Publications - Corporate
Warranties, Indemnities and Disclosure in Business and Company Sales
Introduction
The aim of this note is to explain to the reader some specific and important principles which are relevant when buying or selling a business or the share capital of a company.
The information in this note is general and not sufficiently detailed to apply to the circumstances of any particular situation.
Warranties and Indemnities- What are they?
It has become the convention that when a business or a company is sold the Seller is expected to give and the Buyer expects to receive, in the sale agreement, warranties and indemnities.
In this context, warranties are statements made by the Seller that certain facts in relation to the business or the company are true. Should the Buyer later discover that a warranty was not true when given, this should give rise to a claim for breach of warranty entitling the Buyer to damages.
Indemnities are promises by the Seller to make good losses of the Buyer if specific events occur.
The distinction between a warranty and an indemnity may be significant as the amount of damages recovered by a Buyer under a warranty claim may differ from the amount of compensation which would have been recoverable by the Buyer had the same matter been covered by an indemnity.
Warranties and Indemnities- Why are they necessary?
The Buyer wants to see warranties and indemnities included in the sale agreement because:-
- the Buyer is usually unable to gain a complete knowledge and understanding of the business or the company's affairs before committing to buy;
- where the sale is a sale of a company, the company is a legal person in its own right and the Buyer will, when it buys the shares, buy the company with all its current and future liabilities (whether or not they are known or ascertainable by a review of the company's affairs); and
- the general law does not imply a great deal of protections for the benefit of a Buyer in a transaction of this type (unlike, for example, a sale of goods transaction involving a consumer) and the Buyer will therefore expect suitable protections to be written into the sale agreement.
Warranties and Indemnities- What do they do?
Warranties and indemnities re-allocate risk between the Seller and the Buyer. They are potential "price adjusters". A Buyer is more likely to offer a "full price" for a business or company if, by virtue of the warranties and indemnities given by the Seller in the sale agreement, the hidden risks involved in buying it have been kept by the Seller.
A Buyer who buys a company for a price which is based on the value of its net assets will want to include in the sale agreement, a warranty that the company's net assets are not less than £X (the value upon which the Buyer based its price). The subsequent discovery that net assets were in fact less than £X, perhaps because of a surprise liability surfacing, would enable a warranty claim under which the Buyer could seek damages from the Seller. It is likely that the damages that the Buyer would seek would be similar in amount to the amount by which the Buyer would have reduced the purchase price had it known of the liability before buying the company.
Disclosure- What is it?
In response to the warranties the Seller and its advisers carry out a disclosure exercise which results in the preparation of a disclosure letter. For this exercise to be successful it is necessary for the Seller's advisers to achieve an understanding of all material aspects of the business or company being sold.
The disclosure letter has 2 purposes in a business or company sale:-
- it acts as a collection point for information disclosed to the Buyer about the business or company being sold; and
- it records exceptions or qualifications to the warranties contained in the sale agreement.
Disclosure- Why is it necessary?
Both the Seller and the Buyer are usually keen to make sure that there is somewhere a record of every significant document disclosed during the course of the transaction and this is often done by attaching copies or lists of such documents to the disclosure letter.
The warranties are usually drafted in wide, general terms and disclosure is the mechanism by which exceptions or qualifications to them can be documented and agreed. If the Seller is asked to give a warranty in the sale agreement that the business or company is not affected by any legal dispute but this is not true, then instead of amending the terms of the general warranty, the Seller will, in the disclosure letter (with reference to that specific warranty), disclose details of all relevant disputes. If the Buyer accepts the disclosure, the disclosure will operate to exclude the Seller from liability under the warranty in respect of the specific disputes disclosed. The disclosure letter therefore provides the Buyer with details of known exceptions to the warranties which can be appraised whilst maintaining the protection of the general warranty in respect of other disputes.
Disclosure- What does it do?
As each disclosure in the disclosure letter lessens the Buyer's rights under the warranties (by excluding the matter disclosed from the scope of the general warranty) it effectively increases the Buyer's risk and for this reason the Buyer may not accept all disclosures which the Seller would like to make to it in the disclosure letter.
Successfully limiting a Seller's liability under warranties by conducting a disclosure exercise requires close liaison between the Seller and its advisers.
While it is obviously in the Seller's interests to make full, open and clear disclosure, the Seller should bear in mind that the effect of this may be the Buyer attempting to re-negotiate the purchase price.
Tax Indemnity on sale of a company
When buying a company, as well as expecting warranties about the past and present tax position of the company it is usual for the Seller to enter into a tax indemnity. This may be contained in a separate document or built into the sale agreement.
The tax indemnity is an indemnity from the Seller in favour of the Buyer against any tax liabilities falling on the company prior to completion, apart from liabilities shown in the last audited accounts of the company and those arising in respect of ordinary business after the date of those accounts. The intention is therefore that the indemnity covers surprise tax liabilities which do not arise from normal business.
Because it covers tax liabilities which may arise, but have not yet arisen, in relation to events prior to the sale, the indemnity is not usually qualified by matters disclosed in the disclosure letter.
Joint and several liability
Where there is more than one Seller the Buyer will usually want the Sellers' obligations under the warranties and indemnities to be "joint and several". This is the best position for the Buyer as it means that if it has a claim under the warranties or indemnities it can make that claim against all or any of the Sellers and can therefore select the Seller who is in the best position to pay or settle the claim.
Whilst under English Law a Seller who satisfies a warranty or indemnity claim or who settles such a claim in good faith will usually have a right of contribution from his fellow Sellers under the Civil Liability (Contribution) Act 1978, this Act does not apply in Scotland. In any event what a court may consider to be fair contribution will depend on all the circumstances at the relevant time and it is therefore sensible for joint Sellers to formalise their own contribution arrangements when entering into the sale agreement. This is usually done in a contribution agreement.
Other limits on a Seller's liability
Additional limits on a Seller's liability under the warranties (and in some cases indemnities) will often be negotiated into the sale agreement including:-
- a maximum limit or cap on the total amount of claims;
- a minimum limit (meaning an agreement that no claims will be made unless and until the total of all claims passes an agreed threshold); and
- time limits (so that the Buyer must make his claims within stated time periods and the Seller's liability comes to an end after a period).
Where there is more than one Seller , the Sellers' advisers may also seek an individual maximum limit or cap on the total amount of claims which may be made against each Seller.
Written July 2001. Reviewed November 2005
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