Breach of warranty claims: key issues for sellers and buyers

June 2022  |  SPECIAL REPORT: INTERNATIONAL DISPUTE RESOLUTION

Financier Worldwide Magazine

June 2022 Issue

In this article, we consider the key considerations for sellers and buyers of companies in relation to breach of warranty claims: how to minimise liability for a company after you have sold it and how to try and claw back some of the money paid for a company, if it turns out that the company’s position is not as warranted.

Key elements of breach of warranty claims

Warranty claims are essentially claims for breach of contract in relation to certain promises or assurances given by the seller of a company to the buyer in relation to the condition of the business. In order to determine whether the buyer has a claim for breach of warranty against the seller, and the strength of any such claim, it is necessary to assess certain issues, outlined below.

What warranties were provided by the seller? The contract should set out clearly all warranties being provided by the seller in relation to the company. Warranties commonly include assurances regarding the accounts, properties, commercial contracts and employees of the company. The seller’s liability will be dependent on the exact wording of the warranty set out in the agreement. It is therefore necessary to consider the language used carefully, both when drafting the warranties and when considering if they have been breached. In particular, the seller will usually try and limit its liability to the extent that it was ‘aware’ of the issues at the time of completion, as well as specifying certain key individuals whose knowledge will be imputed to the company.

Have the warranties been breached? This is a question that will need to be determined with reference to the precise wording of the warranties and the factual evidence available as to the true state of affairs of the company. In some instances, breach will be clear cut, such as where it was warranted that there are no ongoing disputes with customers, but a claim had been issued against the company pre-completion. Other situations will be less obvious, or more difficult to prove, particularly where they are qualified by knowledge, or by an obligation on the seller to take reasonable care, for example where it was warranted that accounts or forecasts were prepared with due skill and care.

Were any relevant disclosures made? A sale and purchase agreement will usually be accompanied by a disclosure letter, in which the seller makes disclosures against each of the warranties, as appropriate. For example, the seller would warrant that the company has no outstanding disputes in the sale and purchase agreement, but then provide details of any ongoing disputes in the disclosure letter against that warranty.

Are there any limitations on bringing a claim? In order to restrict the seller’s liability for breach of warranty, it is common for there to be fairly strict limitations on the buyer’s ability to bring claims. For example, there are often strict notification requirements, both in terms of the date by which any claims must be notified, and the form and content of the notice. It is also common for there to be an obligation to issue proceedings within a particular period, failing which the claim would lapse, which is usually much shorter than the statutory limitation period would be, for example one or two years rather than six. There are also usually de minimis amounts per claim or in aggregate and a cap on liability (which is often linked to the consideration paid for the company). Common exceptions include claims regarding provisions that have been made in the accounts in relation to particular items and voluntary, intervening acts of the buyer post‑completion. It is also usual to include an express duty to mitigate loss.

What loss has been suffered? The usual measure of damages for a breach of warranty claim is the difference between the value of the shares as warranted (which is usually taken to be the purchase price paid for the shares) and the ‘true’ value of the shares, had the purchaser known that the warranties were incorrect. The key question is therefore what the purchaser would have done if full disclosure of the relevant matter had been made prior to the acquisition. This will often involve disclosure of key documents and factual witness evidence regarding what the directors would have done if the matter had been fully disclosed. They will need to evidence whether they would have continued with the acquisition or not and, if so, to what extent they would have sought to reduce the purchase price. Disclosure and witness evidence from the seller regarding the extent of reduction they would have been willing to negotiate, if any, is also likely to be relevant. Expert evidence is also highly likely to be required in relation to the amount a willing purchaser with full knowledge of the relevant matter would have been willing to pay (since the true value of the company will be determined objectively, rather than subjectively).The purchase price for a company is often determined with reference to earnings before interest and taxes (EBIT) or earnings before interest, taxes, depreciation and amortisation (EBITDA), with a multiplier applied to reflect its goodwill and potential for future earnings. If a warranty relates to a matter that affects the company’s EBIT or EBITDA and it transpires that the warranty was incorrect, then this can have a significant effect on quantum, once the necessary adjustment has been made to the company’s EBIT or EBITDA and the multiple has been applied. The date for assessing the difference in value will usually be the date of acquisition. However, this can be moved to a later date in certain circumstances (for example if the buyer is locked into the purchase for a certain period, due to a fraud having been uncovered).

Key considerations for sellers

The key issues for sellers when preparing to sell the company and after the sale therefore include: (i) ensuring you disclose everything that could possibly affect the purchase price; (ii) making all disclosures as full and accurate as possible; (iii) taking professional advice in relation to all warranties, particularly relating to accounting and reasonable care, since it will be more difficult for a buyer to argue a lack of reasonable care if professional advice was sought and followed; (iv) making express disclosures against particular warranties in the disclosure letter, and not relying on generic disclosures without reference to specific warranties and the general disclosure of documents in the data room; (v) including as many limitations as possible in relation to financial limits and notification requirements; (vi) considering who will be determined to have knowledge on behalf of the company and ensuring that everything they are aware of is disclosed; (vii) reviewing any notices of warranty claims carefully to ensure they are compliant with the agreement; (viii) considering whether you have any claims against third parties in relation to the alleged breach, such as counterparties to any relevant agreements, or professional advisers for negligent advice or drafting; and (ix) if your liability could be significant, perhaps considering taking out seller-side warranty and indemnity insurance.

Key considerations for buyers

There are a number of key issues for buyers to consider pre- and post-acquisition, including: (i) reviewing the documents provided in the data room in detail and insisting on any issues being addressed as indemnities rather than warranties (so that recovery would be on a pound for pound basis, usually avoiding the strict limitations on warranty claims and obligation to mitigate loss); (ii) ensuring the warranties provided are as wide-ranging, comprehensive and thorough as possible; (iii) trying to restrict the limitations on bringing warranty claims as much as possible; (iv) diarising deadlines for giving notice of any warranty claims and issuing proceedings as soon as completion takes place; (v) undertaking a thorough review of the business against the warranties as soon as possible post-completion, to determine whether there are any possible claims; (vi) ensuring you comply with the notice requirements in the agreement to the letter, including to whom the notice must be sent, via what method and sending it well before the deadline; (vii) including as much detail of the alleged breach of warranty as required by the notice provisions, which often must include the buyer’s best estimate of the value of the claim (to the extent possible), as well as details of the alleged breach, taking legal and accounting advice where necessary; (viii) remembering to issue proceedings or, alternatively, enter into a standstill agreement before the contractual deadline; (ix) if any deferred consideration is payable, considering whether you can set off any breach of warranty claims against payment of the deferred consideration, to retain control of the amount at stake, whether pursuant to an express right in the contract, or equitable set off; and (x) if the seller’s liability for a breach could be significant and there are any concerns regarding their ability to pay, considering placing part of the consideration in escrow until the warranty period has ended, or taking out buyer-side warranty and indemnity insurance.

Conclusion

In summary, careful drafting of warranty provisions, comprehensive disclosure and strict limitations can significantly reduce a seller’s exposure to breach of warranty claims post-completion. In contrast, buyers’ interests will be best protected by attempting to minimise limitations on claims, thoroughly reviewing disclosure and ensuring as many issues as possible are addressed in indemnities rather than warranties, and carrying out a thorough review of the business against the warranties post-completion, to ensure any claims are raised and issued in time.

 

John McElroy is a partner and Faye Moore is counsel at Hausfeld & Co LLP. Mr McElroy can be contacted on +44 (0)20 7665 5026 or by email: jmcelroy@hausfeld.com. Ms Moore can be contacted on +44 (0)20 7936 0919 or by email: fmoore@hausfeld.com.

© Financier Worldwide

BY

John McElroy and Faye Moore

Hausfeld & Co LLP

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