If you are undertaking the process of acquiring the ownership of another business, you will go through a mergers and acquisition (M&A) transaction. In this transaction, you will negotiate the warranties and indemnities of the contract. The purpose of these clauses is to reduce your risk by providing warranties about the company’s overall status. It’s important to understand the key differences between warranties and indemnities regarding a sale and purchase of shares or assets of a company. This article will explain what warranties and indemnities are so that you are informed in your business choices.

What is a Warranty?

Warranties are assurances within the contract from the seller of the business to the buyer. The warranties layout information about the company, including:

  • who owns the company before the sale;
  • assets of the company;
  • financial accounts; and
  • whether the company is subject to any legal proceedings. 

What Are the Purposes of Warranties?

Including warranties in the transaction documents encourage the seller to disclose information to the buyer about the company. You will, therefore, have a contractual safety net if you suffer loss as a result of the seller breaching a warranty.

For example, a seller may provide you with a warranty that ‘the company is not a party to any ongoing legal action’. Therefore, if the company is facing legal action and as a result, you suffer loss, you will have the right to claim against the seller for those losses.

Even if the seller provides you with a comprehensive set of warranties, you should still conduct due diligence on the company. Detailed due diligence will allow you 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 that the warranties covers will vary depending on the negotiating power of the parties. It will also depend on the nature of the shares or assets that each party is acquiring.

A breach of warranty is a breach of contract. Therefore, if the contract has been breached, you must prove that you have suffered loss as a result. 

What is an Indemnity?

An indemnity is a contractual obligation by one party to reimburse the other for any specific liability that arises. Indemnities usually cover specific risks.

For example, you 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 legal responsibility of a specific event or risk from you back to the seller.

Differences Between a Warranty and Indemnity

Warranty Indemnity
Proof of Loss A party must prove that it has suffered loss as a consequence of the breach. A party may claim against the indemnity if it proves it has suffered a loss in relation to the indemnified matter.
Duty to Minimise Loss Party suffering the loss is under a duty to reduce 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 are kept to a minimum. There is no clear duty to minimise 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 may be placed 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.  

Key Takeaways

Parties often misunderstand the technical differences between warranties and indemnities. The scope and extent of the warranties in an M&A transaction will require extensive commercial negotiation. Indemnities should cover specific issues that arise from the purchase of the company or business. You should ensure that 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, contact LegalVision’s contract lawyers on 1300 544 755 or fill out the form on this page.

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