In buying the shares of a target company, a Purchaser cannot avoid taking over the liabilities and commitments of that company. It is therefore normal for a Purchaser of a private company to receive assurances in the form of statements of fact as to those liabilities and commitments. These assurances, in legal terms, take the form of warranties which, if breached, will give rise to a claim for damages against the Sellers by the Purchaser.
There are five main ways of mitigating the potential liabilities of the Sellers. These are to:
- negotiate the extent and detail of the warranties;
- negotiate the basis of liability;
- include specific exceptions;
- include Sellers’ protections; and
- take out warranty insurance cover.
Each of these categories is examined below.
1. Negotiation of warranties
It is common for the warranties schedule (which is initially prepared by the Purchaser’s solicitors) to form the bulk of the Sale Agreement, sometimes running to 40 or 50 pages in length. However, there is obviously a limit to the degree of comfort which a Purchaser can reasonably expect to receive. In acting for the Sellers in reviewing a warranties schedule, the Sellers’ solicitors will need to assess in relation to each warranty what the Sellers can reasonably be expected to give. Some warranties are included merely to confirm or establish factual detail, but others which are onerous should be deleted in full or be sufficiently watered down. It is critical that the drafting of each of the warranties is precise, so that their meaning and effect is clear and fully understood by the Sellers required to give the warranties.
The Sellers should be able, and will be required to warrant certain statements of fact (for example, that the company is not involved in litigation). At the other end of the spectrum are warranties which are either more subjective (for example, has the company sufficient working capital) or which seek to commit the Sellers to warrant forward into the future (for example, the accuracy of a profit forecast). In both these cases, the Purchaser cannot expect the Sellers to give the warranties in such loose terms. What the Purchaser can expect the Sellers to do in such circumstances is to provide full and up to date details and copies of all relevant information, so that the Purchaser can form its own views. Ultimately, if the issue cannot be resolved through the respective parties’ solicitors, it will be a commercial decision for either the Sellers or the Purchaser as to whether, or in what form, the warranty is included.
In between these two extremes are warranties in relation to which neither the Sellers nor the Purchaser are able to provide particular information. It will then be a question of risk apportionment between the parties. A common compromise is for a warranty to be restricted to the Sellers’ knowledge or awareness, although an additional qualification may be included that the Sellers have made reasonable enquiries into the subject matter of the warranties. It will obviously be to the Sellers’ advantage to qualify as many warranties as possible in this way.
2. Basis of liability
This is a matter on which both the Sellers and the Purchaser are likely to form a view. It will be necessary to determine which, if it is not to be all, of the Sellers will be required to act as a warrantor. Some of the sellers may have a more nominal or “hands-off” role. However, if each of the Sellers is to significantly benefit financially from the sale of his shares, then the Purchaser may insist on warranties being given by each of them. The argument may then follow as to whether liability should be joint and several or merely several as between the Sellers. If several liability alone is accepted, a Seller will only be liable in the event of a damages claim to the extent of is proportion of the purchase price. Alternatively, if the Sellers are required to accept joint and several liability, they will each be potentially liable for the full amount of any claim.
3. Specific exceptions
The most commonly used method of providing exceptions to warranties is through the Disclosure Letter. This is drafted by the Sellers’ solicitors with detailed input from the Sellers and their other advisers. Each warranty needs to be analysed in turn and any inconsistency or exception noted and, wherever possible, substantiated by written evidence. Other measures include clauses in the Sale Agreement which allow for “set-off”. These may allow the Sellers to reduce against any warranty claim by a sum equal to the amount by which it emerges after completion that the target company is in a better position than previously thought. A similar situation can also apply if, for example, an insurance policy is available to cover the subject matter of a warranty claim, with the Purchaser being obliged to use the applicable insurance proceeds before being permitted to proceed with a claim for breach of such warranty.
4. Sellers’ protections
Each Sale Agreement will usually include monetary and time limits on the Sellers’ liability under the warranties. The extent and detail of these protections will depend on the nature of the transaction. The most significant of these are:
(a) Maximum Limit (“De +
This imposes a ceiling on the liability of the Sellers under the warranties. This is commonly set at the same level as the price received for the sale of the shares, but this calculation becomes more involved when other benefits or factors form part of the negotiations.
(b) Lower Limit (“De Minimis”)
This is included so that no warranty claim can be brought unless the amount of any claim is over a set amount. The rationale for such a clause is that it builds in a margin of error for the Sellers.
(c) Time Limit
The Sellers will not want to remain “on the hook” for a potential claim for longer than it is reasonable or necessary. After a period of time, the Purchaser will have had the opportunity to establish whether these are any problems with the target company. After that time, a line is drawn and, in the absence of any fraud, the Purchaser will no longer be allowed to pursue a claim. The length of this period normally relates to either a set number of years or a certain number of audits.
5. Warranty insurance
As a fall-back measure, insurance cover is available to indemnify the Sellers against damages and any legal expenses incurred in defending breach of warranty proceedings. Specialist insurance advisers need to be involved but it must be noted that this kind of policy does not provide cover against every action brought. The purpose of the policy is to provide cover specifically against claims which arise out of errors made by Sellers acting in good faith, and who have described their company in terms which later prove to be misleading or inaccurate.
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