Warranties and Indemnities: What’s the difference?

A buyer wants the protection that warranties and indemnities can give and the seller may wish to restrict the scope of warranties and indemnities, including exclusions and/or restricted time limits to bring a claim after completion.

In order to explore the differences between warranties and indemnities in contract law, it is important to first define their meaning:

What is a warranty?

A warranty is a statement of fact in a contract and contains contractual assurances given by the seller to the buyer as to the accuracy of those statements.

A breach of warranty claim typically seeks damages to put the claimant in the financial position it would have been in had the warranty been true on the grounds that the warranty is untrue but subject always to the contractual rules on mitigation and remoteness of damage.

Warranties allocate risk between the buyer and seller, and they provide a clear remedy for the buyer to pursue a claim for breach of warranty if the statements made in the warranties prove to be untrue and cause the buyer a loss.

Damages for breach of warranties are calculated on the contractual principles to put the claimant in a position (usual financial) they would have been in had the warranty been true.

What is an indemnity?

An indemnity on the other hand is quite different.  It is an enforceable promise to reimburse the claimant for a loss suffered or to provide a fixed basis for compensation for a specified loss. As a mechanism to reimburse specific losses it is not usually subject to the same rules as to loss mitigation.

When are indemnities given? 

A buyer of a company will expect the seller to give relevant information to allow the buyer to both form a view on the transaction and to be aware of what is being bought. Due diligence and disclosure are part of the provision of relevant information. The buyer undertakes due diligence and seeks disclosure and typically warranties are sought in respect of a particular issue or known problem for future reassurance.

Breach of warranty claims – making a claim for a breach of warranty

Many claims for warranty breaches emerge post completion, after the buyer is running the company and can see all the operational detail and documentation with regards to turnover, profitability and quality issues, which go to the underlying value of the company.

Claims by buyers are often that they have paid too much for the company, relying on the warranties which have subsequently been alleged to be untrue and that, had they been aware of the true position, they would never have paid the purchase price or would never have proceeded at all.

Usually, the actual market value of the company is the price the claimant paid for the company had the warranties been true and, logically, in a competitive market environment, what a person is prepared to pay for that company is what a person did pay for the company on the basis of the warranties provided.  Ongoing profitability and financial viability are often dependent upon the warranties given.  This is however not inevitably the case.

Damages in such claims are framed on the difference between the market value of the company had the warranties been true (often the purchase price) and the actual market value of the company given the true position, i.e. the difference between “as warranted” and “as is”. Profitability, profit forecasts, cash flow assumptions, asset treatment and a myriad of accounting practices and procedures can all come under scrutiny post completion when the full financial picture becomes clear.

Disgruntled purchasers will often undertake detailed and forensic examinations of the books and records of the company to look for potential warranty breaches and expert forensic accountants can be asked to review all aspects of the warranties generating expert opinions on the accuracy or inaccuracy of the warranties given and the effect on the value of the company.  Expert forensic accountants spend many hours arguing about the underlying business and the warranties given.

Being a contract claim, mitigation of loss and remoteness of damage are also relevant considerations.  Careful drafting of warranties and limits of indemnity can ring fence liability and well drafted exclusion clauses can balance the risk between the parties.

Making indemnity claims

Indemnities certainly have some advantages over contractual warranties. An indemnity is compensatory, so all actual loss proven can be recovered. Limitation dates for indemnity claims start from the date on which the loss is suffered, whereas, with warranties being breach of contract claims, these limitation periods start from the date of the breach of warranty.

Inevitably, the Sale Purchase Agreement will set out detailed provisions for limitation dates for a claim to be notified and presented and those periods are often shorter than the statutory limitation periods. This gives a much shorter agreed period to formally notify a potential claim, for it to be a valid claim, and strict limited time periods to bring such a claim.

Absolute care is needed to ensure complete compliance with the notice provisions in a Sale and Purchase Agreement and full compliance with the time limits to notify a claim in accordance with the requirements in order for the claim to be capable of being pursued. These are not always straightforward, and a failure to trigger a claim properly, or in time, means the claim will be lost forever.

Additional commercial guidance on warranty and indemnity claims

Guarantees

An indemnity or warranty is only as good as the company or person giving it. Consideration should be given pre-completion to the likely way forward if a warranty claim is necessary and the financial security of the party providing the warranty or indemnity and their ability to pay. Personal guarantees, Parent Company guarantees, cross company guarantees, or bank guarantees should be considered as, in breach of a warranty, it is ultimately the ability of the other party to pay that will be key to any recovery.

Contribution Agreements 

Where multiple parties are involved, as either sellers or buyers’, consideration should be given to how a claim would be conducted and progressed should such a claim arise.  In the event of a future warranty or indemnity claim involving multiple sellers, Contribution agreements are a sensible option in order to apportion rights and obligations in advance. Without these in place, multiple parties may have different views, outcomes and both financial and personal circumstances for potential liability and payment.

Forensic Accountants 

Warranty claims of substance, particularly those claims that involve disputes over purchase price and profitability/value of the underlying asset, are often extremely expensive, especially where expert forensic accountants are involved.  There is never a guarantee that two forensic accountants will be in agreement over a breach of warranty or indeed the financial effect of such a breach. To have two different expert forensic accountants arguing over the validity of a claim and attempting to determine the correct damages to be awarded if proven, is ultimately an extremely uncertain and expensive process.

Commercial Mediation and other forms of Alternative Dispute Resolution (ADR)

In all warranty and indemnity claims, a commercial and pragmatic approach involves a careful analysis of liability, causation and quantum from the outset, with the main objective to achieve a resolution in a time and cost-effective manner. Given the uncertainty and prohibitive costs of many warranty and indemnity claims, mediation and other forms of ADR can play a role in trying to keep these types of disputes both proportional and contained. However, inevitably emotions do run high. A buyer, who feels that they have been misled by the seller to purchase a company that they do not believe is worth the purchase price paid, will invariably feel cheated.

The emotional dynamic in a breach of warranty or indemnity claim, where a buyer’s initial excitement and positivity around the purchase has been soured, should not be underestimated when looking at a commercial strategy to settle such a claim. In some cases, commercial mediation can assist in trying to resolve the matter on a strict commercial basis, particularly in matters where parties’ positions have become entrenched, before expensive costs are incurred.

Contact Us

We have substantial experience in all types of warranty and indemnity claims both for sellers and buyers and understand the process and mechanisms involved.  We try and bring and defend such claims in the most commercially pragmatic and robust manner to achieve the outcome that our clients require.

If you are seeking legal advice on a contractual matter or commercial dispute, please contact Peter Rolph by emailing [email protected] or by completing the form below.