Out-Law Guide | 21 Aug 2012 | 9:31 am | 5 min. read
When businesses are bought or sold the seller typically gives the buyer 'warranties', 'indemnities' and 'disclosures' about the business concerned. This guide explains what these are and what impact they can have on the companies concerned.
What are warranties and indemnities?
In this context warranties are statements made by the seller that certain facts in relation to the business or the company are true. Should the buyer later discover that a warranty was not true this could give rise to a claim for breach of warranty entitling the buyer to damages.
Indemnities are promises by the seller to make good losses of the buyer if specific events occur.
The distinction between a warranty and an indemnity may be significant as the amount of damages recovered by a buyer under a warranty claim may differ from the amount of compensation which would have been recoverable by the buyer had the same matter been covered by an indemnity.
Why are warranties and indemnities necessary?
Buyers want to see warranties and indemnities included in the sale agreement because:
- the buyer is usually unable to gain a complete knowledge and understanding of the business or the company's affairs before committing to buy;
- where the sale is a sale of a company, the company is a legal person in its own right and the buyer will, when it buys the shares, buy the company with all its current and future liabilities (whether or not they are known or ascertainable by a review of the company's affairs); and
- the general law does not imply a great deal of protection for the benefit of a buyer in a transaction of this type (unlike, for example, a sale of goods transaction involving a consumer) and the buyer will therefore expect suitable protections to be written into the sale agreement.
What do warranties and indemnities do?
Warranties and indemnities re-allocate risk between the seller and the buyer. They are potential price adjusters. A buyer is likely to offer a higher price for a business or company if there are warranties and indemnities in place, meaning that any hidden risks have been kept by the seller.
A buyer who buys a company for a price which is based on the value of its net assets will want to include in the sale agreement a warranty that the company's net assets are not less than £X (the value upon which the buyer based its price).
Any subsequent discovery that net assets were in fact less than £X, perhaps because of the surfacing of a surprise liability, would enable a warranty claim under which the buyer could seek damages from the seller. It is likely that the damages that the buyer would seek would be similar in amount to the amount by which the buyer would have reduced the purchase price had it known of the liability before buying the company.
What is disclosure?
In response to the warranties the seller and its advisers carry out a disclosure exercise which results in the preparation of a disclosure letter. For this exercise to be successful it is necessary for the seller's advisers to understand all material aspects of the business or company being sold.
The disclosure letter has two purposes in a business or company sale:
- it acts as a collection point for information disclosed to the buyer about the business or company being sold; and
- it records exceptions or qualifications to the warranties contained in the sale agreement.
Why is disclosure necessary?
Both the seller and the buyer are usually keen to make sure that there is a record of every significant document disclosed during the course of the transaction and this is often done by attaching copies or lists of such documents to the disclosure letter.
Warranties are usually drafted in wide, general terms and disclosure is the mechanism by which exceptions or qualifications to them can be documented and agreed. If the seller is asked to give a warranty in the sale agreement that the business or company is not affected by any legal dispute but this is not true, then instead of amending the terms of the general warranty the seller will disclose details of all relevant disputes in the disclosure letter (with reference to that specific warranty).
If the buyer accepts the disclosure then the seller is no longer liable in relation to those disputes. The disclosure letter therefore provides the buyer with details of known exceptions to the warranties.
What does disclosure do?
As each disclosure in the disclosure letter reduces the buyer's rights under the warranties (by excluding the matter disclosed from the scope of the general warranty) it effectively increases the buyer's risk and for this reason the buyer may not accept all disclosures which the seller would like to make to it in the disclosure letter.
Successfully limiting a seller's liability under warranties by conducting a disclosure exercise requires close liaison between the seller and its advisers.
While it is obviously in the seller's interests to make full, open and clear disclosure, the seller should bear in mind that this might lead to attempts by the buyer to renegotiate the purchase price. However, the seller may be guilty of a criminal offence if he dishonestly makes a false representation on a share sale (and, on a share sale, if it conceals any information which could affect the buyer's decision as to whether or not to buy the company). The seller will have to work closely with its advisors to achieve the best balance of risk limitation through the disclosure exercise.
Tax indemnity on sale of a company
A tax indemnity is an indemnity from the seller in favour of the buyer against any tax liabilities falling on the company prior to completion, apart from liabilities shown in the last audited accounts of the company and those arising in respect of ordinary business after the date of those accounts. The intention is that the indemnity covers surprise tax liabilities which do not arise from normal business.
Because it covers tax liabilities which may arise, but have not yet arisen, in relation to events prior to the sale, the indemnity is not usually qualified by matters disclosed in the disclosure letter.
Joint and several liability
Where there is more than one seller the buyer will usually want the sellers' obligations under the warranties and indemnities to be "joint and several". This is the best position for the buyer as it means that if it has a claim under the warranties or indemnities it can make that claim against all or any of the sellers and can therefore select the seller who is in the best position to pay or settle the claim.
Whilst under English Law a seller who satisfies a warranty or indemnity claim or who settles such a claim in good faith will usually have a right of contribution from his fellow sellers under the Civil Liability (Contribution) Act 1978, this Act does not apply in Scotland.
What a court may consider to be fair contribution will depend on all the circumstances at the relevant time and it is therefore sensible for joint sellers to formalise their own contribution arrangements when entering into the sale agreement. This is usually done in a contribution agreement.
Other limits on a seller's liability
Additional limits on a seller's liability under the warranties (and in some cases indemnities) will often be negotiated into the sale agreement including:-
- a maximum limit or cap on the total amount of claims;
- a minimum limit (meaning an agreement that no claims will be made unless and until the total of all claims passes an agreed threshold); and
- time limits (so that the buyer must make his claims within stated time periods and the seller's liability comes to an end after a period).
Where there is more than one seller the sellers’ advisers may also seek an individual maximum limit or cap on the total amount of claims which may be made against each seller.