M&A: what’s the difference between a warranty and an indemnity?

M&A: WHAT’S THE DIFFERENCE BETWEEN A WARRANTY AND AN INDEMNITY?

In a corporate transaction, whether it be shares or assets, the buyer may seek forms of contractual protection by way of Warranties and Indemnities. The buyer will require the seller to include these within the share or asset purchase agreement. This article will discuss why including Warranties and Indemnities will be of benefit to the buyer in mergers and acquisition transactions.

Why does a Buyer need them?

The principle of caveat emptor (let the buyer beware) applies, which places the responsibility on the buyer to gather as much information as possible on the condition of the target company. This is known as a due diligence exercise. English law will not generally afford the Buyer any protection on the purchase, so the due diligence needs to be carried out thoroughly. The information provided from the due diligence exercise will ultimately give the buyer an understanding of the value of the business and can agree on a price with the seller.

The buyer will seek protection using warranties and indemnities and in turn, the seller will attempt to limit their liability by disclosing as much information as possible.

What are Warranties?

A warranty is a statement made by the seller as to the condition of certain aspects of the business.

During the due diligence exercise into the business, the buyer will find relevant information as well as further information that may be provided from the warranties given by the seller in the sale and purchase agreement.  In conjunction with the warranties, the seller will prepare a disclosure letter, which will set out general and specific disclosures regarding the warranties given.

An example could include where the seller is asked to give a warranty that the business is not subject to any legal dispute. The seller would include the details of any relevant disputes in the disclosure letter and therefore the buyer will have no right to claim damages in relation to the disputes that have been disclosed.

What are Indemnities?

Indemnities are for known and specific matters but fall outside the buyer’s responsibility. An indemnity promises to reimburse the buyer should a particular liability arise and does not allow the seller “off the hook” by making disclosures to the buyer.

For example, if X indemnifies Y for loss suffered because of a particular event, then, should that event occur, X should reimburse Y for the loss suffered. Indemnities can be used in circumstances where a breach of warranty may not necessarily give rise to a claim in damages.

One of the benefits of an indemnity is that the buyer has no obligation to mitigate its loss compared to a warranty.

What is the difference between them?

In simple terms, warranties protect against the unknown and indemnities allocate risk in respect of a known liability. 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. The indemnity operates to protect a risk that may or may not materialise and will compensate the buyer pound for pound for a specific loss.

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