Co-Author by Sun Ran
Warranties and indemnities are forms of contractual protection provided by a seller in a sale and purchase agreement. In agreeing to make the acquisition and in agreeing to the purchase price, the buyer will inevitably have relied upon information provided to him by or on behalf of the seller and on various assumptions. In most transactions, the buyer will insist upon the sale and purchase agreement containing warranties and/or indemnities regarding the shares and the underlying business and its assets and liabilities, in order to compensate him if the information or the assumptions on which he is relying prove to be incorrect. This article discusses the key differences between warranties and indemnities in relation to the sale and purchase of shares. It is crucial to seek the most appropriate form of contractual protection as a buyer.
What is a warranty?
A warranty is an assurance of the condition of the business or company or other matters relevant to the sale such as title to the shares. In the context of a sale and purchase of shares, if a warranty proves to be false resulting in a reduction in the value of the shares and the buyer suffers a loss, the seller is liable to pay compensatory damages in order to put the buyer in the position it would have been had the warranty been true, subject to contractual rules of foreseeability and remoteness. The onus is on the buyer to show a breach of contract and quantifiable loss.
What is an indemnity?
An indemnity is a promise by the seller to reimburse the buyer for any loss which that party suffers as a result of a particular event or a set of circumstances in question. It is a contract by which the seller undertakes an original and independent obligation to indemnify (make good) a loss. The buyer is generally able to recover all the losses covered by the indemnity since contractual principles of remoteness and foreseeability will not apply, provided that the indemnity is sufficiently widely drawn.For example, it is possible to draft an indemnity against losses not caused by the trigger event but only connected with it. Express words could require payment of losses that would be too remote to recover as damages for breach of contract. An indemnity may, therefore, have a number of advantages over a warranty and a claim under an
Differences between a warranty and an indemnity
Warranties protect a buyer by providing a possible price adjustment mechanism if a warranty proves to be false and, in the context of a sale of shares of a company, by enabling a buyer to gather information on the business through a disclosure process. The purpose of an indemnity is to provide guaranteed compensation to a buyer on a dollar for dollar basis in circumstances in which a breach of warranty would not necessarily give rise to a claim for damages or to provide a specific remedy that might not otherwise be legally available.
A warranty is subjected to contractual rules of mitigation. The buyer has the responsibility to mitigate losses incurred due to breach of warranty, but there is no clear obligation for a buyer to mitigate its loss under an indemnity. However (in the absence of express words) it may well be concluded that the parties to an indemnity against breach of contract must have intended to require a payment equivalent to damages for breach of contract. That is what the English Court of Appeal concluded in the case of Total Transport Corp v Arcadia Petroleum Ltd (The Eurus)  2 Lloyd's Rep 408. Their decision was based on their interpretation of the contract, not on the nature of an indemnity claim.
Therefore, contracting parties can create an indemnity that expressly applies or excludes the rules on mitigation, remoteness and causation. Whether they have done so is a question of interpretation. In the absence of express wording, the courts are likely to interpret an indemnity against breach of contract as giving rise to a claim equivalent to damages for that breach.
The purpose of a warranty is to encourage disclosures from the seller and therefore obtain from the seller material information which may not otherwise come to light. The process of putting forward warranties and obtaining disclosures should, therefore, complement the due diligence work for a transaction. Assume that the buyer wants the seller to provide a warranty that there is no current or threatened litigation, but in practice, there may be claims or disputes that are likely to lead to litigation. The seller can make disclosures against the warranty to limit liability. Once proper disclosure has been made, the buyer can no longer make a claim for that matter due to a breach of warranty. However, the buyer can seek indemnities after disclosure has been made so that the buyer can be indemnified against any loss that might arise from the circumstances made in the disclosure. Buyers are not prevented from claiming under an indemnity regardless of disclosure.
Proof of loss
It is necessary for a buyer to prove that losses arise as a result of a breach of warranty – such as a fall in the value of the shares being acquired – and other contractual issues relating to matters such as remoteness of damages apply. An action for breach of the warranty will leave it to the court to assess the extent of the loss which can be recovered, especially when there is a dispute as to the impact of the breach of warranty on the actual market value of the shares. With an indemnity worded appropriately, however, a buyer can recover any losses of the underlying assets of the business sustained without having to prove that there is any corresponding loss in value of the shares being acquired, and is generally not subject to contractual issues relating to remoteness and foreseeability. An appropriately worded indemnity also assists a buyer to recover the expense of bringing a claim. Buyer protection also often includes a tax indemnity, which will allocate to the seller risk of liability for tax in the company outside the ordinary course of business up to the completion of the acquisition.
Buyer's knowledge of the breach
Depending on the terms of a contract, a buyer that is aware of a breach of warranty might be precluded from bringing a claim on the basis that they were aware of a breach and decided to enter into a contract regardless. However, knowledge of a breach of contract will not prevent a buyer from making a claim under an indemnity. Indeed, buyers often negotiate an indemnity as contractual protection from a specific problem that they have discovered.
Warranties are commonly subject to a series of negotiated limitations on liability that would not usually apply to indemnities although many sellers resist indemnities. Common limitations that may be sought include limiting the period during which a claim can be brought and defining the amount that may be claimed under a warranty. The limitation period in respect of indemnities starts to run from the date on which the loss is suffered, whereas in the case of warranties the limitation period starts to run from the date of the breach of the warranty. Theoretically, therefore, the limitation period is longer under an indemnity. However, in practice, the time period for claims under a share purchase agreement is usually contractually agreed and not of much significance.
Other practical points
Delay between exchange and completion
Warranties are only true at the moment they are given, so the buyer will have an interest in having them repeated to ensure effectiveness where there is a delay between exchange and completion. However, the buyer may have to accept that there may be late or even last-minute disclosures as circumstances change. The buyer is, however, entitled to object if the seller attempts to swamp him with last-minute disclosure of matters which ought to reasonably be disclosed earlier. The seller may be attempting to sneak through disclosure of material issues at such a late stage such that the buyer is unlikely to be able to properly consider all the implications of the disclosure.
Set-off and security for warranty and indemnity claims
The buyer should take care to ensure the seller will be able and around to pay out indemnities or for breach of warranty. This can be done by requiring the seller's bank, shareholders or parent company to provide guarantees; retention of part of the purchase price for an agreed period in order to satisfy any warranty or indemnity claims which may arise during that period; or set-off any warranty or indemnity claims against deferred consideration.
Where the warranties or indemnities are given by more than one person, there should be clarity over who is liable. The buyer will normally request that they will be liable on a joint and several bases as this gives the buyer the maximum possible flexibility to make claims. It is also common for sellers to enter into a contribution agreement under which they agree, as between themselves, to share any liability in specified proportions.
Warranties and indemnities offer different forms of contractual protection and it is crucial for buyers to negotiate a good balance of warranties and indemnities in a share purchase agreement depending on the circumstances and particular concerns that the buyer has. Warranties are used to "flush out" information by encouraging sellers to make disclosures whereas specific indemnities are used to protect the buyer against specific concerns that arise after disclosure and a general indemnity may be drafted to make it easier to claim for losses impacting the underlying assets or business and expenses of bring claims. In general, an indemnity may have a number of advantages over a warranty and a claim under an indemnity is likely to be easier to establish than a claim for breach of warranty. However, sellers are also more resistant to providing indemnities.
This update is provided to you for general information and should not be relied upon as legal advice.