In brief - Properly drafted contract clauses can provide significant protections and risk mitigation
Warranties, indemnities and guarantees provide key components for the risk management and allocation framework of asset and share sale contracts.
Three typical types of risk mitigation clauses
Often key terms to an agreement will be negotiated relatively quickly, only for lawyers to spend what seems to be an inordinate amount of time arguing over the warranty and indemnity framework and contents.
So what are these troublesome clauses, what are their purposes and why would you want your lawyers to ensure they are drafted with thought and caution?
Warranties a subsidiary to the main purpose of the agreement
Warranties serve as assurances or promises between parties. They are typically included in the contract to manage a specific risk. For example, there could (and should) be a warranty that the financial statements provided in due diligence are accurate at the time of contract and completion. Or if the contract relates to the sale of a transport company, there could be a warranty that all of the business vehicles are in good condition.
What happens if a warranty is breached?
In a breach of warranty case, the non-breaching party is obligated to show a breach of contract, a quantifiable loss, and that the loss was a foreseeable consequence of the breach.
Generally a breach of warranty does not permit a party to terminate the contract; it merely provides for a mechanism to restore a party to the financial position they would have been in had the breach not occurred by the payment of damages.
An example of a standard warranty condition that might appear in the transport company share acquisition might be:
The Seller warrants that the Company accounts fairly present the financial position and assets of the Company as at those dates.
A breach of the example warranty (provided the difference in accounts was detrimental) may allow the buyer to recover a portion of the sale proceeds to put the accounts into the position that was originally stated. Warranties similar to the above are often used to manage risk around the assumptions or reliance placed on party disclosures when entering into a transaction.
Indemnities to cover actual loss
An indemnity is a contractual undertaking to cover fully any actual loss suffered by a party arising from a predefined set of circumstances. An indemnity is intended to operate as a “like for like” reimbursement of the loss suffered.
Distinct from warranties, indemnities are not subject to the limitations inherent in damages claims, such as the duty to mitigate and prove damages in the technical sense arising from the breach.
Whilst indemnities are inherently unlimited in scope, in reality this is largely dependent on the contract drafting. Indemnities may (wisely) be capped at a specific value, such as the value of the contract, or limit the scope of their application to specific types of loss. If the transport company acquisition in our example was by way of a share transfer, rather than a business purchase, the buyer would likely seek an indemnity from the seller for, amongst other things, any undisclosed liabilities that arose prior to completion.
An uncapped and unfettered indemnity will often have effect beyond the parties' intended agreement. If the indemnity clause is not carefully drafted, the transport company seller may find themselves liable for a loss of profit or business suffered by the buyer as a result of faulty vehicles. Unlimited indemnity claims could feasibly exceed the value of the business sale.
Indemnity against specific claims
The transport company share sale agreement in our example may, for example, also include an indemnity against employee entitlement claims:
The Seller indemnifies and keeps indemnified the Buyer from any and all claims made by an employee in relation to entitlements that accrued prior to the Completion Date.
This indemnity would be included to mitigate the actual cost of any claim made by an employee (e.g. disagreement over the accrued annual leave hours or non-payment of superannuation), the source of which originated prior to the completion date and was not disclosed during due diligence.
Indemnities such as the above example can provide comfort to a purchaser that any undisclosed skeletons in the closet will be the responsibility of the seller - not the unsuspecting buyer.
Indemnities to reduce threat of litigation
Indemnities can also be used to release parties contractually from certain obligations to make payments. For example, if a party agrees not to make certain claims against the other, the provision can be given effect by the first party, giving the other party an indemnity in respect of those claims.
The Buyer and Company agree to indemnify and hold harmless the Seller (being a director) for any loss of the Company directly or indirectly incurred by the Seller as a director of the Company.
This indemnity could be used to prevent any threat of litigation by the company or the buyer arising from the seller's operation of the company. Correctly drafted, indemnities used in this manner provide comfort that a statement of claim will not be forthcoming in relation to that matter.
Personal guarantees to assure value of warranties and indemnities
The value of warranties and indemnities is limited to the capacity of the party giving those assurances to pay for any claims made against them. Guarantees can provide comfort to contracting parties that the warranties and indemnities are worth more than the paper they were written on.
Because personal guarantees inherently pose a significant risk to the assets of the guarantor, careful consideration needs to be given to their inclusion.
Guarantees are often paired with an indemnity to cover the actual loss of a breached obligation in a similar manner to this:
The Guarantor unconditionally and irrevocably:
(a) guarantees Buyer the due and punctual performance and observance by Seller of all of the obligations contained in or implied under the Agreement that must be performed and observed by Seller (Guaranteed Obligation); and
(b) indemnifies Buyer against all losses, damages, costs and expenses which Buyer may now or in the future suffer or incur consequent on or arising directly or indirectly out of any breach or non-observance by Seller of a Guaranteed Obligation.
A business buyer might require a similar guarantee from the director of the seller, or a relative of the seller, to mitigate the risk that the seller will be unable to back their guarantees or indemnities financially.
Value in risk management and allocation framework
Spending the time negotiating warranties, indemnities or guarantees prior to executing an asset or share agreement may prevent an uncomfortable conversation with your lawyer at a later date about why those protections weren’t drafted or properly limited in the first place.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2021.