Company & Asset Sales: Protecting the Buyer
Company Commercial solicitor Andrew Bailey considers the issues surrounding security for warranties and indemnities.
In many contractual arrangements it is usual for one party to give warranties and/or indemnities to the other party. The nature and scope of such warranties or indemnities will vary, but will obviously be in respect of matters relevant to the contractual arrangements being negotiated. This is particularly the case in the context of M&A transactions.
In agreeing warranties and indemnities, one should always remember that the warranties and indemnities being given are only as good as the party giving them. A party can promise the world, but if their creditworthiness is questionable or they cease to exist (for whatever reason) or they become insolvent then the promises they make become worthless.
This article is a brief summary of the options available which may assist a party with securing the warranties and/or indemnities that are given to them. Below we look at the options in the context of an M&A transaction - be it a share sale or an assets sale - and where the warranties and indemnities are being given by the seller to the buyer.
Warranties and Indemnities
By way of brief summary:
- A warranty is a contractual protection or promise/assurance given by one party to the other. A breach of a warranty gives rise to an action for breach of contract. Such action is subject to the legal requirement for the non defaulting party to prove loss and to mitigate their losses where possible.
- An indemnity is a contractual commitment whereby a party undertakes as an independent obligation to make good a loss suffered by the counter-party. Such loss will be as a result of, or in accordance with, the circumstances specified under the terms of the indemnity given. This generally means that the party giving the indemnity will be liable to make good the loss on a pound for pound basis.
Security for Warranties and Indemnities
As noted above, and as with all contractual obligations or promises, warranties and indemnities are only as good as the party giving them.
If a party (the buyer) has concerns as to the creditworthiness, or the ability of the party giving the warranty/indemnity (the seller) to deliver on its promises, then security should be sought at the time the transaction is being negotiated.
For example, if the seller is an individual he or she may have insufficient personal resources to cover the losses that could arise if a breach of warranty or a breach of indemnity occurred.
Likewise, if the seller is a limited company that company may have insufficient resources or assets available to it which could result in the company becoming insolvent if faced with a breach of warranty or indemnity claim.
In either case, the purchase price may be passed on to another, used to repay debt or simply dissipated. In any such case, there is no practical ability to recover. This would leave the non-defaulting buyer at risk of not recovering its losses.
By way of brief summary, the following options are available as possible ways of securing warranty and indemnity obligations:
Options Points of Note
Escrow / joint bank account With this option the purchase monies are deposited and held in escrow and/or in a joint designated bank account for a specified period - for example until the warranty or indemnity period has expired.
The buyer then knows that a 'pot' of cash is available to draw against if a warranty claim or breach of indemnity claim arises.
Advantage: certainty. Disadvantage: the cash is tied up, so may not be an attractive option.
Retention of purchase price Similar to the above option, the buyer may seek to hold back and retain a proportion of the purchase price until the warranty or indemnity period has expired.
The buyer is at less risk as they have not paid to the seller the amount of money the buyer believes could be at risk if a specific warranty or indemnity claim arises.
Advantage: buyer has control. Disadvantage: payment may be uncertain / credit risk for the seller.
Set-off rights Where part of the consideration is held in escrow, or retained or where there is a deferred payment arrangement (for example an earn out), there should also be a contractual right permitting the buyer to set off any warranty or indemnity claims against the escrow, the retained payment or the deferred payment.
This right of set off means that any losses suffered as a result of a breach of warranty or indemnity can be discharged against the obligation on the buyer to pay to the seller the retained or deferred purchase price.
Advantage: relies on known legal principals. Disadvantage: can easily lead to litigation.
Bank guarantee or a guarantee from shareholders / parent company The seller (particularly where the party is an individual) could be asked to arrange for a bank guarantee for the obligations they give under the contract. This then provides the buyer with recourse against funds should a breach of a warranty or indemnity arise.
The ability to obtain a bank guarantee is dependant on the seller's bank being willing to provide one, often having regard to the perceived risk. It can also be expensive for the seller to put in place as the bank will charge for giving a guarantee. As a result this option is not that common in the M&A context.
Where the seller is a company, in particular a subsidiary company, shareholders of that company - be it a parent company or individuals - could be asked to give a guarantee for the obligations of the selling company. This provides the buyer with a right of recourse against such guarantors for any default by the seller. The premise being that the guarantor is more financially viable to bring a claim against.
Advantage: certainty. Disadvantage: costs and can be impracticable.
Charge over assets This option is similar to a bank guarantee, but with this option a specific charge (or other form of security) is granted by the seller as security.
The charge is granted over an asset or assets of the seller -for example cash in an account. The buyer can then enforce its charge over the asset(s) should a breach of warranty or indemnity claim arise which the seller does not pay up on.
Advantage: each side gets what they want. Disadvantage: expensive to monitor, review and/or enforce.
Warranty and indemnity insurance Specific warranty and indemnity insurance is available from various insurance providers. Such insurance can be obtained by a seller or a buyer. If a claim for a breach of warranty or indemnity arises then a claim would be made under, and subject to, the terms of the policy.
Obviously costs can be an issue here. A premium needs to be paid - often at the cost of the seller. The premium can be expensive depending on the level of perceived risk and the likelihood of a potential claim being made under the policy. However, such insurance protection has become more popular in recent years.
Advantage: freedom and certainty. Disadvantage: costs.
Of course, in agreeing one or more of the options outlined above the commercial realities of the situation also need to be considered, including the key commercial drivers for the transaction, the status of the parties and the nature of the negotiations taking place. There are also the extra costs associated with putting in place each option.
Nonetheless, a party should at least ask itself the question: "What happens if things go wrong?" The next question is: "What security (if any) is needed, and if considered necessary, which option or combination of options may work best in the circumstances?"
This article is a summary only of the issues referred to. If you require more information, or would like to discuss any of the points raised in more detail, then please contact a member of the Company and Commercial Department.
If you wish to discuss how the content of this article could affect you or your company please contact your usual contact in the Company Commercial department at Payne Hicks Beach or, the author, Andrew Bailey.
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This publication is not intended to provide a comprehensive statement of the law and does not constitute legal advice and should not be considered as such. It is intended to highlight some issues current at the date of its preparation. Specific advice should always be taken in order to take account of individual circumstances and no person reading this article is regarded as a client of this firm in respect of any of its contents.
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