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Warranties

This Article looks at the meaning of the term “warranties” and why they are a vital part of any negotiations in buying, or investing in, a company or business, the difference between a “warranty” and an “indemnity”, the scope of activities that warranties usually cover, who normally gives the warranties and the use of warranty insurance.

Introduction

On buying shares in a 'target' company, the purchaser buys the company (assuming for these purposes it is buying all of the shares) subject to all its liabilities, both past and present, and continuing commitments whether or not the purchaser is aware of them, unlike the purchase of a business, where liabilities and commitments generally do not pass to the purchaser unless the purchaser has agreed to specifically take them over (see paragraph below). In a share sale, other than change of control provisions (i.e. provisions in a commercial contract with the target company where the contract is or can be terminated automatically when the shares of the target change hands), the change of ownership will not affect any of the company's rights or obligations, so the purchaser will be responsible for all of the company's existing and future liabilities and commitments.

On buying a business (namely the underlying assets of the company, rather than the shares) warranties are also important, even though the purchaser does not automatically inherit all the liabilities of the business. In this case, liabilities for the business will generally remain with the seller unless the purchaser agrees to accept them (subject to certain exceptions, for example, employment liabilities). Also, through the novation or assignment of contracts (i.e. where the purchaser contractually agrees to take over a contract between the target company and a third party), the purchaser will take on various contractual liabilities. As a result, the purchaser of a business will want the seller to warrant title to the assets, the absence of liabilities and the adequacy and state of the assets.

On any acquisition (whether of shares or assets) the principle of 'caveat emptor' (buyer beware) applies. The law provides no statutory or common law protection for the purchaser as to the nature or extent of the assets and liabilities it is acquiring and as a result the purchaser will use warranties as its main source of limiting its risk and as a secondary source of due diligence. In short, the warranties can be as important as the price being paid; this article explains why.

What is a warranty?

A warranty is a contractual term in the sale agreement in which the warrantor (normally the seller, but see below as to who gives the warranties) makes a positive or negative statement of fact to the purchaser regarding the target company or business. If such a statement proves to be untrue, then a claim for damages will arise. In certain circumstances there may also be a right to rescind the contract for misrepresentation.

Warranties can be given on an absolute basis; e.g. "the Company is not engaged in any litigation" or on a qualified basis and subject to the knowledge of the warrantor; e.g. "so far as the warrantor is aware, the Company is not engaged in any litigation". Awareness qualifications reduce the protection offered by the warranty and so are likely to be resisted by a purchaser, especially in relation to important warranties which relate to key assets or the absence of material issues/defects.

Why have warranties?

Warranties have two purposes:

First, they provide the purchaser with a chance to recover some of the money it has paid for the business or company if a warranty turns out to be untrue and the purchaser suffers loss as a result; the financial risk that the statement made in the warranty is untrue therefore passes to the warrantor. Warranties therefore provide a retrospective price adjustment.

Second, the warranties work in conjunction with the disclosure exercise. The concept of disclosure is that the warrantor is liable where the warranty is untrue, save in respect of problems previously and expressly drawn to the attention of the purchaser in the "Disclosure Letter". Accordingly, where a warranty is or may be untrue the warrantor makes a suitable disclosure which allows the purchaser to judge more accurately that the price it is paying is correct and excuses the warrantor for that particular liability. In this way the warranties flush out potential problems, build on the earlier due diligence exercise and encourage the seller to disclose known problems to the purchaser.

Who gives the warranties?

Normally the people that stand to benefit the most from the transaction will be asked to provide the warranties and, in the case of a share purchase, this will normally be the shareholders of the target company; in the case of an asset purchase, it will be the company from which the assets are being acquired.

However, this is not always the case. Some private equity houses take a robust position on warranty protection, offering nothing beyond capacity to transact, title to shares and absence of encumbrances. Other institutional investors may offer some limited warranties given that the purchaser would otherwise deeply discount the price or simply refuse to complete the purchase in the absence of warranties. These investors adopt this approach typically because they themselves have not been involved in running the business, i.e. that they don't know themselves whether the warranty being given is true. Such an approach can be more workable where another warrantor with first hand knowledge of running the target company is prepared to offer warranties. Who gives the warranties will therefore often be much debated.

In addition to share/asset purchases, warranties are often also given in connection with investments. For example, where a venture capitalist injects cash in return for equity the managers (assuming they have some shareholding or other economic interest) are often required to provide warranties to the investor.

What do warranties cover?

Warranties can cover any liability and can be subject to, or free from, contractual limits. As you would expect, a warrantor will seek to limit the scope of the warranties and cap the monetary amount for which it may be liable under the warranties. On the other hand, a purchaser will seek warranty cover in respect of 100% of the purchase price and free from limitations. Often the warrantor and the purchaser cannot agree on a suitable level of warranty cover and this creates a "warranty gap" (the difference between what a purchaser could expect to recover if the warranties were untrue and the purchase price). In this case, the parties may look to other options, such as escrow arrangements or warranty insurance.

Warranty insurance

On occasions, the warrantor or purchaser will pay an insurance company a premium to write a policy to recompense the purchaser in the event that a warranty is untrue. This is typically dovetailed with the warrantor's primary liability (if any); it could provide the purchaser with additional protection or it could be the purchaser's only protection. In addition, warranty insurance can provide cover against less financially reliable sellers/warrantors.

Warranty insurance can also be used in conjunction with an escrow. An escrow is an amount of the purchase price that is set aside and not paid to the seller, pending the passing of an agreed amount of time or the satisfaction of certain other agreed conditions. The funds in escrow are primarily for the benefit of the purchaser and the sale agreement will set out when the purchaser is entitled to receive funds from the escrow account.

Where the size of an escrow is too low, the parties sometimes turn to warranty insurance. Insurers generally require sight of the purchaser's due diligence report to determine the extent of due diligence, so often a purchaser has to arrange a more detailed report than it would normally consider necessary. The warranties in the sale agreement are often renegotiated as the insurer may refuse to cover certain warranties to reduce its exposure. It is worth noting that the policy will generally only cover undisclosed liabilities, and not existing liabilities.

Unfortunately, purchasing warranty insurance is both expensive and time consuming. However, it can sometimes be the only means of allowing a purchaser to complete the deal.

What is the difference between a warranty and an indemnity?

Until this point, this article has referred only to warranties. In most deals the purchaser will also seek a similar, but different form of protection, namely an indemnity. On the one hand a warranty is a statement by the warrantor about a particular state of affairs of the target company or business and a breach of that warranty will give rise to a successful claim in damages if the purchaser can show that the warranty was breached and that the effect of the breach is to reduce the value of the company or business acquired. The onus is therefore on the purchaser to show breach and quantifiable loss.

On the other hand an indemnity is a promise to reimburse the purchaser in respect of a specific risk or liability, should it arise (for example 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). The indemnity provides a guaranteed remedy on a pound-for-pound basis for the purchaser. In most cases it is both easier to claim under an indemnity and the amount claimed for the breach will be higher when compared to a warranty claim.

Risks commonly covered by indemnities, other than tax, are environmental risks, doubtful book debts, repayment of loans and product liability and IP claims. However, they are used on a bespoke basis to address specific issues that arise from due diligence that are of concern to the purchaser.

On occasion, a warrantor will be asked to give all the warranties 'on an indemnity basis'. These seemingly innocuous words greatly increase the warrantor's exposure and thus are commonly strongly resisted. It is not market practice for warranties to be given on an indemnity basis.

Warranties in action

The sale and purchase agreement will set out the terms upon which a purchaser has agreed to buy the shares of a company or, in relation to a business acquisition, the assets specified in it. That agreement covers a number of matters, including what conditions need to be satisfied before the sale goes ahead, the nature and timing of the consideration payments, the scope of the warranties, and their limitations, any indemnities (as well as a tax covenant), and any restrictive covenants.

The scope of the warranties will often include general or "sweeper" warranties (often rejected by the warrantor) giving it the comfort that it has been provided with all the information that it ought to have been provided with in order to make a proper assessment of the company or business, and that there is nothing which the warrantor knows that would, in the ordinary course, affect a purchaser's decision to acquire the company or business. In addition there will be specific warranties, which will vary from agreement to agreement depending on the sector.

Typically, the specific warranties would cover the following areas:

Conclusion

It is not possible to negotiate the price of the target shares or assets without taking into account the scope and nature of the warranty and indemnity protection required. Both a seller and a purchaser will need legal advice and should be prepared to allocate a significant amount of time to the consideration of the warranties and indemnities and the resulting disclosure issues.

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This article is for general information purposes only and does not constitute legal or professional advice. It should not be used as a substitute for legal advice relating to your particular circumstances. Please note that the law may have changed since the date of this article.

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