Warranties and indemnities

As explained elsewhere on this site, neither common law nor statute protects the purchaser of the shares in a company. Rather, the principle of caveat emptor, or ‘buyer beware’ applies. Unless a misrepresentation has been made, under the common law there is almost no comeback if the company does not prove to have the assets or potential that was expected, or if the company’s liabilities prove greater than expected. As liability for misrepresentation is very likely to be almost totally excluded by the acquisition agreement (other than for fraudulent misrepresentation, which cannot be excluded), the purchaser of a company needs good legal representation to ensure that he gains the protection that is not provided by the common law.

There are two principal means of achieving this. First, a wise purchaser will instruct his solicitors and financial advisers (working together) to perform a thorough due diligence exercise. Secondly, the purchaser’s solicitors will ensure that the contractual terms provide as much protection for the purchaser as can be negotiated. This may in some cases take the form of deferred consideration payable when the true value of the company has been ascertained, but in almost all cases warranties and indemnities will be required from the vendor to protect the purchaser.

In business acquisitions, the purchaser is not in as exposed a position because he does not automatically assume the liabilities of the business. However, if he is well advised he will still seek warranties and indemnities, although these may be less extensive than in a share/ company acquisition.

The protection afforded by warranties and indemnities

A warranty is an assurance given by the vendor in the acquisition agreement that a certain state of affairs exists. In practice a normal acquisition agreement will contain a long schedule of general warranties covering almost every facet of the business, including accounts, assets, contracts, borrowings, real and intellectual property, litigation, regulatory matters, employees and pensions. In addition there are usually concerns specific to the company or business being acquired, and there will therefore also be specific warranties covering these matters. Therefore the warranties are effectively a checklist of matters which may concern the purchaser.

If these assurances transpire to be untrue, in principle the purchaser will have a claim against the vendor for breach of contract. However, this is subject to common law restraints; such as the principle of ‘remoteness’- loss that does not flow naturally from the breach of warranty, or which was not fairly and reasonably in the parties’ contemplation when they made the contract, is in principle irrecoverable. Two other important restraints are the fact that only nominal damages can be awarded where no actual loss has been caused to the purchaser by the breach of warranty; and the fact that the party who suffers loss must use reasonable endeavours to minimise (or ‘mitigate’) his loss wherever possible. The normal measure of compensation on a share sale is for the purchaser to be awarded the difference between the value of the shares in the company if the warranty had been true and their actual value; i.e. the difference in the value of the shares with and without the matter which caused the breach of warranty.

In complete contrast, an indemnity is a promise to indemnify, i.e. to reimburse the purchaser in respect of a designated type of liability if it arises. For example, if the purchaser is concerned that a particular ex-employee is likely to bring an Employment Tribunal claim against the company, but the vendor assures him that this will not be the case or that if it happens the claim would be easily defeated, the parties might agree that the vendor indemnifies the purchaser against the costs of defending such a claim, and against the costs of meeting any judgment awarded against the company.

Crucially, unlike warranties, if an indemnity has been given and is later triggered by an event, the actual loss must be reimbursed to the purchaser, pound for pound. The principles of remoteness and mitigation do not apply, unless negotiated into the acquisition agreement by the vendor. So, in our example, if the ex-employee successfully brought a claim of unfair dismissal and was awarded £12,000, the vendor would be required to pay the purchaser £12,000 plus his legal costs (and probably costs of lost management time) and interest.

On a share sale the tax position of the company will be covered by warranties (covering matters such as the target company’s compliance with VAT and PAYE requirements etc.), but also by a document called a Tax Deed. This should really be called a Tax Deed of Indemnity, because this document is really an enormous indemnity against the tax position of the company not being as expected. Any specific tax charges which arise over and above those provided in the accounts will be caught by the Tax Deed, and the vendor will be required to indemnify the purchaser.

Indemnities can therefore result in enormous post-completion reductions in the purchase price and are a very useful means of allocating some specific risk from the purchaser to the vendor. Warranties will pass less risk back to the vendor, but can still result in significant liability if they are breached. Of course, as explained elsewhere on this site, this assumes that the vendor remains capable of meeting a judgment, and in the jurisdiction. If the vendor has no guarantor and then proceeds to lose all of the sale price at the gambling tables, or to emigrate to a country that does not recognise or enforce UK judgments, in practical terms any warranties and indemnities will not be worth the paper they are written on. For this reason at least part of the purchase price is often held in a joint bank account of the parties’ solicitors and not released for a certain period after the acquisition in case it is required to meet warranty and indemnity claims. This is the retention mechanism.

Limiting the vendor’s liability

Rather than simply accepting potentially huge exposure to warranty and indemnity claims, a well-advised vendor will negotiate his own contractual safeguards into the warranties and indemnities.

Some of the ways he can do this are:

  • By negotiating the deletion of certain of the warranties and indemnities.
  • By negotiating changes to the wording of the warranties and indemnities to reduce their scope – such as by adding qualifications like time periods, amounts or the state of knowledge of the vendor. For example, a warranty that the company has not acquired any asset on terms which were not by way of bargain at arm’s-length might be ‘watered down’ massively by adding the words ‘within the last twelve months’.
  • By limiting the maximum liability under the warranties, usually to the price paid for the target company or business.
  • By negotiating a minimum threshold for claims, and a de minimis limit on each claim. For example, a £1 million acquisition agreement may provide that no individual claim can be raised unless the liability in respect of that claim exceeds, or is likely to exceed £2,500; and that before any claims can be brought at all either one claim or a ‘basket’ of claims, must exceed £25,000. This is only common sense, as it is in neither party’s interest potentially to have to litigate over very small value claims; and sensibly advised parties will realise that it is almost impossible to accurately value any business or company and a small margin of error should be ignored. Once that margin is exceeded, though, all loss will normally be recoverable – in our example, if the ‘basket’ of claims is worth £40,000, then the whole £40,000 will be recoverable, not just £15,000.
  • By agreeing time limits on bringing claims. General warranty and indemnity claims normally need to be notified within 12-24 months of the acquisition, but because the Inland Revenue has 6 years from the end of any tax year to investigate, Tax Deed and tax warranty claims are normally subject to a much longer limitation period, in some cases up to 7 years.
  • By providing for ‘set off’ of amounts understated in the accounts, or sums received from third parties etc., as ‘credits’ against warranty and indemnity claims.
  • By providing for remoteness and mitigation principles in indemnity claims.
  • Lastly, but of very great importance, by use of a disclosure letter.

The disclosure letter

The disclosure letter goes hand in hand with warranties. It is a letter from the vendor, or his advisers, setting out aspects of non-compliance with the warranties. These are cross-referenced against, and qualify, the warranties. So where disclosure has been made, in principle the purchaser is put ‘on risk’ of the individual matter contained in the letter, and cannot later claim in respect of it.

An example should make this clearer.

A typical warranty might be a statement that, “so far as the Vendor is aware there is no industrial action or dispute which is threatened or existing concerning the Business”.

The Vendor and the Business are capitalised because they are defined in the agreement, and to understand the warranties it is necessary to cross-refer to the definitions set out in the agreement.

The statement may or not be true. If the vendor believes that it is true, it will not disclose anything against that warranty, and the purchaser will rely upon the warranty, because warranties are terms of the contract. If it subsequently transpires that the statement was untrue, subject to the limitation clauses within the acquisition agreement, the purchaser would have a claim against the vendor for damages (a monetary award) for breach of contract.

Conversely, if the vendor is aware of impending industrial action he would be very foolish not to disclose that in the disclosure letter; with a full explanation and an analysis of the likely costs.

The purchaser will not normally object to this. This is because, although the primary aim of warranties is to protect the purchaser, their secondary purpose is to elicit for the purchaser information about the business or company being acquired. Since no business is a ‘typical’ business, there will be instances where the statements in the warranties will be untrue or misleading, particularly in the case of widely drafted warranties.

So in those cases, the vendor will provide information – ‘disclosures’ - to correct the representations made by the warranties. The disclosures will consist in each case of a concise summary of the instance of non-compliance with the warranty, coupled in most cases with supporting documents, or a precise cross-reference to documents already disclosed. The disclosures need to be full and fair, as otherwise they may not be found by a Court to have given the purchaser adequate warning of the problem; and therefore not to have qualified the warranties.

As noted above, the ‘incentive’ to make the disclosures is that the vendor cannot be in breach of warranty in the future for those instances of non-compliance with the warranties that it discloses fully and fairly.

A well-advised vendor will also make ‘deemed disclosures’ of matters that do not need to be specifically stated, such as all problems shown in the accounts or in the company’s file at Companies House, and all matters in the public domain.

The purchaser will subject the disclosure letter to the same degree of scrutiny that he will the acquisition agreement.

The drawback for the vendor with qualifying the warranties by making disclosures is that the purchaser may not wish to accept certain disclosures, because the disclosure effectively throws the risk of that problem back to the purchaser; albeit that he is forewarned and therefore forearmed. It is arguable whether this approach is now legally effective. Alternatively, the purchaser may seek to reduce the purchase price by the amount of any liability disclosed, or by the costs of rectifying any problem disclosed. Another very likely response (also explained above) would be for the purchaser to demand indemnification from the vendor in the contract, in respect of certain disclosures that particularly concern them, so again throwing the risk and cost of the problems back at the vendor.

These pages only give an outline of the negotiations that should take place regarding warranties and indemnities. Whether you are the vendor or the purchaser, we would be very pleased to give you the benefit of our long experience of these negotiations and procedures, and guide you through the whole process to a successful and lucrative outcome.