Warranties v Indemnities

Purchasers looking to buy a company, either through a share sale or an asset sale, will often seek warranties and indemnities from the seller, which are forms of contractual protection.  Often the drafting of the warranties and indemnities will be heavily negotiated. Although the giving of warranties and indemnities by the seller both act to minimise the risk exposure of the purchaser, it is worth noting that there are some key differences between warranties and indemnities.

Warranties

A typical share or asset purchase agreement will contain many warranties.  These are statements about the company or business being sold, which are given by the seller for the benefit of the buyer.  Warranties typically cover all matters relating to the company or business being sold, including specifics relating to the company’s accounts, employees, real estate, and its intellectual property.

Warranties serve two purposes: firstly, they provide the buyer with a remedy (a claim for breach of warranty) if the statements made about the company later prove to be incorrect, and the value of the company is thereby reduced.  Secondly, they encourage the seller to disclose known problems to the buyer – as the seller will not be liable for any matter to the extent that proper disclosure is made against them, the effect of the warranties should be to flush out potential problems about the target.

Indemnities

An indemnity is a promise made by the seller to reimburse the buyer in respect of a specific liability, should it arise. The purpose of an indemnity in an acquisition is, broadly speaking, to shift the risk of a particular event or matter to the seller, and to allow the buyer to recover on a pound-for-pound basis in respect of that matter or event. Indemnities are often used where a warranty may not allow a buyer to recover damages: for example, because the buyer had knowledge of the matter before signing the acquisition agreement, or because a damages claim may not be available.

A seller will sometimes (after extensive negotiation) give indemnities covering specific risks which are of particular concern to the buyer. For example, where the target is involved in any unresolved litigation, the buyer may require the seller to bear the risk of the outcome of the litigation in the form of an indemnity.

Ascertaining Loss

A breach of warranty will only give rise to a successful claim in damages if the buyer 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 calculation of the loss will be based on the difference between the market value of the company had the warranty been true, less the market value of the company on the basis that the warranty has been breached.  However, with an indemnity claim, all the buyer need do is prove that it has suffered loss in relation to the indemnified matter.

To illustrate the difference, consider the following example: in the acquisition agreement, the seller gives a warranty stating that the target company is not involved in any litigation.  Following completion, the buyer realises that there is an outstanding claim for say £100,000, which the target company is defending.  If the buyer had merely received a warranty from the seller stating that there were no outstanding claims against the target company, he probably would not be able to claim damages for £100,000 in respect of the breach of this warranty.  Although this is the extent of the target company’s potential losses if it unsuccessfully defends the claim (excluding the possibility that it may have to pay legal costs as well), the litigation is unlikely to have resulted in a reduction of £100,000 in the target company’s value (which will be based on the target company’s net assets, projected earning, goodwill etc.).  However, had the buyer received an indemnity from the seller in relation to the same matter, he would have been able to recover all costs incurred in relation to defending the claim including the payment of damages, as he had suffered loss (regardless of whether the loss affected the company’s value).

Other Differences

There are a few other differences between warranties and indemnities to note.  Firstly, with a warranty claim, the buyer is under an obligation to mitigate any loss it has incurred.  However, with an indemnity claim, the law is less clear as to whether there is such a duty to mitigate.  Secondly, prior to the signing of the acquisition agreement, the buyer’s knowledge of a breach of warranty may prevent him from bringing such a claim following completion of the transaction – conversely, buyer’s knowledge is not a barrier to bringing an indemnity claim.  Finally, the proper disclosure of matters by the seller will qualify any warranty given, however disclosure does not qualify any indemnities given by the seller.