The Bite-Size Business Brief: Warranties, Disclosure and Indemnities

Warranties, Disclosure and Indemnities

Introduction

The starting position in the sale of a business is caveat emptor (“buyer beware”). Risk in an M&A transaction generally shifts to the buyer upon completion of the sale, which is when the seller transfers legal title to shares or assets to the buyer. As a result, a buyer will usually require a seller to provide detailed and accurate information about the business being sold and they may seek a variety of contractual protections in the sale and purchase agreement (SPA).

Warranties

An SPA will often contain a suite of operational warranties which may cover a variety of areas/functions relating to the business, including as to ownership, solvency, accounting practices, employment, insurance, intellectual property, real estate, litigation and so on. Each warranty is essentially a contractual statement of assurance provided by the seller to the buyer confirming that a certain state of affairs exists. If a warranty is found to be false after the acquisition completes, the buyer may be able to recover damages from the seller for breach of contract. The level of damages payable would place the buyer in the financial position it would have been in had the warranty been true. As such, warranties are often heavily negotiated as they go to the heart of risk allocation in an M&A transaction. A seller will usually aim to limit warranties so they do not predict the future and the extent of certain warranties may be qualified by materiality, duration or the extent to which the seller is actually aware of the warranted matter.

A seller should also ensure that their liability in respect of a warranty claim is not uncapped in regard to duration and quantum. Additionally, a seller will often seek to include a limit on liability such that any individual claim must have a minimum value (known as the de-minimis) and this will often sit alongside an aggregate threshold (known as the basket) where any claims meeting the de minimis threshold are first pooled, and can then only be claimed against once the basket threshold is exceeded.

Disclosure

A seller may be protected against a breach of warranty claim if the buyer has, or is deemed to have, knowledge of the situation prior to entering into the SPA. The process of disclosure involves the seller sharing (or disclosing) to the buyer known circumstances and facts about the business. For example, a seller may be asked to warrant that there have been no recent employee dismissals. If, however, an employee was dismissed recently, the seller should provide specific details (i.e. the disclosure) to the buyer relevant to the dismissal. This should ensure that the seller is protected from a breach of warranty claim, i.e. disclosure has the effect of “qualifying” the warranties.

In an M&A transaction formal disclosure is usually captured in a disclosure letter drafted by the seller and addressed to the buyer, which includes both general and specific disclosures. General disclosures typically include items such as publicly searchable information and the contents of any data room provided. Specific disclosures are made against the specific warranties and should detail matters that qualify or contradict the specific warranties in the SPA.

Indemnities

An indemnity is essentially an undertaking from a seller to reimburse a buyer, on a dollar for dollar or dirham for dirham basis, for a specific loss, without the need to prove any “fault”. Indemnities are generally only appropriate for covering specific liabilities that the buyer may have uncovered during due diligence or disclosure, but which have not yet crystalised. For example, the target business could be the defendant in active litigation which has not yet been settled. In this scenario it may be appropriate for the seller to indemnify the buyer against any future amounts that may be payable to settle the litigation.

Before agreeing to an indemnity a seller should consider appropriate limits to its liability, including:

• capping the maximum liability;

• imposing a time limit after which the buyer’s right to make a claim is lost; 

• excluding liability for consequential loss; and/or

• requiring the buyer to inform the seller of the occurrence of liability to allow the seller to mitigate any loss and potentially take control of any related third party claim.

Warranties vs Indemnities

Some of the key differences between a warranty and an indemnity are as follows:

• When a buyer brings a breach of warranty claim, they are obligated to mitigate the losses that are being incurred. There is no obligation for a buyer to mitigate its losses under an indemnity. 

• The seller does not need to have contributed towards any damage in case of indemnities; the manifestation of the defined damage is generally sufficient.

• Depending on the SPA terms, a buyer that knows about a warranty breach might be prohibited from bringing a claim on the grounds that they were aware of the breach and still entered into the agreement. However, knowledge of a breach of contract will not prevent an indemnity claim.