In last week's article, available here, we considered in some detail the protection that the warranties in a share purchase agreement provide for buyers. The conclusion was that detailed warranties don't negate the need for a buyer to conduct a detailed due diligence exercise, with the article highlighting that where a buyer identifies areas of specific risk during due diligence, it should seek specific indemnities from the seller in the share purchase agreement. But how do indemnities differ from warranties? And what sort of matters are indemnities commonly provided in relation to?

What are the basic principles of indemnities?

An indemnity is an express obligation from the seller to compensate the buyer in respect of a pre-identified matter or issue by making a monetary payment. An indemnity will generally give the buyer the right to recover on a £ for £ basis any losses or costs it incurs in relation to the matter which is the subject of the indemnity.

Why are indemnities used?

Indemnities are used to allocate the risk of an identified matter from the buyer to the seller. In the context of an M&A transaction, indemnities are commonly provided for anticipated litigation involving the target, failure by the target to comply with legislation (for example in relation to GDPR or employment law) and environmental liabilities. This said, they can be drafted to cover any aspect of the Target where it is agreed that the commercial risk should sit with the seller and that the buyer should not be out of pocket.

How does an indemnity claim differ from a warranty claim?

In the context of an M&A transaction a warranty will only give rise to a successful claim if the buyer can establish that:

i)   the warranty was untrue; and
ii)  the value of the target at completion was lower than the value had the warranty been true.

An indemnity claim will, in contrast, provide the buyer with £ for £ recovery for the loss it has suffered and is not contingent on a reduction in the value of the target.

Let's look at an example. As part of its due diligence process, a buyer (Buyer) receives a due diligence report from its lawyers advising that, after inspection of the statutory registers of the target (Target), they believe there are errors within them. Let's assume that Buyer takes note of this and includes a warranty in the share purchase agreement whereby the seller (Seller) warrants that Target's statutory registers are compliant with the law. Seller does not make any disclosure against the warranty under the disclosure letter. Following completion, Buyer seeks to bring a claim against Seller for breach of warranty. Considering the two tests for warranty claims set out above:

i)   was the warranty untrue? and
ii)  was the value of Target at completion lower than the value had the warranty been true?

The warranty was clearly untrue and so the first limb is satisfied. As to the second limb of the test, it seems very unlikely that the value of Target is impacted in any material way by some administrative shortcomings in relation to its statutory registers. Buyer is therefore likely to be unable to recover any material sum from Seller for the breach but will still incur time and cost putting it right.

If, however, Buyer had included an indemnity in the share purchase agreement in respect of Target's statutory registers not complying with statutory requirements, it would have been able to bring an indemnity claim against Seller. The sum recoverable under the indemnity would likely have been an amount equal to Buyer's costs remedying the issue (likely legal fees for reconstituting the registers).

As pre-identified areas of risk, indemnity claims are also generally excluded from the de minimis and hurdle provisions included in an agreement to protect a seller from facing trivial or low value claims from a buyer. They consequently are generally a much more powerful tool for buyers to mitigate and manage transaction risk.

Conclusion

The above example highlights why detailed warranties don't negate the need for a detailed due diligence exercise. Where a buyer identifies areas of specific risk during due diligence, it can seek specific indemnities from the seller in the share purchase agreement.