Commercial risks are present in any given M&A transaction, risks that if were known earlier may affect the parties’ willingness to complete. Buyers and Sellers will generally try to allocate this risk through conducting due diligence (to identify and assess risk) and relying on the warranties and / or indemnities in the sale and purchase agreement (SPA).
This results in heavy negotiation of the SPA, where the Seller will want to minimise their ongoing exposure and achieve a ‘clean’ exit and the Buyer will want maximum contractual protection against future loss and liability, with the end product come signing often ending up somewhere in the middle.
A warranty is an assurance given at a point in time by a party as to the state of affairs of past, present or future facts or the nature of the business or assets being sold. They are often of general application (e.g. title and capacity), however, some warranties will be deal-specific and have heightened importance due to the nature of the Seller’s business (e.g. employment or IP).
If a warranty in the SPA is breached (i.e. the warranty was untrue), a breach of contract arises. Provided the innocent party suffers loss as a result of the breach, they may be entitled to sue for damages (subject to the contractual rules of causation, remoteness and mitigation). The purpose of damages under a breach of warranty is to put the innocent party in the position it would have been in had the warranty been true.
An indemnity is a contractual commitment by a party to cover any potential liability and make good a loss suffered by another party. In the M&A context, indemnities will often be used to cover specific issues (e.g. environmental issues, litigation or tax) identified during the Buyer’s due diligence in order to allocate risk back to the Seller against the known event, risk or liability.
The scope of recovery under an indemnity claim is much broader, with the innocent party generally able to cover their whole loss on a dollar-for-dollar basis provided the loss is within the terms of the indemnity and the ‘claims period’ in the SPA has not expired. Importantly, the contractual rules of causation, remoteness and mitigation do not apply (unless the SPA expressly provides for this).
So which is better for me?
The answer to that question will often depend on what side of the deal you are on.
From the Buyer’s perspective, an indemnity is more advantageous – the procedure for recovery is less onerous and there are no common law rules of damages. However, indemnities will be strictly construed and if there is any doubt as to its construction, it will be resolved in favour of the indemnifying party.
Market practice in Australia has shifted towards warranties being given on an indemnity basis, an important development as this removes the requirement of remoteness and causation and subject to the terms of the indemnity, mitigation of loss. As a Seller, if you are going to provide warranties on an indemnity basis, it is crucial that the limitation / exclusion of liability clauses in the SPA are effective.
Limiting / excluding liability
There are many ways to limit (i.e. the requirement for the party to compensate the other for losses is limited up to a specified amount) or exclude (i.e. liability is excluded, restricted or qualified for a particular reason) a party’s liability, so it is important to consider which limitations are most appropriate to include in the SPA.
For example, as a Seller, you should include quantum and time limits on the Buyer’s right to claim for a breach of warranty or indemnity, obtain exclusions for consequential or indirect losses and restrict the Buyer’s right to claim for losses the Buyer could have taken steps to mitigate or avoid (among other customary limitations of liability).
Whether you are a Buyer or Seller, the warranties and indemnities in the SPA will have a significant impact on your level of post-completion risk. It is therefore vital that you are aware of your obligations under the SPA and you ensure that the terms of the SPA reflect what you have agreed with the other party.
By Robert Feiner and Ferguson Ryder