Even the most comprehensive due diligence won’t reveal every potential liability lurking within a target company. Buyers therefore rely on warranties and indemnities in the Share Purchase Agreement (SPA) to protect against unforeseen losses. Warranties obligate the seller to confirm the accuracy of key statements (e.g., about financial accounts, legal compliance), while indemnities provide direct compensation for specific risks. Below, we explore how these contractual tools function, how sellers limit their exposure, and why the disclosure process matters for both parties.
Nature of Warranties
- Contractual Promises by the Seller
- Accuracy of Information: Sellers affirm that financial statements are accurate (“true and fair view”), that major customer contracts are valid, and no undisclosed liabilities exist.
- Allocation of Risk: If a warranty proves untrue, buyers can claim damages for resulting losses, essentially shifting the risk of unknown issues back to the seller.
- Typical Areas Covered
- Corporate & Financial Warranties: Capital structure, audited accounts, tax returns, etc.
- Operational Warranties: Asset ownership, IP rights, permits and licenses, employee matters, environmental compliance.
- Litigation & Disputes: Declaration of ongoing or pending lawsuits, governmental investigations.
- Consequences of Breach
- Damages Claim: Buyers may seek compensation for losses, measured against how the company’s value is diminished by the breach.
- Reputational & Negotiation Fallout: Repeated warranty breaches can sour buyer-seller relations and complicate deal completion.
Key Point: Warranties are broader statements about the company’s condition; their breach often requires the buyer to prove the actual loss and causal link to the inaccuracy.
Indemnities
- Euro-for-Euro Compensation
- Specific Known Risks: Indemnities are often used for narrowly defined issues, such as outstanding tax liabilities or a pre-existing lawsuit.
- Direct Reimbursement: If a specified liability materializes, the seller compensates the buyer in full, regardless of actual loss calculations or valuation impacts.
- Typical Indemnified Items
- Tax Indemnity: Covers any tax underpayments or disputes that originate prior to closing but surface post-acquisition.
- Litigation Indemnity: Ensures the buyer isn’t burdened by legacy lawsuits or claims where the cause of action arose before closing.
- Environmental or Regulatory Risks: In high-risk sectors (e.g., manufacturing), indemnities protect against cleanup costs or compliance penalties tied to historical conduct.
- Comparison to Warranties
- Stricter Buyer Protection: Breach of a warranty may require the buyer to prove a diminution in share value, whereas an indemnity typically triggers immediate coverage for the specified cost.
- Scope & Negotiation: Because indemnities are powerful, sellers often resist broad indemnities unless absolutely required by the buyer’s due diligence findings.
The Disclosure Process
- Balancing Act for Seller
- Full & Frank Disclosures: Sellers can avoid warranty breaches by revealing exceptions or known issues upfront. If disclosed, the buyer cannot later claim a breach for that item.
- Enhancing Trust: A well-documented disclosure letter helps reassure buyers that the seller is transparent, often leading to smoother negotiations.
- Buyer’s Perspective
- Opportunity to Reassess Risks: Disclosures may lead to further investigation, a reduced purchase price, or additional indemnities for items of concern.
- Accuracy of Seller’s Data: Buyers should verify that disclosed facts align with findings from due diligence; any contradictions raise red flags.
- Disclosure Letter Mechanics
- Schedules & Annexes: Commonly, the seller attaches a schedule of exceptions to the warranties in the SPA.
- Ongoing Obligations: If material changes occur post-signing but pre-closing, the seller must update the disclosure letter accordingly.
Practical Tip: The completeness of disclosures can directly influence the final risk allocation. Sellers who thoroughly reveal potential liabilities often face fewer post-closing disputes.
Limiting Factors on Liability
- Time Limits (Limitation Periods)
- General Warranties: Often expire after 12-36 months, reflecting that issues usually emerge quickly.
- Tax Warranties/Indemnities: Typically extend longer (up to 6 years or more), given delayed tax audits.
- Caps on Liability
- Overall Liability Cap: Sellers frequently negotiate a maximum amount they can be held liable for—often equal to or less than the purchase price.
- De Minimis Thresholds: Claims below a certain monetary threshold won’t be pursued, preventing trivial disputes.
- Knowledge Qualifiers
- Sellers’ Actual Knowledge: Some warranties are qualified by the seller’s “best knowledge,” shifting the burden of proof for unknown issues.
- Seller’s Enquiry Obligation: Even with knowledge qualifiers, sellers are expected to conduct reasonable investigations to avoid “willful blindness.”
- Basket & Threshold Mechanisms
- Basket: Claims only become actionable once the aggregate of smaller breaches surpasses a specified “basket.”
- Deductible vs. Tipping Basket: Either the seller pays for all damages once the basket is exceeded (tipping) or only amounts above the basket threshold (deductible).
Conclusion
Warranties and indemnities function as critical risk-allocation devices, ensuring buyers do not inherit detrimental liabilities post-closing. While warranties address broad factual statements about the company, indemnities provide laser-focused coverage for clearly identified risks (e.g., tax disputes, environmental violations). The disclosure process serves as the seller’s safety valve, enabling it to list known exceptions and avoid future claims. Finally, time limits, liability caps, knowledge qualifiers, and monetary thresholds round out the negotiation, balancing protection for the buyer against the seller’s need for a clean exit. An effective SPA will carefully calibrate these mechanisms, minimizing uncertainty on both sides and reinforcing trust in the transaction.
