Warranties and Indemnities in M&A

With most mergers and acquisitions (M&A), there is a commercial risk that some fact, matter or circumstance might be uncovered once the deal has completed which, if known from the outset, would likely have caused one party to reconsider the terms on which the deal was to be consummated.
As lawyers, we help manage this risk through a contractual framework known as warranties and indemnities. Often, this framework will be extensively negotiated between the parties to a transaction.

Warranties
What is a warranty?
In simple terms, a “warranty” is a statement of fact made by one party to another. Typically, the truth or accuracy of that statement is guaranteed under the terms of the contract by the party making the statement.
In a sale and purchase agreement, a warranty may take the form of an assurance from the seller as to the condition of the target company or business. Generally, warranties given in these agreements are qualified by the details of any exceptions to those warranties set out in a disclosure letter delivered by the seller at the time of signing the agreement.
Warranties are given at a point in time. Hence, a buyer in an M&A deal will be encouraged to have the warranties repeated to ensure it covers any delay which may eventuate between signing and completion.

What is the purpose of a warranty?
One of the key advantages of warranties is that they assist with loss recovery. Warranties set out the expectations of the parties to the transaction. Where those expectations are not met, the recipient of the warranties will be entitled to recover from the party giving the warranty for the loss suffered because of the breach of warranty. Commercially, this is a mechanism which parties to a transaction can use to allocate risk between themselves.

Remedy for breach
A breach of a warranty will constitute a breach of a contract and damages for the breach are determined on a contractual basis, with the aim of returning the innocent party to the position they would have been in had the warranty been true.

Knowledge of warranties
Knowledge also plays an important role in warranties. Often, a seller who provides a warranty will not be aware of the risks involved and the likelihood of those risks eventuating. This however, does not mean that they should not bear that risk. It is necessary for the seller to ascertain all relevant facts and disclose these in the contract or accompanying disclosure letter to ensure that the expectations of the buyer are met. However, it is also up to the buyer to conduct the necessary due diligence so that they are aware of the risks involved with the deal.
If a buyer was aware of a breach of warranty before the transaction but entered into it regardless, they may be unable to claim damages for that breach.

Indemnities
What is an indemnity?
An indemnity is a contractual term pursuant to which one party agrees to compensate another for loss suffered with respect to specific liabilities.

What is the purpose of an indemnity?
Indemnities manage risk and assign liability in instances where a particular risk materialises. For example, a buyer may seek an indemnity from the seller against loss arising from environmental risks, litigation or tax liabilities. This operates as a risk allocation mechanism whereby the liability shifts from the buyer back to the seller.
The implications of indemnities can produce unintended and costly outcomes. As such, it is necessary to take caution in the drafting process to ensure the degree of risk allocation is clearly expressed.

Remedy for breach
The breach of an indemnity is itself a breach of contract. A party may therefore claim against the indemnity if it can be proven that it had suffered a loss in relation to the indemnified matter. The nature of recovery is dependent on the distinct features of the indemnity as articulated in the contract.

Warranty v Indemnity
The benefit of an indemnity over a warranty is that it will reimburse a party for actual loss suffered, such that any arguments concerning quantum of loss arising from a warranty claim can be avoided altogether.
It is customary for warranties and indemnities in M&A contracts to be subject to limitation of liability regimes. These regimes will seek to limit a party’s liability in various ways, including by time, minimal thresholds on individual loss and aggregate caps on liability.