What are warranties, representations and indemnities and why are they so important to get right in mergers and acquisitions?
In episode two of our M&A Deconstructed Series Two, mergers and acquisitions experts Nick Davies and Justin Levine discuss the specifics of warranties, representations, and indemnities as they continue their mission to demystify the entire process of buying and selling a business.
In addition to covering the basics, such as the differences between each component and what should be included within them, the two M&A specialists cover claims on warranties, enforcing indemnities and the increasing popularity of warranty and indemnity insurance in mergers and acquisitions.
Take a look at this in-depth discussion in the video or read through the transcript below…
Video sub-topic timestamps:
00:00 – Introducing warranties, representations and indemnities in M&A
01:57 – What are the differences between warranties, representations and indemnities?
02:26 – What are warranties in mergers and acquisitions?
04:00 – What is the difference between warranties and indemnities?
05:57 – What are indemnities in mergers and acquisitions?
06:55 – What are representations in mergers and acquisitions?
08:37 – Claims, mediation and court action in mergers ad acquisitions
11:57 – How are warranties, representations and indemnities linked to due diligence?
12:48 – Who drafts the SPA in mergers and acquisitions?
14:30 – Warranty and indemnity insurance in M&A
Morning, Justin. Welcome back.
How are you?
Good today. Thank you.
Excellent. So we’re here again today to do another of our videos, demystifying some of the M&A terminology and process. We recently did a video which was hopefully helpful for people on what is an SPA, share sale and purchase agreement. We talked about a key component of that document being the warranties, and we know that warranties can also include representations, indemnities. So we’re going to talk a little bit today about those, try and provide a bit of insight for people.
So from your perspective, what is the main area of confusion for clients on warranties, indemnities, representations? What questions do you get asked and what do you think people struggle with?
It’s a good question. The answer is actually all of it because most, if not all, my clients, when it comes to the SPA, sale and purchase agreement, and it comes to the part that’s embodied in that, enclosed in that, the notion, the term of warranties, indemnities, representations, clients are familiar with the term warranty, but it’s often in terms of their own business, they might make a product where they offer a warranty on. So of course the term is familiar, but not in the context of selling a business.
Not in the legal meaning.
Not in the legal meaning. And I think if I was being quite candid, I’d say even after selling the company and going through the process there’s also a degree of ambiguity as to exactly what those are. And I know the legal council will take a client through this and explain it in minute detail as you go through the process, but I think it’s quite complicated.
So I think probably what would be helpful is let’s just break each one down and say, “Well, a seller is asked to make representations, they are asked to give warranties and they’re asked to give indemnities, what are the key differences between them? What are they?”
Yeah, sure. I appreciate it can be complicated because there are so many different headings and different… All these are all designed to achieve a similar purpose and that’s to give comfort to a buyer about certain factors within the business.
Warranties are probably the most extensive section of the SPA. You’ll have a warranty schedule in the SPA, and that will include dozens, probably hundreds in some cases, of statements of fact about the company that’s being sold. And the sort of things that it will cover are shares, contracts, insurance, employees. And if I just give you an example of a warranty, it may be that no employee is currently suing the company for unfair dismissal or for some other breach of the employment legislation. And as a seller, you would be reading that warranty and thinking, yes, that’s correct, we’re not currently being sued, so you don’t have a problem.
You’re making that commitment to the buyer to reassure them about that particular situation in the business and everything’s rosy. Or you may read that warranty and think, oh, actually we are being sued, there’s an issue with an employee so you should then be going to the buyer and saying, “We need to disclose against that warranty to tell you about a situation we’ve got in the business.”
And the warranties are often described as a sort of information flushing exercise, really that’s the role of due diligence and really issues such as I’ve just described about employees and so on should be coming out in due diligence. But the warranties are a way of getting the sellers to commit to the buyer contractually these statements of fact about the business.
The distinction with indemnities, and there should be less indemnities typically in an SPA, is that warranties are subject typically to a number of limitations. And what I mean by that is that you don’t want to sign a share sale and purchase agreement and have these warranties is open and hanging over you add in for item. I think as any sensible seller would want to know, well, 12, 18, 24 months after I sold the company, the buyer cannot have a cause of action against me if these warranties turn out to be untrue, inaccurate, misleading.
So those warranties we’ve talked about there being this large schedule in the SPA, they’re subject to limitations, and the sort of limitations will be time, there might be some de minimis thresholds. And by that we mean that a buyer would have to have a claim which exceeds a certain threshold value.
Let’s say, for example, there’s a warranty about assets in the company and it turns out that warranty is incorrect by 10 pounds and the real position is there’s 10 pounds less of asset value in the company than was warranted. Now, a seller would say, “Well, come on, that’s de minimis, we don’t expect you to have the right to bring a claim for us for that.” So, you’d have a de minimis threshold which would normally say a claim has to exceed a certain value before a buyer can bring it.
As well as the de minimis limitation, we also have what we call a basket limitation, and that might include a multiple of claims, so you have to get above then a higher threshold. So if your de minimis threshold was, say, 5,000, your basket level might be 25,000 so you’d have to have qualifying claims which each of which would have to be over the de minimis, but then in aggregate they’d have to exceed the basket threshold.
Indemnities don’t tend to have those limitations. Indemnities are for particular and specific areas of risk which have been identified in due diligence. They might relate to an ongoing piece of litigation. They might relate to an ongoing tax issue. They might relate to some failure to deal with the share capital in some way. And what a buyer is really saying there is we have identified this issue as a particular area of risk for us as a buyer and what we wish to do is allocate that risk onto the seller via an indemnity. Sellers would not have the benefit of the full suite of limitations against those indemnities, but you can often negotiate some limitations. You might say there’s a cap on the indemnity, you might say there’s a time threshold. So that’s indemnities, that’s warranties.
Representations are slightly different, again, and I think this is where it perhaps becomes unhelpful or unclear.
Warranties can be described as being given simply as warranties. And that means that they are contractual statements which can be enforced by the buyer. That means that the buyer has the usual remedies for breach of contract. If the warranties are described as also being given as warranties and representations, the buyer may have an additional claim for misrepresentation.
Misrepresentation widens up some further potential remedies and in some extreme cases can include rescission, that is undoing the contract, going back to where the parties were before it was signed. That’s fairly extreme. And in my view it’s less common to see warranties given as representations as well. In some cases it’s justified, in some cases it’s necessary, but this is a point of negotiation between the buyer and the seller. So that’s a summary of the distinctions. I hope that helps. It is slightly technical, slightly complex.
I think that if people sit down, take the time to think about it and we describe it, people can get a grip on it. It is very important to understand. You want to be very clear when you are signing up on your share sale and purchase agreement what statements are you giving, how long are you giving them for, what’s your maximum exposure, in what period do the warranties expire essentially, well, what are the thresholds. We’ve talked about you want to be absolutely clear on that so that when you are looking at your own business you can think, well, what’s the risk for me in signing these warranties? That’s the key point.
I think it’s interesting because owners are of SME’s, small, medium size companies, in my experience are very surprised, if you like, that a buyer is going to acquire their business and then ask the seller to commit to warranties and indemnities. And that’s a repeated thing I come across. People expect, hang on a second, you buy my business, you take it, that’s that. And of course it isn’t. But I think that there is a material element of it, and if I just distil it down is, and this is my non-expert view, I hope you correct me as we go through, but with warranties if the seller agrees to warranties, if the buyer suspects there has been a breach then the buyer has to take legal action, go to court and effectively prove that there’s been a breach of warranty and then make a claim. Whereas with an indemnity that’s different, isn’t it? When an indemnity is in effect, if there has been a breach, the buyer can claim on a pound for pound basis without having going through that hoop. Have I understood that correctly?
Yeah, that’s largely correct. The only point I’d make is on a warranty claim you don’t necessarily have to end up in court. I think that court actions are becoming rarer and rarer these days, just because of the way the court system is and the costs. So if a buyer, which is to instigate a warranty claim, what will first happen is the buyer will investigate the alleged or purported claim, they will make their case and they will set it out in a letter of claim to the sellers. The sellers will look at that and they will either think, oh, yep, we’re on the hook for that. That’s a shame. Let’s negotiate a settlement and pay whatever the claim may be. Or the sellers may look at that claim and think this is nonsense, we don’t agree and we wish to challenge it. So you’ll write back and say, “We don’t agree,” set out your position, and there will then commence this negotiation and everything else.
If the parties fundamentally cannot agree over time then a [commercial] mediation may happen or a court action may happen, as you say. But in each and every case, the warranty claim will be subject to those limitations I’ve described. So they have to get the claim in, in the right time period. They’ll have to exceed the value thresholds. They’ll have to serve the claim in accordance with the process set out in the SPA. That means sending it correctly, first class post, courier, whatever it might be, to the right address. That’s just got to be done. So that’s how a warranty claim would typically work. On an indemnity, you are right in that the reference to pound for pound really suggests or makes clear that you are not subject to these thresholds. And if you suffered a £1,147 loss, under your indemnity you are entitled to recover that £1,147 loss.
You’re not subject to those limitations. Even on receiving an indemnity claim from a buyer, a seller may still say, “I don’t agree.” I think that it’s easier to enforce an indemnity because it should have been drafted and crafted in such a way that makes it very clear where the risk is allocated between the parties. And I think that a reasonable seller, if they’ve agreed to give an indemnity, they understand very clearly that they’re on the hook for that issue should it arise. So that’s the slight difference in process in enforcement terms. Your summary distilled it well.
Thank you for that. The key thing from my side is that there is a link between the due diligence, the sale and purchase agreement, the SPA, and the reps, warranted and indemnities. And the point being from my side is looking upstream, a lot of the issues that come out in the due diligence or can come out, intellectual property, IP issues, tax issues, environmental issues, health and safety, labour contracts and so on. A lot of them are very preventable way upstream.
And that’s the key point, is actually is if as much as it’s like selling anything, the particular company, the more the preparation work is done upstream to identify those presale, do the pre-due diligence yep, fix the issues, the less likely it flows downstream where the seller has to sell a business and be on the hook for potentially serious things. But the question is, Nick, who drafts these?
Absolutely. So you’re absolutely right that a lot of the issues that crop up in DD are preventable. They can be prevented before you get to a sale process. And quite often we find that if we give somebody who’s thinking of selling their business a due diligence questionnaire, or a set of sample warranties, and probably 90% of most warranties are fairly generic so you can look at something which is going to be similar to any buyer’s going to produce. But in terms of who drafts them, a buyer or buyer’s legal advisor would normally produce the first draft of the share sale and purchase agreement, because what they’re saying there is we want to buy your company and these are the terms on which we are prepared to do it.
That SPA will include their warranties that they want. As I’ve said, a lot of those warranties will be generic and will be fairly typical, but where the buyer has done a good due diligence exercise, they may have spotted or highlighted certain areas of risk which they feel warrant or… Sorry, excuse the pun there, which require additional warranties, which are more on those specific issues, or if the risk is so great they may say, “Well, actually this justifies and requires an indemnity.”
So the buyer will do the first hash of the draft of those. The seller’s legal advisors will look at it and say, “Well, actually that warranty’s too broad. We want to narrow the language slightly, or that indemnity needs to be subject to a cap, or we need,…” In some cases you may be able to say, “We can go away and fix that issue, and if we fix the issue, you don’t need the indemnity.” And I think that’s preferable because anything you can do to remove, to de-risk the transaction and de-risk the documentation is in the seller’s interests.
Thank you for that. One final just topic briefly is insurance to cover for warranty and indemnity. It’s available in the open market so that a seller can go and purchase insurance to protect them against potential claims. In my experience, in the SME space with deals at 10, 20, 30 million pounds, I’ve yet to see a seller engage in it. What’s your personal view?
W&I [warranty and indemnity] insurance is supposedly increasing in popularity. I think you’re right, I think at the SME level it’s rare. We have done deals which have included [warranty and indemnity] insurance. It’s available to both buyers and sellers actually, which is quite interesting.
At the SME level it’s quite expensive, I think, in my view, and often the exclusions from it are quite extensive, so a lot of the known issues might not be covered, but it depends in each case on the terms of the insurance. But it’s something people should look at and we can help people look at if they are nervous or concerned about risk, but it’s not something we are seeing on every deal or even regularly really. So it’s not too popular at that SME level.
So thank you, Nick. What I’ve taken from this, but it’s also we’ve done a lot of projects together, is that when you sell a business you have a sale and purchase agreement, it’s comprehensive, very detailed. A seller is asked to give warranties, indemnities, maybe representations, and from my side as a reasonably experienced commercial person you need a very experienced legal guide to go through it. Otherwise, it would be almost impossible to navigate that process. So thank you for your input.
And we’ll catch you on the next video.
Look forward to it. Thanks, Justin.
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As part of this in-depth series, other topics discussed include:
Justin Levine, Managing Director, The NonExec Limited M&A Boutique
Justin leads a boutique exit advisory firm specialising in manufacturing, technology, IT, digital, healthcare, wholesale and distribution markets. With the support of a 15-strong virtual team of analysts and researchers, he helps private business owners with growth and exit strategies. Connect with Justin >
Nick Davies, Partner and Specialist M&A Solicitor, Steele Raymond LLP
Nick acts for a wide range of business clients across various sectors, advising on complex corporate transactions including company sales, purchases and mergers. Nick also advises on on mergers, de-mergers and re-organisation. Connect with Nick >
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