One of the ways of disposing your interest in a private company is to transfer your shares to another person. In doing so, buyers and sellers sign a share sale and purchase agreement (SPA) which contains the full details of the transaction and respective rights and obligations of such parties. It is crucial for the parties to SPA to understand the regime particularly with respect to the warranties and indemnities when the disposal of business is structured through share acquisition rather than asset acquisition. Especially, sellers need to examine each and every warranty in SPA to understand the assurance given and if any disclosure is required. Sellers are also asked by buyers to give certain indemnities and therefore should understand and be aware of the potential consequences.
No Implied Terms:
Above all, the degree of risk in share acquisition is greater when it is compared with an asset acquisition as buyers will acquire all the assets and liabilities of the target company in share acquisition. Furthermore, English law does not provide any implied terms into SPAs either under common law or statute to protect buyers. For this reason, in practice, buyers usually wish to have a comprehensive warranty cover included under SPA. Otherwise, buyers will have very little comeback to seller if a promise is not expressly contained in SPA. That is why common law jurisdictions produces lengthy SPAs in comparison to civil law jurisdictions.
Warranty vs. Indemnity
Much of an SPA is usually occupied with specific warranties given by the seller in favour of buyer as to the state of business covering broad range of business risk areas including but not limited to accounts, contracts, employees, intellectual property rights, litigation, data protection, tax, and compliance. Buyers also seek further protection in the form of indemnities. In most of the other jurisdictions there is no such distinction between warranties and indemnities. However, as per English Law there is a different treatment to the provisions of indemnity and warranty, particularly in relation to the consequences arising from breaches.
With warranties, a warrantor (seller for the purpose of SPA) undertakes that a particular state of affairs exists, i.e., assurance given by seller to buyer – e.g., shares are not subject to any charges. Any breach of warranties by seller will give buyer a right to claim for damages on the basis of breach of contract. Warrantee (buyer for the purpose of SPA) must establish its loss under the standard contractual principles. The usual example of loss given within the context of share acquisition is ‘the difference between the amount paid for the shares and the market value of the shares at the time of acquisition.’
On the other hand, an indemnity is a promise to reimburse the indemnity holder (buyer for the purpose of SPA) in respect of a future liability. For example, a seller may give an indemnity to a buyer against an outstanding debt owed to the company if it becomes a bad debt.
Sellers’ course of action:
- Sellers will have to negotiate the proposed warranties and indemnities by the buyer to be included in the SPA to limit his potential liability by excluding some of them or drafting them differently.
- Sellers to make disclosures. Making disclosure is crucial for sellers to avoid liability. In practice, buyers provide the first draft of SPA and warranties and indemnities in it can be considered as a checklist for sellers to ensure that all the required disclosures are made. In UK, the disclosures are usually made in the form of a letter and a bundle of documents attached.
Protection from tax liabilities
It is usual for buyers to seek protection from tax liabilities both in the form of warranties and indemnities. Warranties deal with the company’s compliance with tax regulations whereas indemnities deal with a potential tax which may arise above the amount provided in the accounts and attributable to the seller’s ownership period. Seller should be aware of the consequences of giving indemnity and consider arguing warranties instead of indemnities where appropriate as warranties are appropriate for many matters in which buyers seek indemnity. Indemnities will be in the advantage of buyers as with indemnities buyers will not be required to prove the link between an unexpected tax and the value of shares otherwise required with warranties.
Seller should negotiate to include a limitation clause in SPA in relation to the amount of potential claim that can be brought by the buyer (‘financial liability cap’). Such limitation shall not be subject to Unfair Contract Terms Act 1977 as agreements dealing with ‘transfer of securities or any of any right or interest in securities’ are excluded from its scope. Considering this position under English Law, seller is free to negotiate and include limitation on claims in SPA. It will be reasonable if seller can achieve to include a maximum liability clause which limits the liability of seller equal or below the price that buyer paid for the shares.
Seller should also negotiate to include a provision in respect to a time limitation. There should be a limit in time where the buyers can bring a claim against the seller arising from a breach of warranty. For example, most commercial warranties are subject to limitation of 18 to 36 months.
Sellers should be aware of the rules governing the assignment of warranties and indemnities under English Law. In the event that buyer decides to sell his company soon after he acquires it, the benefit of warranties and indemnities will be received by the new buyer. Therefore, seller should ensure the inclusion of an express restriction on assignment in the SPA.
This article is only a summary of key issues arising in relation to the warranties and indemnities in transactions. Every transaction has its own nuances and also professional advice should be sought which will provide protection for sellers.
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