In the Spotlight
Warranties & their role in the process of selling a business
Will Axtell, Corporate Partner at Penningtons Manches Cooper and contributor to the Rockworth Partners Network gives an overview of Warranties in the context of a company sale. This is an edited excerpt from Pennington Manches Cooper’s legal framework and process – Guide to Selling a Business.
What are warranties?
Warranties are contractual statements (essentially promises about a state of affairs) made by sellers to a buyer in the acquisition agreement.
They relate to all aspects of the business and assets (and the target company itself, on a share sale) including customers, suppliers, IT systems and financial, employment, pensions, property, environmental & sustainability and IP matters.
Why are warranties important?
Warranties may give rise to liability for a seller if they turn out to have been inaccurate or misleading at the point in time when they were given and, as a consequence, the company or business is worth less than it would have been if the warranties had been true.
They therefore function as a method of adjusting the purchase price retrospectively.
In addition, sellers face potential criminal liability if they make any statements they know to be false, or conceal any facts with the intention of inducing someone to buy shares in a company; or if they engage in conduct that creates a false or misleading impression as to the value of those shares. These offences could be committed if a seller fails to disclose known inaccuracies in the warranties.
The importance of full disclosure in protecting sellers cannot, therefore, be underestimated.
How are warranties covered in the sale agreement?
The warranties are customarily set out in a lengthy schedule to the acquisition agreement. Each warranty statement contains a particular assertion. For example, a warranty might state that ‘the Company is not involved in any dispute with any of its customers’. If a seller is aware that the target is in dispute with one or more of its customers, it will not want the warranty to be given in this form as it would then be exposed to a claim for breach of contract by the buyer.
The most obvious way of addressing this problem would be for the warranty itself to be amended, for example, to say that ‘the Company is not involved in any dispute with any customer, except X Limited’ and then go on to describe the nature of this dispute.
To avoid warranty schedules becoming extremely cumbersome, the usual practice is for the warranty to be qualified in a separate document known as the ‘disclosure letter’ drafted by sellers’ solicitors and setting out details of all known inaccuracies in the warranties.
In this way, warranties also function as a means of buyers eliciting information from sellers about any known problems that might not have been identified in due diligence.
When are warranties given?
Sometimes there will be an interval of time between the date on which the acquisition agreement is entered into (known as ‘exchange of contracts’ or simply ‘exchange’ or ‘signing’) and the date on which the acquisition completes and ownership passes to the buyer (known as ‘completion’).
This may be the case where a third party needs to consent to the transaction (for example, a regulatory body or the shareholders of buyer or seller).
Warranties are given at exchange and, where there will be an interval between exchange and completion, they are usually repeated at completion (and sometimes are deemed to be repeated on each intervening date). Often, buyers will be agreeable to sellers updating the disclosure letter at completion to include any matters or circumstances that have arisen since exchange (but not any that existed at exchange but which the sellers failed to disclose at that point).
Any disclosures made in any updated or supplementary disclosure letter will not operate to qualify the warranties given at exchange (so preserving a buyer’s ability to sue if there were any undisclosed inaccuracies in the warranties at the point when the contract was entered into).
It is vital therefore, from a seller’s point of view, that any known inaccuracies in the warranties are disclosed in the original disclosure letter that they deliver at signing.
What’s the difference between a warranty & an indemnity?
It is important for sellers and buyers to be aware of the distinction between a warranty and an indemnity.
A warranty is a contractual statement made by sellers regarding the state of the target company or business.
An indemnity is a promise by sellers to reimburse a buyer for a specific liability if the need ever arises.
A breach of warranty will only give rise to a successful claim if a buyer is able to demonstrate that the warranty was untrue, the seller(s) did not make an adequate disclosure in the disclosure letter and, as a consequence of the breach, it has suffered a loss in terms of the company or business being worth less than it would have been had the warranty been true.
An indemnity, however, is a contractual promise to reimburse a buyer upon the happening of a specific event, irrespective of whether a target company or business can be shown to be worth less as a result of that event.
Who gives warranties?
In the case of a share sale, either all or a sub-set of the sellers of the target company will give warranties to the buyer.
Institutional shareholders such as private equity funds customarily do not give warranties. Likewise, sometimes other shareholders who are not involved in the day-to-day running of the business (eg spouses of director shareholders, trustee sellers, business angel investors or former employees) may be able to resist giving full form warranties.
Are there limitations on warranty liability?
If there are a number of sellers, a buyer will usually request that the warranties are given on a ‘joint and several’ basis. This means that the buyer may pursue any one or more of the warrantors in relation to the full amount of a warranty claim.
Understandably, individual warrantors will wish to limit their liability to their share of the sale proceeds. It is common practice and usually acceptable for an individual seller’s liability to be limited in this way although this may be resisted if the sellers are closely connected to each other, for example, husband and wife. Sometimes, depending on the relative bargaining strengths of the parties and the circumstances, lower financial caps can be agreed and/or a proportionate liability for claims.
Sellers will also usually benefit from other limitations on warranty liability such as time limits and exclusions for small claims.
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