Warranties and Indemnities

This guide outlines the use of warranties and indemnities in commercial transactions, particularly in the context of sale and purchase agreements.

Warranties and indemnities - allocating risk

Warranties and indemnities are a means of reallocating risk between vendors and buyers. They also, via "disclosure" against warranties only can help elicit information. In English law the fundamental principle of caveat emptor ("buyer beware") applies. This means that, in a sale and purchase transaction, the law will not generally afford the buyer any protection. The buyer may seek protection by means of warranties and indemnities while the vendor may attempt to protect its position by refusing to give certain warranties and indemnities, restricting their scope or the situations when claims may be brought or by disclosing against warranties.

What is the difference between a warranty and an indemnity?

Put simply, a warranty is a contractual statement of fact made by the warrantor to the warrantee which is usually contained in a share or asset purchase agreement. Warranties often take the form of assurances from the seller as to the condition of the target company or business. An award of damages for breach of warranty aims to put the claimant in the position it would have been in had the warranty been true, subject to the usual contractual rules on mitigation and remoteness.

In contrast, an indemnity is a promise to reimburse the claimant in respect of loss suffered by the claimant. The purpose of an indemnity is to provide pound for pound compensation in respect of a specific loss. Indemnities can be used in circumstances where a breach of warranty may not necessarily give rise to a claim in damages (for example, because the seller has disclosed against the warranty or because the loss arises from a third party claim). In addition, generally when relying on indemnities the innocent party is not subject to the obligation to mitigate its loss.¹

In general warranties protect against the unknown and indemnities allocate risk in respect of a known liability.

Warranties

In a typical sale and purchase transaction, the buyer carries out due diligence. The buyer will expect the seller to provide relevant information. Generally such information will be provided firstly by the provision of due diligence materials then via the warranties in the sale and purchase agreement in conjunction with the disclosure letter prepared on behalf of the seller setting out details of exceptions to the warranties. For example, if the seller is asked to give a warranty in the sale agreement that the business or company is not the subject of any legal dispute, the seller will qualify the warranty by including details of all relevant disputes in the disclosure letter. The buyer will then have no right to claim damages in respect of the disputes that are disclosed, but may have a cause of action in respect of any other disputes which existed but which were not fairly disclosed.

Share or asset sale warranties have two main functions. First, warranties sought in respect of a particular subject require the seller to disclose information about any known problems to the buyer which relate to the subject. Secondly, they are a means of allocating risk as between the buyer and the seller as they provide the buyer with a remedy (i.e. a breach of warranty claim) if the statements made in the warranties are untrue and cause the buyer loss. In other agreements such as loan agreements, warranties perform an analogous function but also operate as a trigger for events of default.

What damages can be claimed for breach of warranty?

A warranty is a term of the contract, a breach of which gives the innocent party the right to claim damages but not to treat the contract as repudiated. A warranty can therefore be contrasted with a condition, which entitles the innocent party to treat the contract as repudiated, and an "intermediate" (or "innominate") term, which may entitle the innocent party to treat the contract as repudiated depending on the nature and consequences of the breach.²

Damages for breach of warranty are calculated on a contractual basis and aim to put the claimant in the position he would have been in had the warranties been true.

Value "as warranted"

In the majority of cases, warranties will relate to matters of quality, such as the profitability of the target company. Here the measure of damages for a breach of warranty is calculated by taking the market value of the target company had the warranty been true and deducting the actual market value of the target company.³ This is often referred to as the difference between the value of the business "as warranted" and "as was".

Usually the market value of the company had the warranties been true will be based upon the price the claimant paid for the company. However, the defendant may be able to reduce the amount of damages payable by showing that the claimant made a bad bargain and that the true market value is less than the price paid. Alternatively, the claimant may show that he made a good bargain and the market value is greater than the price paid.⁴

Profit forecasts

In some situations the calculation of damages for a warranty claim can be more complex. For example, the warranty may relate not to whether the company has a specified level of profits but to whether reasonable care has been exercised in producing a profit forecast. Here, the measure of damages will be the difference between the price agreed on the basis of the forecast as made and the price that would have been paid had the forecast been properly made. Although the court is likely to find that the profits that should have been forecast will be the same as the profits that were actually achieved, if the seller can show that any proper forecast would have been higher than the profits achieved, then the seller would not be liable to the extent that the price paid was referable to the over estimate.⁵

Mitigation and remoteness

As the claim is a contractual one, damages for breach of warranty will be reduced to the extent that the buyer fails to mitigate his loss or in respect of loss which is held to be too remote. As regards remoteness, following the rules in Hadley v Baxendale,⁶ loss will not be too remote if, at the time of contracting, that loss flows naturally from the breach (direct losses) or that loss could reasonably be supposed to have been in the contemplation of both parties as the probable result of the breach of contract (indirect or consequential losses). Therefore, if a party wishes to recover for a loss extending beyond his direct losses, it may be sensible to provide for this expressly in the contract. Conversely, if the parties wish to limit liability for any particular type of loss, whether direct or indirect, then an appropriately worded limitation or exclusion clause should be agreed.⁷

Indemnities

Indemnities are appropriate for matters which are specific and known and which clearly fall outside the responsibility of the buyer. They often deal with issues such as environmental risks, litigation and product liability matters. It is also common for tax liabilities relating to the seller's period of ownership to be dealt with in a tax deed of indemnity.

The indemnity operates to provide a contractual right for pound for pound compensation in respect of a specific loss. Therefore, if X undertakes to indemnify Y for loss suffered as a result of a particular event, then, if that event occurs, X should reimburse Y for all the loss suffered as a result of the event in question.

Indemnity or warranty?

An indemnity has a number of distinct advantages over a warranty:

• An indemnity generally compensates a party for all loss actually suffered so the difficulties which may arise in respect of a warranty claim regarding quantum of loss can be avoided.
• An indemnity may also allow a claimant to frame its claim in debt as opposed to breach of contract (see below).
• The limitation period in respect of indemnities starts to run from the date on which the loss is suffered, whereas in the case of warranties the limitation period starts to run from the date of the breach of the warranty. Theoretically, therefore, the limitation period is longer under an indemnity. However, in practice, the time period for claims under a share purchase agreement (whether in respect of warranties or indemnities) will be contractually agreed and will inevitably be shorter than the statutory limitation period so this is probably not of much significance.

Do the rules about mitigation and remoteness apply to indemnity claims?

The key advantage of an indemnity over other forms of recovery is that it can avoid issues regarding quantum of loss. The claimant can recover all the loss it suffers as a result of a breach of the relevant indemnity.

Traditionally it was thought that, as an indemnity claim was a debt claim, problems associated with issues such as mitigation and remoteness of loss would also be avoided. However, this approach, at least to the issue of remoteness, was put into doubt by the Court of Appeal in The Eurus case⁸, where it was held that there was no authority for the proposition that a claim for indemnity was not subject to the rules of remoteness. Instead, the Court of Appeal affirmed a paragraph in Halsbury's Laws of England stating that the "extent of a person's liability under an indemnity depends on the nature and terms of the contract". When acting for the buyer, therefore, it is advisable to provide expressly for the exclusion of the rules relating to remoteness and mitigation when drafting an indemnity.

Claims for misrepresentation?

Can the buyer bring a claim in tort for misrepresentation as well as a contractual claim for breach of warranty? Traditionally warranties have been drafted so that they are stated to be given both as warranties and representations in order to enable the buyer to do this. However, in Senate Electrical Wholesalers Ltd v STC Submarine Systems Ltd,⁹ it was stated that a claim in tort for a warranty specified to be a representation was "almost certainly, if not certainly, doomed to failure". Whilst it is, therefore, doubtful whether an attempt to dress up a warranty as a representation will always work, there have been cases recently where arguments have succeeded on both representations and warranties in the same agreement.¹⁰ 

If a claim is brought on the basis of an alleged misrepresentation rather than an alleged breach of contractual warranty, then unless the claimant chooses to rescind the contract, generally the tort measure of damages applies, namely to put the claimant in the position he would have been in had he not entered the contract.

If you are a vendor, it is good practice to exclude as part of an entire agreement clause in a contract all pre-contractual representations and at the same time include a waiver of all rights flowing from any right to claim for misrepresentation.

Some further practical points

• Warranties in certain specialist areas (such as IP or tax) may be ring-fenced or "boxed" so as to make them self–standing. This means that the general disputes and investigations warranty will not cover disputes and investigations in these areas. However, the trade-off may well be that the buyer also insists on disclosures being ring-fenced.
• Warranties are only true at the moment they are given, so the buyer will have an interest in having them repeated to ensure effectiveness where there is a delay between exchange and completion.
• The buyer should take care to ensure the seller will be able/around to pay out indemnities/for breach of warranty, e.g. by requiring bank/parent company guarantees.
• Where multiple sellers are involved there should be clarity over who is liable for which warranties/indemnities, e.g. joint and several liability.

1. See below, "Do the rules about mitigation and remoteness apply to indemnity claims?".
2. Hong Kong Fir Shipping Co Ltd v Kawasaki Kisen Kaisha Ltd [1962] 2 QB 26. For further details regarding the classification of contractual terms, see Ashurst Quickguides: Interpretation of Contracts under English Law and Terminating Contracts. In particular, the position is reversed under certain policies of insurance.
3. See Lord Hoffman in South Australia Asset Management Corporation v York Montague [1997] AC 191 at 216: "In the case of a warranty, one compares the plaintiff's position as a result of entering into the transaction with what it would have been if the information had been accurate".
4. Eastgate Group Ltd v Lindsey Morden Group Inc [2002] 1 WLR 642.
5. See Lion Nathan Ltd v CC Bottlers [1996] 1 WLR 1438.
6. 156 ER 145; (1854) 9 Ex. 341 and see Chitty on Contracts (29th ed. 2004) at paragraph 26-044.
7. It is worth remembering that losses like loss of profit or business are generally direct, rather than indirect, and so losses and liability may need to be excluded or limited accordingly.
8. Total Transport Corp v Arcadia Petroleum Ltd (The Eurus) [1998] 1 Lloyd's Rep. 351.
9. Unreported transcript, CA, 26 May 1994.
10. MAN Nutzfahrzeuge AG v Freightliner Ltd and others [2005] EWHC 2347 (Comm). See also Infiniteland Ltd v Artisan Contracting Limited [2005] EWCA Civ 758 where, in respect of a share purchase agreement where the warranties were not dressed up as representations, the Court of Appeal did not rule out the possibility of a claim in tort based on the warranties being treated as representations.