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 come in.
In this article, our dispute resolution solicitors, 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.
- 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 are the elements of a breach of warranty claim?
- How to make a 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?
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?
Generally speaking, 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 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, therefore, 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?
Yes. As mentioned above, it’s 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 completion of the sale, because these will have arisen and been disclosed in the due diligence process undertaken beforehand.
What are the elements of a breach of warranty claim?
There are a few key elements to bringing a breach of warranty claim. These can be summarised below:
- Checking the warranties provided by the seller: The exact wording of the warranties and what they relate to are both crucial factors. The success or failure of the claim will largely be dependent upon the wording used.
- Checking whether any of the warranties have been breached: This might be clear but often it is not. All of the circumstances will have to be considered, and seeking assistance from a specialist business disputes solicitor may be necessary to help determine whether there’s actually a breach.
- Checking the disclosures: The SPA will be drawn up when a business is sold and sets out the terms of the sale. This is often accompanied by a disclosure letter and the two will need to be read in conjunction with one another when there’s a potential breach of warranty claim on the horizon. An example of how this works in real terms would be that there could be a warranty in the SPA stating that, subject to the disclosure letter, the business being sold has no outstanding disputes, but then the disclosure list would detail any outstanding disputes with a view to covering the seller.
- Checking whether there’s any limitation on bringing a claim: It’s very common for there to be strict time limits imposed in the SPA, as a contractually-binding document, about how soon after a sale is completed any warranty claims can be brought against the seller and the chances are that it will be much shorter than the statutory limitation period – for example, one or two years as opposed to six. There’s also likely to be a specific form of notice that’s required by the SPA too when it comes to formally notifying the seller of the claim before any court proceedings are begun, so it’s vital to ensure that these factors are considered and followed.
- Determining what loss has been suffered: Usually, the measure of damages for a breach of warranty claim is 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. The key question to be asked in light of this would be to look at what the buyer would have done if full disclosure of the matter in question had been made prior to the sale. This is likely to lead to further evidence being necessary and may in some cases require expert evidence being given.
How to make a warranty claim
Returning to the share purchase agreement is the first step in bringing a warranty claim so that any notification requirements are correctly fulfilled at the outset: if they’re not then this can render the notice given to the seller invalid and additionally, proof of the notice being given should be kept.
Once due notice has been given, court proceedings for the warranty claim can then be issued if agreement cannot be reached on the claim. It’s advisable at this point – at the very latest – to seek professional legal support to guide you through the litigation process.
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 is 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, generally speaking, 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 the seller. This can lead to significant savings in the cost of court proceedings.
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.
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.