In a mergers and acquisition (M&A) transaction, parties extensively negotiate the warranties and indemnities. The purpose of these clauses is to reduce the buyer’s risk by providing the buyer with warranties about the company’s overall status (e.g. its profitability, assets and liabilities). Indemnities protect the buyer from specific risks, for instance, those related to a particular business risk or event. It’s important to understand the key differences between warranties and indemnities regarding a sale and purchase of shares or assets of a company. We discuss these differences below.
What is a Warranty?
Warranties are contractual assurances from the seller to the buyer about the company (or business), and include:
- who owns the company before the sale;
- assets of the company (e.g. intellectual property);
- financial accounts; and
- whether the company is subject to any litigation.
What is the Purpose of Warranties?
Including warranties in the transaction documents encourage the seller to disclose information to the buyer about the company. The buyer also has a contractual remedy if they suffer loss as a result of the seller breaching a warranty.
For instance, a seller provides the buyer with a warranty that ‘the company is not a party to any material litigation’. If in fact, the company is a party to litigation and as a result, the buyer suffers loss, they will have the right to claim against the seller for those losses. This example assumes that the parties did not further limit the scope of the warranty through any other provisions.
Even if the seller provides a buyer with a comprehensive set of warranties, the buyer should still conduct due diligence on the company. Detailed due diligence will allow the buyer to identify and assess the risks of the purchase and address these accordingly (e.g. seek a price adjustment or an indemnity over specific risks).
The number of matters the warranties covers will vary depending on the negotiating power of the parties and the nature of the shares or assets a party is acquiring.
What Happens if There is a Breach of Warranty?
A breach of warranty constitutes a breach of contract. A party must prove that it has suffered loss as a result of the breach. The onus is on the party allegedly suffering loss (i.e. the buyer) to prove that there has been a breach of contract and a quantifiable loss.
What is an Indemnity?
An indemnity is a contractual obligation by one party to reimburse the other with regards to any specific liability that arises. Indemnities usually cover specific risks. For example, a buyer may seek a tax indemnity from the seller about specific tax-related matters that are unresolved at the time of the transaction. The indemnity shifts the potential liability of a specific event or risk from the buyer back to the seller.
Differences Between a Warranty and Indemnity
|Proof of Loss||A party must prove that is has suffered loss as a consequence of the breach.||A party may claim against the indemnity if it proves it has suffered loss in relation to the indemnified matter.|
|Duty to Mitigate Loss||Party suffering the loss is under a duty to mitigate any loss arising from the breach. This means that if one person breaches the contract, the other person is required to take reasonable steps to ensure that further losses that are incurred as a result of the breach are kept to a minimum.||There is no clear duty to mitigate loss unless the contract expressly states this requirement.|
|Knowledge of a Breach||If a party knew about the breach before the transaction but entered into it regardless, then they may not be able to claim against the warranty.||A party can still claim against an indemnity if they knew about the breach and still entered into the transaction.|
|Disclosure||Disclosing information may qualify a warranty.||Disclosing information will not necessarily qualify an indemnity.|
|Limitations||Parties negotiate limitations on warranties (for example, limitations on the minimum amounts a party can claim against, or the period in which a party suffering the loss must bring a claim).||The limitations parties negotiate for the warranties will not automatically apply to the indemnities. Parties must specifically negotiate any limitations that apply to indemnities separately.|
Parties often misunderstand the technical differences between warranties and indemnities. The scope and extent of the warranties in an M&A transaction will be the subject of extensive commercial negotiation. Indemnities should cover specific issues that arise from the purchase of the company or business. Parties should ensure this clause is carefully drafted to reflect the allocation of risk in the transaction. If you have any questions or need assistance negotiating your transaction documents, get in touch with our commercial lawyers on 1300 544 755.
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