What is a warranty and why are they required? Corporate Law

Unlike a property acquisition, when acquiring shares or business (and assets), the principle of caveat emptor (buyer beware) applies, meaning, the law provides no statutory or common law protection for the buyer in relation to company, shares or business which it is acquiring.

Therefore, buyers will require contractual protection from the Seller of the shares or business (and assets). The most common form of contractual protection is provided in the form of warranties relating to the business/company/tax affairs given by the selling party. Warranties are contractual promises made to the buyer by the person giving the warranty about the state of affairs of the company and/or business at the date of completion.

Who should give warranties?

Where there is an acquisition of shares, the seller is the person legally entitled to such shares (ie. the shareholder), a shareholder may be an individual or a corporate entity. It is the shareholders who typically are required to give warranties in such scenarios. Where there are multiple selling shareholders, those with smaller minority shareholdings or those who are not materially involved in the day to day operation of the company/business may often be unwilling to give full warranties.  

Where the acquisition involves the transfer of a business (and assets) as a going concern, the seller may be a sole trader, partnership or limited company and it is typically the seller who gives warranties in such situations. However, it is common practice, for buyers to insist that the “real/beneficial” owners of the business (and assets) being transferred to personally “stand behind the seller” and give the warranties alongside the seller. This is of paramount importance where the seller is a limited company and following the transfer of the business (and assets) the company is left as an empty shell and thus, not worth suing in the case of a warranty breach.

Breach of warranty and consequences

A breach of warranty is a breach of contract and the buyer’s remedy is typically damages (subject to the buyer having suffered a loss). It is often said that warranties are only as good as the seller giving them. What this means is, the seller may happily give an extensive set of warranties to a buyer, but not have the financial means to meet their warranty obligations. This is when mechanisms such as, escrow accounts, right of set-off and retention amounts should be considered.

Warranty vs Indemnity

An indemnity is different to a warranty. An indemnity is essentially a promise to reimburse the buyer in respect of a liability or potential liability, should it arise. They are usually requested by the buyer where an identifiable risk is revealed during the disclosure process. An indemnity will place the risk of such liability, or potential liability to the indemnifying party and allow the indemnified party to recover any losses in relation to such liability (on a pound for pound basis). Tax liabilities are often accounted by an indemnity from the seller to the buyer.

Limiting liability under warranties

A seller’s liability under warranties can be qualified in a number of ways such as imposing time limits for bringing a warranty claim, capping the overall liability of the seller and putting in place financial thresholds for qualifying warranty claims. There are various other ways of limiting liability under warranty claims such as prohibiting double recovery and prevention of liability due to changes in legislation.

Perhaps the most effective way of limiting liability under warranty claims is a thorough disclosure process whereby the seller will disclose facts and/or circumstances which are inconsistent with the warranties and therefore in most cases absolving themselves of liability.

Limitations of a seller’s liability under the warranties is often contentious and heavily negotiated.

If you need any advice about warranties do contact Tim Edwards, Corporate Director on 01905 677059 or tedwards@thursfields.co.uk