Getting the Deal Done

Part 3 – Warranties and Indemnities in M&A Transactions

What’s The Difference?

When purchasing a business whether by share or asset acquisition, the principal of caveat emptor (buyer beware) applies. The general law does not offer protection in this regard as to the extent of the assets and/or liabilities being acquired. Accordingly, a purchaser must protect themselves by way of contractual provisions. Warranties and indemnities are therefore used to reduce the inherent risks in such transactions and to apportion such risk between the buyer and the seller.

1. What is a Warranty?
   A warranty is a contractual statement usually as to the condition of the target company or its assets. In an M&A transaction warranties can be extensive and detailed covering all aspects of the target. In a share sale they can run to forty or fifty pages of warranties. However, the number and extent of them will be dependant on the nature of the business in question.
   A claim for a breach of warranty gives rise to a contractual claim for damages. The entitlement to damages is such as to put the innocent party in the position it would have been in had it not been for the breach of warranty. A breach of warranty may result in a liability but unless that liability in turn reduces the value of the assets purchased, no damages would be payable. If the value of the asset is reduced as a result of the breach of warranty, then the damages recoverable would be the amount of that loss irrespective of whether this is more or less than the liability incurred.
   Accordingly, if you purchased a company for €10, your maximum loss would be €10 notwithstanding that the breach of warranty may have resulted in the company incurring liabilities far in excess of that. A warranty therefore acts as retrospective price adjustment and the onus is on the buyer to demonstrate breach and quantify the loss arising from that breach.
2. What is an Indemnity?
   An indemnity is a promise to reimburse the indemnified party in relation to a particular type of liability should it arise. It is a contract to make good the loss Euro for Euro, rather than an entitlement to sue for damages. Its purpose is to move the risk for a particular matter back to the seller or indemnifier. Indemnities are generally used where there is a specific concern regarding a likely liability or where a claim on foot of a warranty may not be possible or sufficient to adequately compensate euro for euro for the potential liability. A warranty claim may not be possible or fully compensate the buyer but an indemnity against such liability offers guaranteed compensation to the buyer in that eventuality.
3. Important differences between the two3.1. A breach or warranty may give rise to a cost or a liability being incurred but that liability may not result in a corresponding diminution in the value of the assets acquired. The entitlement to damages only extends to the amount of the loss of value in the assets and not the actual liability incurred. An indemnity claim on the other hand would entitle the innocent party to be reimbursed for the full cost of liability incurred as a result of the breach of indemnity irrespective of whether it resulted in a loss of value in the assets acquired.

   3.2. Limitations of warranty liability will usually be hotly debated in M&A transactions. Commonly accepted limitations include limitations as to quantum of claim, time period within which a claim can be made or an restriction on claiming in respect of matters that have been disclosed to the buyer. No such limitations are usually permitted in respect of indemnities.

   3.3. The suite of warranties in a transaction will usually be very extensive whereas, indemnities will usually only relate to specific matters of concern.

   3.4. There is a common law obligation to mitigate ones loss in respect of a breach of warranty but no such corresponding duty for a breach of indemnity.

While the suite of warranties in a transaction will usually be very extensive it is no substitute for a buyer carrying out thorough due diligence. The warranty review and disclosure process and the due diligence process are complementary. Together they offer a buyer the opportunity to properly assess the deal at hand. Warranty claims are relatively uncommon as the due diligence and disclosure process will usually result in all cards being put on the table. If a buyer decides to proceed notwithstanding issues disclosed, indemnities allow the buyer to protect against those particular concerns.

For further information on this topic, please contact Elaine McGrath at emcgrath@reddycharlton.ie