Warranties and indemnities are contractual clauses that provide protection to buyers. In a typical sale and purchase agreement, it is the buyer who bears the risk that the asset they’re acquiring may turn out to be defective or less profitable than expected. The purpose of warranties and indemnities is to shift some of that risk back onto the seller, providing the buyer with more security. The extent of the protection offered will depend on the wording of the clause.
Warranties
A warranty is a contractual statement which refers to either the condition of the thing that is being acquired or a state of affairs. Its purpose is to provide the buyer with a remedy, namely a claim for damages if statements that the seller has made about the company turn out to be untrue. It also encourages the seller to disclose known problems to the buyer prior to the completion of the sale.
A seller’s liability under a warranty can be limited when the seller has properly disclosed information about the condition of the thing that is being sold or the relevant state of affairs. This gives the seller an incentive to disclose information that may make the asset less attractive to the buyer and enables the buyer to make an informed decision about the asset that they are purchasing.
Indemnities
Indemnities provide a more direct form of compensation in specific circumstances and should cover risks that are of particular concern to the buyer. An indemnity is a promise by the seller to reimburse the buyer for losses they have suffered if a specific event occurs. The buyer should be able to recover that loss pound for pound, provided that the indemnity is framed as a debt claim. To draft an indemnity as a debt claim, the clause should:
- Identify the sum that is due or, if this is not a fixed figure, how that sum should be calculated; and[SN1]
- Payment under the indemnity should be conditional on the occurrence of a specific event.
The most difficult part of drafting an indemnity is explaining the specific event or circumstance that will trigger liability. It is important that this portion of the clause is clear and unambiguous.
Seller’s liability
Breach of a warranty is equivalent to a breach of contract. Therefore, the seller giving the warranty can only be liable for loss and damage that is foreseeable as a result of that breach. If the loss is too remote, the buyer will not be able to recover it from the seller. Buyers are also under a duty to take reasonable steps to avoid incurring loss, or to mitigate loss, that stems from a breach. A failure to do so may affect the amount that can be recovered from the seller.
A seller’s liability under a warranty is also limited by the buyer’s awareness. In Eurocopy plc v Teesdale [1992] BCLC 1067, the Court of Appeal confirmed that a buyer’s actual awareness of the relevant facts and circumstances at the time of entering into a contract can prevent a buyer from bringing a successful claim for breach of warranty. If a seller can establish that the buyer was aware of the facts and circumstances that caused the breach and chose to enter into the contract anyway, the buyer will be unable to recover damages for that breach, regardless of whether it was disclosed in due diligence exercises. .
The principles of remoteness, mitigation, and the buyer’s knowledge may apply to indemnities. However, if an indemnity is drafted as a debt claim these principles may be excluded. In Total Transport Corp v Arcadia Petroleum Limited [1998] 1 Lloyds Rep 351, the Court found that the term indemnity could be construed in two ways. The first is that it could give rise to a claim for damages, in which the principles of remoteness, mitigation, and the buyer’s knowledge will apply. The second is that the indemnity could be framed as a debt claim, in which case these principles will be excluded, and the buyer’s recovery will be more straightforward as it cannot be challenged on the grounds of remoteness or mitigation.
Limiting the seller’s liability
There are drafting tools that can be used to limit a seller’s liability under a warranty or indemnity. Whether these are adopted will depend on the agreement reached between the parties and the strength of their bargaining powers.
Sellers will often seek to qualify warranties based on their knowledge at the time of the sale by including phrases such as “so far as the seller is aware”. The effect of this is that the seller cannot be expected to disclose matters which are not within their knowledge, and liability should be limited accordingly.
Whether something is within the seller’s knowledge is an objective test that depends on whether that fact would have been known to the seller if they had conducted reasonable enquiries, as the High Court held in Triumph Controls UK Ltd v Primus International Holding Co [2019] EWHC 565 (Ch). In this case, warranties contained within a share purchase agreement were qualified as the seller’s knowledge, based on the reasonable enquiries of five named individuals. The actual knowledge of the seller and the extent of the enquiries that they carried out were deemed irrelevant.
Time limits and financial caps may also be used to limit a seller’s liability. In Scotland, the standard limitation period for breach of warranty claims is five years. However, it is common for parties to agree that any claims for breach of warranty under a contract must be raised within two or three years of the date on which that contract was concluded. This gives the buyer enough time to identify any problems with the asset that they have purchased, whilst also placing a reasonable limit on the seller’s liability.
Minimum and maximum financial limits can also be used to limit liability under warranties and indemnities. Minimum limits can apply to individual claims or to aggregate claims. These prevent the buyer from raising trivial claims which often cost more to deal with than they are worth. Maximum limits apply to the seller’s aggregate liability under the warranties in the contract and are usually limited to the total consideration, which is the value paid to the seller for the asset. Financial caps are particularly important if parties want to take out warranty and indemnity insurance.
Insurers will be reluctant to provide cover for liability under warranties and indemnities if that liability is uncapped. Even if a seller appears to have an abundance of assets, circumstances can change quickly — particularly in today’s economic climate. Parties should consider including financial limits within their agreements, and taking warranty and indemnity insurance to cover financial loss that might arise out of a breach of warranty or claim under an indemnity.
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