Warranties and indemnities are key contractual mechanisms in any complex or high value commercial transaction, especially in the context of sale and purchase agreements (SPAs).
The following guide outlines the use of warranties and indemnities in SPAs, comparing the key differences and examining how these types of clauses can be enforced through the courts. We also look at the importance of putting in place warranty and indemnity (W&I) insurance to protect the parties against the risks associated with warranty or indemnity claims.
Warranties & commercial transactions
When it comes to selling a company or company stock, ensuring that the sale and purchase agreement (SPA) reflects and protects the parties’ interests, as either a buyer or seller, will often be the overriding consideration on both sides. The SPA is the primary legal document in any complex or high value commercial sales transaction, such as where one business is acquiring another, or when selling off company stock, land or other valuable business assets.
The SPA will provide the legal framework to complete the proposed sale, incorporating the agreed terms and conditions, typically after protracted negotiations. It will also be used to put in place a number of important contractual provisions to protect the parties’ respective interests and mitigate any potential risks, including warranties.
A warranty is a contractual assurance made by a seller as to the condition of the company or the assets being sold. Warranties can cover all kinds of issues, including company accounts, contracts, taxation, debt, litigation, employment, property and intellectual property rights. In order to protect the buyer against any unexpected liabilities post-completion, the seller can be asked to provide contractual assurances, in the form of warranties, in respect of any area of concern regarding the state of a company’s affairs. From the buyer’s perspective, a warranty therefore represents one of the most important types of contractual provision within a SPA.
Under English common law, the starting point for a buyer in any asset or share purchase transaction is the latin maxim ‘caveat emptor’ or ‘let the buyer beware’. This means that the law will not generally afford the buyer any protection as to the nature or extent of the assets and liabilities that they are acquiring. This means that the buyer will usually conduct a thorough due diligence exercise to learn as much as they can before entering into the transaction. This information-gathering phase will enable the buyer to better understand the risks and liabilities involved with the purchase of the company, or the company’s stock or assets, and highlight the areas where protection should be sought in the form of warranties.
Indemnities & commercial transactions
An indemnity is essentially a promise by one party to compensate another for the loss suffered in relation to certain eventualities, commonly referred to as ‘trigger events’. A trigger event can be anything defined by the parties, including any fault or negligence by one party, or a specific action or breach of contract. The indemnity then operates to transfer the risks, or reallocate the associated costs, between the parties, changing what they would otherwise be liable to pay or entitled to be awarded. An indemnity will simply be triggered by losses being incurred, without the need to prove fault, in this way avoiding rules around causation, remoteness and mitigation under a normal damages claim.
In the context of asset or share purchase transactions, an indemnity is usually an agreement by the seller to reimburse the buyer for any losses arising from the fact that a warranty turns out to be incorrect. They are therefore commercially significant and often heavily negotiated contractual provisions that allow the parties to manage the risks around post-completion liabilities, making the seller automatically liable for any loss suffered by the buyer.
As a general rule of thumb, where disclosures are made against a warranty by the seller, thereby limiting the statement of fact, the buyer will always seek to secure an indemnity against any known liabilities that they have discovered. A disclosure letter can be used to fix the buyer with knowledge about specific aspects of the business which may be inconsistent with any warranties contained within the SPA. This means that if a warranty is breached, provided the relevant matter has been fully disclosed within the disclosure letter, the buyer will be prevented from bringing a claim in this respect, unless they have an indemnity place.
Warranties and disclosures serve separate but interdependent purposes. While the warranties are a protection for the buyer, the disclosures work so as to limit the seller’s liability under a warranty. Typically, these disclosures will enable the buyer to evaluate the nature of the risk and adjust the purchase price to reflect this, although the buyer will often insist that certain critical warranties are made on an indemnity basis so as to redress the balance.
Differences between warranties and indemnities
In broad terms, both warranties and indemnities are a means of reallocating risk between a buyer and seller, where the buyer will often seek specific contractual statements and assurances from the seller to bridge the lack of protection afforded by common law. Equally, the seller may attempt to protect its position by disclosing against warranties, or by restricting the scope of any warranties and indemnities given. In this way the parties can seek to regulate their relationship and provide clear guidance from the outset regarding party responsibility, especially in respect of liabilities once the transaction has been completed.
However, even though both warranties and indemnities aim to reallocate risk as between the parties, they have a number of key differences. In very broad terms, warranties are a way of protecting against the unknown, while indemnities are a way of allocating risk in respect of a known liability following disclosure. However, their main differences derive from the way in which they operate as a matter of law and how easily they can be enforced through the courts.
A warranty is a contractual statement of fact made by the seller, where any breach of warranty will only sound in damages if the buyer is able to show that the warranty was breached ‘and’ that the effect of this breach was to reduce the value of the company or assets acquired. The onus will therefore be on the buyer to show both breach of contract and a quantifiable loss. A breach of warranty claim will also be subject to the normal legal requirements of proving loss. This means that the loss and damage must be a foreseeable result of the breach, and steps must have been taken by the buyer to mitigate their loss.
In contrast, an indemnity is a contract by which the seller undertakes, as an independent obligation, to indemnify or make good a specific loss. The indemnity represents a separate promise to reimburse the buyer for the indemnified liability, should it arise. The purpose of an indemnity is therefore to provide guaranteed compensation to a buyer on a pound-for-pound basis, usually in circumstances in which a breach of warranty would not necessarily give rise to a claim for damages, for example, because the seller has disclosed against the warranty.
Given the clear difficulties arising out of a breach of warranty claim, when compared with indemnities, buyers should always be wary of using warranties as a substitute for thorough due diligence. It is better and often cheaper for a buyer to know of a problem in advance so that they have the opportunity to seek specific contractual protection in the form of an indemnity or, alternatively, to negotiate a price reduction or even walk away, rather than risking the uncertainty of having to sue for breach of warranty at a later stage.
How are warranties and indemnities in commercial contracts enforced?
Both warranties and indemnities can be enforced through the civil courts in circumstances where losses have been incurred for which the seller is potentially liable, although a claim for breach of warranty will be much more difficult to prove than an indemnity claim.
Under warranties contract law, if a warranty is breached, the buyer will be able to claim damages for breach of contract, at least in theory. The aim is to compensate the buyer by putting them in the position that they would have been in had the warranty turned out to be true. However, to succeed in a breach of warranty claim, the buyer will need to prove that:
- the warranty is untrue and that the contract has been breached
- they have suffered loss or damage
- the loss or damage was caused by the breach
- the loss or damage is not too remote, where it was reasonably foreseeable
- they have taken all reasonable steps to mitigate their loss.
In some cases, the asset or share purchase agreement will include a formula setting out how any damages should be calculated. In respect of asset purchase transactions, damages for breach of warranty are usually the market value of the business had the warranty been true, less the actual market value. In respect of share purchase transactions, the usual measure of damages will be any devaluation of the company’s shares as a result of the breach. In cases where a buyer is unable to show that the market value of shares has actually decreased as a result of the warranty being untrue, they will be unable to prove that they have suffered any loss. In contrast, in respect of any claim for an indemnified liability, a buyer can recover any loss sustained without having to prove that there has been a diminution in share value.
However, indemnities can also present their own problems, depending on the wording. For example, in Wood v Capita Insurance Services Ltd [2017] UKSC 24, the Supreme Court was tasked with resolving the uncertainty in relation to the relevant factual event that triggered the indemnity. The question was whether the seller was required to indemnify the buyer where there had been a loss pertaining to the mis-selling of insurance, and whether any loss had to arise out of customer ‘claims or complaints registered with the FSA’. Equally, in Capita v RFIB Group [2015] EWCA Civ 1310, the Court of Appeal found that using the words ‘directly or indirectly’ within a contractual indemnity imported a test of remoteness into the clause.
It is cases like these that highlight the importance of both warranties and indemnities being clearly and well-drafted. Where these contractual protections are ambiguous, or too narrow or wide in scope, this can often lead to costly and time-consuming litigation, resulting in unnecessary uncertainty, stress and expense for the parties. With the help of a legal expert, warranties and indemnities can be tailored to the specific needs of the parties, and the circumstances of each complex or high value commercial transaction.
Is warranty and indemnity insurance needed to protect against a claim?
The use of warranty and indemnity (W&I) insurance is an established tool when it comes to the transfer of risks in the context of complex and high value commercial sales transactions, and is available to both buyers and sellers. For the seller, W&I insurance can be used to cover them for liability as a result of warranties and indemnities. For the buyer, a policy can be used to claim against the insurer, instead of the seller, in the event of any consequential losses.
A W&I insurance policy will often be used to plug the gap between the level of liability the seller is willing to accept and the level of protection that the buyer is seeking, including:
- where a seller is unable or unwilling to give the warranties that the buyer requests
- where a seller is willing to give the warranties, but not at a level that the buyer is comfortable with in order to proceed with the deal
- where a seller wants a clean break, without the ongoing worry of any future claim, for example, if a warranty turns out to be untrue or an indemnified liability event is triggered.
However, the process of structuring and implementing W&I insurance will need to be tailored to the specific requirements of each case. This means that the drafting of any documents setting out where the parties’ respective risks lie will be vital to the underwriting process, and for which expert advice and assistance should again be sought.
Warranties & indemnities FAQs
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Legal disclaimer
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.
Author
Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.
Gill is a Multiple Business Owner and the Managing Director of Prof Services - a Marketing Agency for the Professional Services Sector.
