When shares in a private company are sold, warranties and indemnities play critical roles in defining the rights, responsibilities, and risks of both the buyer and seller. These tools allocate liability for potential issues, ensuring a degree of transparency while protecting the buyer from unforeseen costs or erosion of value. Below is a breakdown of their types, nuances, and associated timeframes.
1. Warranties: Types and Definitions
Warranties are legally binding assurances provided by the seller about specific aspects of the target company's condition. If breached, the buyer may claim damages, provided the breach causes a demonstrable loss. Warranties typically fall into the following categories:
A. General Warranties
These cover broad aspects of the company's operations and legal standing. They include assurances that:
- The company complies with applicable laws and regulations
- Contracts, intellectual property, and licenses are valid and enforceable
- There are no undisclosed liabilities or litigation risks
B. Specific Warranties
These address particular issues unique to the company, often identified during due diligence. They typically refer to potential risks flagged during the review process.
Example: "The company is not aware of any cyber security breaches or near-misses, as defined under the terms of their cyber insurance policy, since January 2023."
C. Fundamental Warranties
Fundamental warranties concern critical aspects of the transaction itself, often with extended liability periods. They include:
- The seller's ownership and authority to sell shares
- The company's share capital structure
These warranties are non-negotiable because they are essential to the validity of the transaction.
D. Tax Warranties
Tax warranties specifically ensure the company has complied with tax laws and that all liabilities have been properly calculated, accounted & disclosed. These warranties focus on tax matters up to the point of sale.
Key Difference: Tax warranties often have longer claim periods, typically up to seven years, due to statutory tax authority review periods.
Tax warranties can often run for dozens of pages in the Sale & Purchase Agreement, such are the volume and complexity of tax affairs that a Company can be subject too through the ordinary course of its operation.
2. Indemnities: Nature and Function
An indemnity differs from a warranty in that it provides compensation for a specific liability or cost, regardless of whether the buyer suffers a financial loss. While warranties require the buyer to prove a loss caused by a breach, indemnities allow direct recovery of the specified amount.
Common Indemnities:
- Addressing tax liabilities incurred pre-sale
- Covering known legal disputes or regulatory fines
Example: "The seller indemnifies the buyer for any tax liabilities exceeding £10,000 that arise from pre-completion periods."
3. Timeframes for Claims
Time limits for making claims under warranties and indemnities are critical to the transaction. The ranges set differ by transaction, buyer & seller but common timelines are as follows:
| Type | Typical Time Limit |
|---|---|
| General Warranties | 12–24 months post-completion |
| Fundamental Warranties | 5–7 years |
| Tax Warranties and Indemnities | 7 years |
Exceptions:
In cases of fraud, time limits do not apply. A fraudulent act, regardless of disclosure or indemnity terms, allows for unlimited claims for an indefinite period.
4. Qualifying Disclosures and Their Role
Disclosures are the seller's primary tool to manage & mitigate liability. They are included in the Disclosure Letter, which lists exceptions to warranties set out in the Sale & Purchase Agreement.
Criteria for Valid Disclosures:
- Specific: Broad statements are inadequate. A qualifying disclosure must detail the specific case, parties, amounts, and timeline
- Comprehensive: It should give the buyer a clear understanding of the nature and implications of the disclosed matter
Examples:
Qualifying Disclosure: "The company is a defendant in litigation with XYZ Ltd, case reference ABC123, claiming damages of £100,000 for breach of contract, trial scheduled for [date]."
Non-Qualifying Disclosure: "The company may be involved in litigation."
Non-qualifying disclosures expose the seller to potential liability despite disclosure attempts.
5. Limiting Liability
To reduce risk exposure, sellers negotiate caps and thresholds on liability. Whilst these often differ by transaction, buyer & seller, common limits are:
| Type | Typical Threshold |
|---|---|
| Specific Claim Threshold | 0.1% of purchase price |
| Basket Threshold | 1% of purchase price |
| Cap on Liability | 50-100% of purchase price for fundamental warranties and indemnities |
Example Thresholds for £10m Transaction:
- Specific Claim Threshold: £10,000
- Basket Threshold: £100,000
Conclusion
Warranties and indemnities are essential to managing risk in share sales. By understanding their distinctions, types, and timeframes, buyers and sellers can craft agreements that balance protection and fairness. For tailored legal advice, consult an experienced solicitor familiar with corporate transactions, who can be assisted by a corporate finance advisor such as ourselves.