Warranties and indemnities

Barry Riley

Warranties and indemnities

We often get asked by clients to clarify the technical differences between a warranty and an indemnity, which are two very different things in respect of a private acquisition/disposal. Both will be contained within the sale and purchase agreement, and the impact of each should be fully understood and not at all underestimated.

What are warranties?

Warranties are contractual statements contained in the acquisition agreement which take the form of assurances from the seller as to the condition of the business and, in particular, any existing liabilities. They are usually contained in a separate schedule to the agreement.

A thorough due diligence exercise should provide the buyer with a good picture of the value of the business and allow it to agree a price based on its knowledge and expectations gleaned from the exercise.  Warranties should not be seen as a substitute for due diligence – the two are complementary. It is always preferable for a buyer to know of a problem in advance, as it then has the opportunity to walk away, argue for a price adjustment or seek specific contractual protection, rather than to have to sue for breach of warranty at a later stage.

Quite apart from the uncertainties inherent in disputed claims, the buyer’s rights in relation to breach of warranty are invariably limited in the agreement itself.

Warranties serve two main purposes:

1. To provide the buyer with a remedy if the statements made about the company later prove to be incorrect and the value of the company is thereby reduced. Warranties therefore provide a form of retrospective price adjustment.

2. To encourage the seller to disclose known problems to the buyer. As the seller’s liability under the warranties is invariably limited to the extent that proper disclosure is made against them, the effect of the warranties should be to flush out potential problems.

The difference between a warranty and an indemnity

Warranties should be distinguished from indemnities. An indemnity is a promise to reimburse the buyer in respect of a particular type of liability, should it arise. The purpose of an indemnity is to provide a guaranteed remedy (on a pound-for-pound basis) for the buyer where a breach of warranty may not give rise to a claim in damages, or to provide a specific remedy which might not otherwise be available at law.

For example, on a share purchase, the buyer will usually seek a warranty as to the accuracy of the target company’s books and records. If it subsequently finds that they are in a mess, the value of the company has probably not diminished, but it may have to incur costs to tidy them up. If it had taken an indemnity from the seller, it would be able to recover those costs.

It is also common for the seller, on a share purchase, to give a tax indemnity in respect of all tax liabilities of the target company to the extent that they are not provided for in the last audited accounts or they do not arise by way of corporation tax on normal trading profits since the last balance sheet date.

Indemnities are usually most appropriate to cover specific risks which are of particular concern to the buyer

Other risks commonly covered by indemnities are:

–          Environmental risks.

–          Doubtful book debts.

–          Repayment of loans by the target.

–          Product liability claims in relation to products sold before completion.

–          Litigation for infringement of intellectual property rights that may have a significant impact on the target’s    business.

In certain areas, there may be an overlap between warranties and indemnities. For example, in relation to tax, the warranties will cover the accuracy and timely submission of returns. Indemnities are appropriate if the target is liable to pay tax not provided for in the relevant accounts and for obtaining protection against liability under anti-avoidance provisions.

It is imperative that individuals involved with the sale or purchase of a business get their head round the differences between the terms, and understand the implications of each; both will have an important part to play in the preparation and negotiation of the final contract for sale or purchase.

For more information on the above commentary, please contact Barry Riley on 0117 9453 042 or briley@metcalfes.co.uk

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