There is no automatic protection for the buyer during the sale or acquisition of a business, product or service. That is why buyers need to carefully review the assurances given by the seller, especially during times of economic uncertainty. These assurances will be drafted within the sale contract, taking the form of warranties and indemnities. Read on to understand the key differences between the two.
What are Warranties?
In simple terms, a warranty is a contractual statement made by the seller regarding the company being sold and its assets. Warranties can cover a range of aspects, such as intellectual property, share ownership, finances, product quality, and employment issues.
If a buyer can prove that a warranty was not true on the date it was made and this resulted in a reduction in the value of the company, this is treated as a breach and the buyer can claim damages from the seller. The aim is to put the buyer in the position they would have been in if the contract was fulfilled correctly. However, it is worth noting that the buyer must mitigate their loss. If they fail to do so, the damages they can claim may be limited.
Warranties serve to allocate risk between the buyer and seller. But warranties do more than just protect buyers by allowing for price adjustments if a warranty is false. Warranties also help buyers gather important information about the company through disclosures.
Nonetheless, warranties should not replace due diligence. Businesses also need to be proactive and identify issues early in the buying process. This is more effective and economical for buyers as it allows them to negotiate or walk away as opposed to pursuing legal action later for a breach of warranty.
Remedies for Breach of Warranty
If a buyer can prove that a warranty was untrue and resulted in a loss, they may seek compensation to cover losses suffered. Another option is specific performance, which is where the court orders the party who breached the contract to fulfil their obligations as originally agreed upon.
What are Indemnities?
An indemnity is a contractual obligation where one party agrees to compensate the other party for any losses incurred in the event of a particular pre-agreed liability. Unlike a collateral contract that grants the right to claim damages, an indemnity ensures that any losses are fully recovered.
A warranty or an Indemnity? The Differences
The main difference between a warranty and an indemnity is that to claim compensation, the buyer must prove the warranty was breached and losses were incurred as a result. An indemnity, on the other hand, guarantees reimbursement for specific liabilities without the need to prove loss or breach affecting the company's value. Here are other important differences between indemnities and warranties.
Mitigation
Under common law, buyers must mitigate any loss for a breach of warranty but this obligation does not necessarily apply to an indemnity.
Proof of Loss
With warranties, the buyer needs to prove that the company’s value has fallen as a result of the breach. Whereas, with indemnities, a buyer can recover losses without having to prove that the value has dropped.
Knowledge of a Breach
When it comes to warranties, if entered into a contract with knowledge of a breach, they may not be able to bring a claim against the seller. However, claims can still be made under an indemnity regardless of the buyer’s knowledge.
Limitations
Unlike indemnities, warranties usually come with negotiated limitations on liability. These limitations will vary depending on the business and negotiating power of the parties.
Common limitations include disclosure requirements, time limits for claims, and even caps on the amount of compensation that can be claimed. For large transactions, these limitations can be extensive.
Sellers may reject indemnities, forcing buyers to either accept warranties, negotiate a price reduction, or abandon the deal. That is why due diligence is extremely important for buyers. Equally, sellers need to ensure that they can fulfil the agreements. In some cases, it may be wise to have security measures in place, such as staggered payments, bank guarantees, or even insurance if the seller’s credit is questionable.
How Claims Arise
To raise a breach of warranty claim, the buyer must prove that the warranty was not true at the date of completion. Whereas, indemnities will outline the specific facts and matters covered. Usually, they will address losses incurred by the target company or buyer after completion based on certain agreed-upon facts and circumstances.
Assessing Damages
For a breach of warranty, the damages payable by the seller will be the difference between the value of the company on the basis that the warranties were true and the value of the company based on the actual state of affairs.
With indemnities, the buyer can claim any losses arising from the facts and matters covered by the indemnity.
Rules of Mitigation and Remoteness
It is worth noting that indemnities do not require the buyer to minimise their losses. This means that the seller has to cover the loss, regardless of whether the buyer could have made it smaller. This puts the seller at risk of facing a larger loss than they may have anticipated.
To avoid this, it is a good idea to consider adding a clause about mitigating losses to limit your potential financial burden.
Misrepresentation Claims
If a claim is based on misrepresentation as opposed to a breach of warranty and the claimant does not cancel the contract, a misrepresentation claim aims to put the claimant in the position they would have been in if they had not entered the contract.
Key Takeaway
Both warranties and indemnities are crucial in business transactions. However, they provide different protections. A breach of warranty requires proof of loss and may involve limitations. Indemnities, on the other hand, ensure compensation for specific liabilities without needing to prove loss. To determine which option is more appropriate for you, call our team today.
