Why are warranties necessary?
Warranties are forms of contractual protection that a purchaser will always look to include in a share or asset purchase agreement. They are contractual statements, usually contained in the acquisition agreement, as to the condition of the target company or business.
A thorough due diligence exercise should provide the buyer with a good picture of the value of the target company or business and allow them to agree a price based on their knowledge and expectations obtained from this exercise. Warranties should not be seen as a substitute for due diligence – the two are complementary. It is always preferable for a buyer to know of a problem in advance, as they then have the opportunity to walk away, argue for a price adjustment or seek specific contractual protection, rather than to have to sue for breach of warranty at a later stage.
Warranties are only as good as the seller giving them. If a buyer has any doubts about the creditworthiness of the seller, they may want some kind of security for breach of warranty. An individual seller may not have the means to meet claims or may leave the country, making enforcement difficult or impossible. A corporate seller may distribute the proceeds of the sale by paying a dividend and disposing of any remaining assets or may become insolvent after the sale. In these situations, warranties, however comprehensive, are worthless.
If the buyer is concerned about this risk, there are certain forms of security that could be implemented, such as: obtaining a bank guarantee from the seller or a guarantee from the seller’s parent company; depositing part of the purchase price into an escrow account until the warranty limitation period has expired; retain part of the purchase price until the warranty limitation period has expired; or, if part of the consideration is deferred pursuant to an earn-out or similar arrangement, the buyer could insert provisions in the agreement allowing it to set off deferred payments against warranty claims. Where the seller has taken out W&I insurance cover, the buyer may be prepared to forgo some or all of these options.
If the warranties given in a purchase agreement turn out to be inaccurate, they give grounds to sue the provider of the warranty for breach of contract and for the recipient of the warranty to recover the loss arising out of the warranty’s inaccuracy.
Should a purchaser wish to make a claim for breach of warranty, it is essential to adhere to any limitation periods. This is one of the most common areas where difficulties arise for purchasers, when it emerges that the agreement they have signed provides for a short limitation period within which claims must be commenced.
Under English law, a claim for breach of contract (i.e. the target business not being as described) must be brought within a six-year period. However, in most cases, the parties will agree to a shorter limitation period in the sale agreement.
The contractual limitation period for bringing claims as agreed between the parties tends to be limited to 18 months to two years. That is the period in which the potential claimant can make a claim. If that period has expired, the party seeking to make the claim will be out of time and there is likely nothing further that can be done.
By comparison, the limitation period relating to tax claims usually runs to six or seven years, as purchasers do not want to find themselves liable for the tax that arose prior to the purchase and be prevented from claiming this back from the seller.
Notification provisions tend to go hand in hand with limitation periods. These provisions are terms of the contract which set out how the other party is to be notified should a claim be brought against them. This is usually set out in the contract itself and can provide for where and when notification is to be given, and whether any specific information is required to be set out in the notice itself. If these provisions are not adhered to, this could invalidate the notice.
It is not unusual for notice of a potential claim to be served by a company’s secretary or responsible officer because of time pressure. However, a knee-jerk reaction to serve a notice which is inadequate because it does not comply with the contractual requirements, may mean that any chance of making a claim is lost. This will certainly be true if there is no time to give a further notice.
Another timing issue to be aware of is the time limit for bringing a claim after notification has been made. In most cases claimants will find that giving notice of a claim starts a second clock running such that they may only have a further 6 or 12 months to issue a claim at court. Failure to do so acts as a bar to future proceedings.
In light of the potential risks and strict limitation issues highlighted above, we would urge purchasers to seek legal advice as soon as they become concerned that a business they have acquired is not as it was originally represented prior to the acquisition to avoid falling foul of any notification delays or other issues as to the form and content of the notice of claim.
Similarly, any party that has received notice of a claim should seek prompt legal advice to determine whether there are any potential defences to the claim, such as the purchaser’s knowledge of the facts, matter or circumstances giving rise to the alleged claim or whether there have been any defects in claim notification.
If you have any queries, please contact our Dispute Resolution and Litigation team on 01228 552600 or 01524 548494.
This alert does not provide a full statement of the law and readers are advised to take legal advice before taking any action based on the information contained herein.