The most common way to buy a business is to buy the shares in the company that operates the business. In her latest blog post, Beyond Corporate Paralegal, Millie Brookes, looks at what Warranties and Indemnities are, and how a seller can protect itself against a claim.  

The primary document in a share purchase transaction is the share sale and purchase agreement (SPA). This document contains the key details for the purchase itself, such as the price and the mechanics of and conditions to completion as well as certain rights and obligations of both the buyer and seller. For the buyer, a secondary but vital purpose of the SPA is to ensure that the seller can be held responsible for the condition of the company at completion and offers recourse if the condition differs from that expected while the seller wants to limit its exposure so far as possible. This allocation of risk is achieved through warranties and indemnities, limitations on liability and the disclosure exercise.

What is a warranty?

Within an SPA, warranties are statements of fact made by the seller about the condition of the company at completion. They are used to allow a buyer to establish the ‘full picture’ of the business they are acquiring. As there isn’t a standard set of warranties, it is for the parties to the agreement to decide on which areas to cover. Warranties can cover a range of aspects of the business such as tax, intellectual property, employment and litigation and usually a comprehensive approach is adopted. An example of a warranty is ‘the Company’s statutory books are written up to date’. When making these statements, the seller should be assured that the warranty is true.

What is an indemnity?

Indemnities within an SPA are promises made by the seller to reimburse the buyer in respect of any loss suffered. They are essentially assurances that compensation will be paid in the event a specified loss is suffered. An example of an indemnity (simplified for these purposes) would be ‘the buyer will indemnify the seller against any costs, expenses, damages and losses suffered arising out of any claim made against the company by a third-party for breach of its intellectual property rights’.

How do warranties and indemnities differ?

If the seller breaches a warranty it has given, this will give the buyer a right to claim for damages on the basis of a breach of contract. The aim of these damages is to put the buyer in the position it would have been in had the warranty been true. However, when calculating the buyer’s loss, regard will be given to the buyer’s duty to mitigate its losses as well as contractual principles of remoteness. Breaches of warranties will only be successful if the buyer can show that the warranty was breached and the effect of the breach reduced the value of the shares in the acquired company. It could be difficult for a buyer to prove this diminution in value. Whereas indemnities provide guaranteed compensation for a specified loss on a pound for pound basis. In terms of quantification of the damages, indemnities are typically easier to quantify as they cover all loss suffered whereas warranty claims are subject to mitigation and remoteness.

The limitation periods also differ. Indemnity claims run from the date on which the loss is suffered, in comparison to warranty claims which run from the date of the breach of the warranty. This can often mean that the limitation period for indemnities is longer but this isn’t always the case. Often, a time period for claims will be contractually agreed under the SPA, meaning that there will be a specified limitation period.

How can a seller protect itself against a warranty and/or indemnity claim?

A primary way for a seller to protect itself is to undertake a detailed disclosure exercise, reviewing each warranty and indemnity and stating clearly in correspondence to the buyer any information that qualifies the warranty/indemnity. Ensuring that all of the required disclosures have been made is a crucial way for the seller to avoid liability. The disclosures will usually be made in the form of a letter with an attached agreed bundle of documents. Additionally, during the negotiation stage the seller should be sure to exclude or amend any warranties or indemnities which are not appropriate.

In conjunction with the disclosure exercise, the seller should agree limitation clauses within the SPA in relation to the warranties and indemnities. These limit both the time period in which a claim can be brought and a maximum amount of liability, usually the consideration paid for the shares sold.

How can a seller obtain comfort that it can keep its sale proceeds?

An added layer of assurance that the seller can obtain is warranty indemnity insurance (W&I Insurance). In the event of a warranty breach, the buyer would claim against the policy instead of against the seller directly.  One benefit for a seller is that W&I insurance reduces the need for buyers to ask for any of the proceeds of sale to be held in an escrow or hold-back accounts which will allow the seller to access the full consideration amount of the sale and make a clean exit at completion of the deal. However W&I insurance can be costly and take time to put in place and some buyers will not allow sellers to have it in place, though that is more common on a partial exit than a full exit.

Conclusion

Warranties and indemnities are a crucial component during the share sale transaction in terms of allocation of risk and eliciting information from a seller about the true condition of the business. In short, appropriate warranties and indemnities allow a buyer to ensure it buys the company in the expected condition and appropriate disclosures and limitation provisions allow a seller to maximise its chances of keeping the monies paid for its shares. As such, due care and attention is fundamental to a successful outcome for both parties and should be seen as a collaborative exercise for the benefit of both sides.