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Company Law

Analysis - guidance - compliance

04 FEB 2015

Due Diligence or Warranties & Indemnities – which is best?

Due Diligence or Warranties & Indemnities – which is best?

Part 2 on Due Diligence

The concept behind “Due Diligence” is to ensure that before you buy a company or business, you know the behind the scenes details, where there may be problems, where there may be risks, and how big those risks might be. You go into the transaction well informed with your eyes open and hopefully don’t get any big surprises on day 1 (or day 100).

So does this mean that there is no need for Warranties & Indemnities in the Sale and Purchase Agreement?

It would be naïve to purely rely on the seller providing you with all the information you need, both good and bad, and therefore it is important that the Due Diligence exercise is backed up by Warranties & Indemnities. The starting point is to seek a Warranty that the information provided as part of the Due Diligence exercise is true, complete and accurate, not misleading and that there is nothing material missing. That will then give you comfort that what was provided can be relied upon.

You should then be seeking a series of warranties to cover the significant parts of the company or business you are buying. Warranties are “promises” which the seller makes to you about what you are buying. If it turns out after completion of the transaction that the Warranty is not true, and the seller has breached it, then you can usually claim damages against the seller (subject to other limitations). The Warranties can be phrased as positive statements such as “The company owns all the assets included on the asset register as at the date hereof a copy of which is included in the Data Room as item x”, or “The company has all necessary software licences to fully operate all of its IT processes”, or as confirmation of information such as “The seller has provided complete and accurate copies of all contracts relating to employees to the purchaser”, or as a negative statement “There are no existing or threatened claims by any third parties and no circumstances which might give rise to any third party claims against the company”.

The seller will, of course, negotiate the Warranties in order to ensure that there is no chance of any breach, and therefore claim, and so it is important for you, as the purchaser, to concentrate on those areas where you feel there is potential risk, or where if the Warranty turned out to be incorrect, you or the company could suffer significant damage or inconvenience.

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So, if the normal process is for the seller to give Warranties (and Indemnities in some cases), then why is Due Diligence still important? The wording of Warranties is very specific; if a subsequent problem or issue does not fit within the strict wording of the Warranty, you will not be able to make a successful claim, however serious the issue may be or unfair the situation. It is therefore far better to check out the details and the risks in advance than solely to rely on bringing a claim for breach of Warranty after the event.

The seller will also be looking to minimise any future exposure by negotiating and limiting the wording and scope of the Warranties. In addition it is normal to further limit the protection by imposing a time limit for the bringing any Warranty claims after completion – this might be limited to 18 months, or one accounting period, although there are strong arguments to have a longer period specifically for environmental and tax claims. As well as time, there will be financial limits included; a de maximus, which is the maximum you can claim in the event of breach of Warranty (sometime limited to the purchase price or a percentage of the purchase price); however this might not be sufficient compensation in a disaster scenario; and a de minimus, which is a sum so small that it is not worth the parties time to claim it (again often a percentage of the purchase price). However a number of small claims could soon add up to a large sum, and therefore it is common to also have a threshold so that small claims have to be aggregated and only if they exceed the threshold will they be claimable. Finally the seller will exclude any claim where you knew there was an issue prior to completion, because it had been specifically disclosed to you in the Disclosure Letter. This is an ancillary document to the Sale and Purchase Agreement in which the seller goes through each of the Warranties and sets out in writing anything of which the seller is aware would cause him to be in breach of the Warranty, effectively putting you on notice and then preventing you from later claiming breach of Warranty in connection with that specific matter.

So if, after completion, you find a skeleton in the cupboard, or something horrible crawls out of the woodwork, you would first have to find a Warranty in the Sale and Purchase Agreement which had been breached by the specific issue arising; then check that it had not already been disclosed in the Disclosure Letter; that you were within the time period for bringing a claim; that you were within the financial constraints; and then show what the loss is that you have suffered as a result of the breach of Warranty. No easy task – and also time consuming and potentially expensive, especially when you are trying to run or integrate the newly acquired business.

That is why Due Diligence remains an essential element in the process of acquisition, not as an alternative to Warranty & Indemnity protections – Due Diligence allows you to decide not to take the final step and buy the business. But if you do make that leap and sign, Due Diligence when used in conjunction with Warranty & Indemnity protection is a sensible “belt and braces” approach by any purchaser to managing risk in a transaction.

See Part I of this article
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