head of claim), otherwise it may not be economically viable to make a claim in the first place.
What other considerations are important?
An important (but often overlooked) factor in considering and avoiding potential warranty claims is the lack of attention paid to the dispute resolution clause in the SPA, at the negotiation stage of the sale of assets or share capital. It’s common to find that when individuals or companies are making a purchase, they don’t actually envisage that a dispute will arise; however, in the cold light of day, it can often be anticipated or pinpointed where or what the disputes are likely to originate from. Consequently, focus should be placed on tailoring the dispute resolution clause to make sure that it best suits your purposes, whether you are acting as a buyer or a seller. This can lead to significant savings in the cost of court proceedings. For more information on this topic read our guide on dispute resolution clauses.
Ultimately, paying careful attention to such matters can pay dividends in the long run in circumstances where a dispute arises, so engaging thoroughly with the sale process in this regard can prove invaluable further down the line.
Summary
It’s clear that when buying and selling a business, all parties involved in the sale need to be fully aware of and understand any warranties and as a buyer, you should place a heavy emphasis on ensuring that rigorous due diligence is carried out before the sale is completed. The right legal support from a business dispute solicitor throughout this process is strongly recommended so that the possibility of future warranty claims is minimised but if a potential claim does materialise, you must act quickly to avoid being caught out by any contractual limitation periods imposed by the SPA and take steps to give proper notice of the claim to the seller.
