Understanding Warranties and Indemnities in M&A Transactions in Australia
Mergers and acquisitions (M&A) transactions inherently involve risk. Buyers seek assurance about the business they are acquiring, while sellers aim for a clean exit with minimal future liability. Warranties and indemnities are fundamental tools within the Sale and Purchase Agreement (SPA) used to allocate these risks between the parties. Understanding their distinct functions and implications is crucial for anyone involved in buying or selling a business in Australia.
What are Warranties?
Warranties are contractual statements or assurances made by the seller (and sometimes the buyer) about the state of affairs of the target company or business at a specific point in time (usually at signing and completion). They essentially guarantee certain facts are true.
- Purpose: To provide the buyer with a snapshot of the business and a basis for a claim if the assurances turn out to be incorrect, causing the buyer loss.
- Scope: Warranties are typically extensive, covering areas like:
- The seller's title to the shares or assets being sold.
- The accuracy of financial accounts.
- Compliance with laws and regulations.
- The status of material contracts, employees, assets, and liabilities.
- Taxation matters.
- Absence of litigation.
- Breach: If a warranty proves to be untrue, it constitutes a breach of contract. The buyer can sue the seller for damages.
- Damages: The aim of damages for breach of warranty is typically to put the buyer in the position they would have been in had the warranty been true. This often involves complex calculations based on the diminution in value of the business acquired.
- Limitations: Sellers heavily negotiate limitations on warranty claims, including time limits, financial caps (overall liability limits), and thresholds (minimum claim amounts, often referred to as 'de minimis' for individual claims and 'baskets' for aggregate claims).
- Disclosure: Sellers can qualify warranties by making specific disclosures against them (usually in a Disclosure Letter). If a matter is fairly disclosed, the buyer generally cannot claim for breach of warranty regarding that specific matter.
What are Indemnities?
Indemnities are specific promises by one party (usually the seller) to cover the other party (usually the buyer) for a particular, identified potential loss or liability. Unlike warranties, which are broad statements of fact, indemnities address specific known or potential risks.
- Purpose: To provide the buyer with dollar-for-dollar compensation for specific risks identified during due diligence or known potential issues.
- Scope: Indemnities are targeted. Common examples include indemnities for:
- Specific tax liabilities identified pre-sale.
- Ongoing litigation.
- Known environmental contamination issues.
- Specific employee claims.
- Breach: A claim under an indemnity arises when the specified loss occurs.
- Damages/Recovery: Recovery under an indemnity is typically on a dollar-for-dollar basis for the specified loss. Crucially, the common law rules of causation, remoteness, and the buyer's duty to mitigate loss generally do not apply to indemnity claims unless expressly stated in the SPA. This makes recovery potentially simpler and more complete than for a warranty breach.
- Negotiation: Buyers seek indemnities for specific risks they are unwilling to accept. Sellers resist giving indemnities or seek to limit their scope and duration.
Key Differences Summarised
| Feature | Warranty | Indemnity |
|---|---|---|
| Nature | Assurance about state of affairs | Promise to cover a specific loss/liability |
| Scope | Broad, covering many aspects | Narrow, focused on identified risks |
| Trigger | Statement proves untrue | Specified loss/liability occurs |
| Recovery | Damages (subject to causation, remoteness, mitigation) | Dollar-for-dollar compensation (common law rules generally don't apply) |
| Knowledge | Covers unknown breaches | Often covers known or identified risks |
Warranties Given on an Indemnity Basis
Reflecting the buyer's preference for the simpler recovery mechanism of indemnities, market practice in Australia often sees warranties being given 'on an indemnity basis'. This means that while the statement is framed as a warranty, the SPA specifies that a breach will be treated like a claim under an indemnity, allowing for dollar-for-dollar recovery without the buyer needing to prove loss based on diminution in value or satisfy the common law rules of remoteness and causation (though mitigation might still be relevant depending on drafting).
When sellers agree to this, it becomes even more critical for them to negotiate robust limitations on liability within the SPA.
Warranty & Indemnity (W&I) Insurance
A significant development in the M&A landscape is the prevalence of W&I insurance. This insurance policy protects the buyer (buy-side policy) or seller (sell-side policy) against financial losses arising from breaches of warranties and certain indemnities (often tax indemnities) in the SPA.
- Benefits for Buyers: Easier recovery against an insurer, potentially higher liability caps, bid enhancement in auctions.
- Benefits for Sellers: Enables a 'clean exit' by transferring liability risk to the insurer, allows quicker access to sale proceeds (less need for escrows).
- Process: Often initiated by the seller ('sell-side flip') and then taken over by the preferred buyer.
- Cost: Typically 1-1.5% of the policy limit, plus broker fees and underwriting costs.
- Exclusions: Policies have standard exclusions (e.g., known issues, forward-looking statements, fines, certain environmental matters).
W&I insurance can bridge the gap between buyer demands for protection and seller desires for a clean exit, facilitating deals that might otherwise stall on risk allocation.
Conclusion
Warranties and indemnities are critical risk allocation mechanisms in Australian M&A deals. Warranties provide broad assurances, while indemnities offer specific protection against identified risks. The trend towards warranties given on an indemnity basis and the widespread use of W&I insurance further shape how parties manage post-completion liability. Careful drafting and negotiation of these clauses, often with the input of experienced legal advisors and potentially W&I insurers, are essential for both buyers and sellers to protect their interests.
Disclaimer: This article provides general information only and does not constitute legal advice. You should seek specific legal advice tailored to your circumstances.