Warranties v Indemnities: understanding the differences

When parties to a transaction involving the sale and purchase of a business agree the main terms on which they are going to contract, the next step is for the buyer to investigate a little further and carry out a due diligence exercise. During this exercise the buyer will submit a detailed questionnaire and the seller will respond by providing information about the business, which is usually supported by accompanying documentation. This information will, generally, include relevant facts and matters about the business that will enable the buyer to analyse the scope of the risk involved.

The information that is disclosed by the seller also helps the buyer prepare the sale contract. A key part of this document is the warranty schedule. Warranties are promises on statements of facts about the business given by the seller to the buyer. They cover a broad range of topics from promises confirming that historical accounts of the business are accurate, to promises that there are no live or anticipated disputes involving the business.

Warranties give a level of protection to the buyer for a prescribed period (usually one to two years) after completion of the sale and purchase transaction (“Warranty Period”). If, within the Warranty Period, the warranty turns out to be untrue, a buyer may be able to bring a claim for damages against the seller under the relevant warranty. Any damages awarded to the buyer would be limited to the reduction in the value of the business that is caused by the warranty being untrue. So if the seller is able to show that the buyer would have still paid the same price for the business even though the warranty was untrue, then the buyer would not be able to claim any damages, even though the buyer may have incurred costs in rectifying the issue.

The buyer’s ability to bring a warranty claim may be restricted if the warranty given by the seller is qualified by the seller’s knowledge. Such warranties are usually prefaced with “So far as the seller is aware…” This qualification puts the onus back on the buyer to prove that the seller knew the warranty being given was untrue.

The buyer may be further restricted under the terms of the sale contract, where a shrewd seller may insert provisions limiting his liability in respect of potential claims. These provisions may include:

• monetary limitations such as:
  • a cap on the seller’s total liability;
  • claims having to reach a certain value before the claim is made
• limitations excluding or limiting the buyer’s ability to make a claim where:
  • the buyer knew of the matters for which he is now trying to make claims.
  • the information was disclosed before completion.
  • the matter is covered by insurance.
  • the buyer may recover losses from a third party.

Indemnities are another form of protection for the indemnified party (usually the buyer). However, the party giving the indemnity does not usually benefit from the limitations as described above. Indemnities are usually given by one party to the other in respect of a known risk. In these circumstances the party giving the indemnity is promising to take responsibility, accept liability and, where appropriate, compensate the other party for events relating to a specific liability if it should arise in the future. Indemnities generally enable the indemnified party to recover its losses on a pound for pound basis.

On a sale of a business the buyer may seek a warranty as to the conformity of a company’s data protection policies and the resilience of its IT security. If after completion these are found to be inadequate, it may be argued that the value of the company will not have diminished, but costs may be incurred in rectifying the matter. If the buyer had obtained an indemnity from the seller in respect of this issue he would have been able to recover his costs under the indemnity. On the other hand, the buyer may seek a warranty as to the accuracy of the accounts of the company. If, after completion, it is found that the company had been making less profit than promised, then the value of the company would be likely to be significantly diminished and the level of damages for breach of such warranty would be significant, especially if the purchase price had been calculated on the basis of a multiple of annual profits.

Before concluding we should also consider claims for misrepresentation. This is an option available to a buyer in circumstances where a seller has made untrue statements of fact before entering into the sale contract and those untrue statements and induced the buyer to enter into the contract. A successful misrepresentation claim may enable the wronged party to rescind the contract and also to recover damages. Rescission of a contract means cancelling a contract and unwinding it entirely. This would, undoubtedly, be a costly position for the unsuccessful party to find himself in.

However, misrepresentation claims are not without hurdles. One of the main difficulties is that, invariably, sale contracts contain ‘entire agreement’ clauses. These clauses seek to prevent the buyer from relying on pre-contractual representations as a basis for a claim for misrepresentation. Additionally, whilst the warranty schedule in a sale contract may contain representations, it is not usually possible to make a claim against a seller in respect of a representation that is contained in a warranty. The case of Idemitsu Kosan Co Ltd v Sumitomo Co Corp [2016] EWHC 1909 (Comm) demonstrated that once a representation is drafted in the form of a warranty it is treated as a warranty only. The exception to this is where a seller makes an untrue pre-contractual statement that he knows is untrue. In these circumstances the buyer would be able to bring a claim in deceit. Fraudulent and/or dishonest behaviour is not tolerated by the courts and any protections ordinarily conferred by an ‘entire agreement’ clause would fall away.

If you have any questions about buying and selling businesses or the sale contracts that would facilitate these types of transactions, contact Jon Rathbone in our Corporate Department or call 01242 574244.