Protecting against Warranty Claims: A Brief Guide to the Warranty and Disclosure Process

Protecting against Warranty Claims: A Brief Guide to the Warranty and Disclosure Process

As part of the legal process of acquiring or disposing of the share capital of a private company, the main transaction document is typically a share purchase agreement (SPA). The SPA will contain the main terms of the sale and will often contain commercial warranties from the seller to the buyer. Warranties are in effect contractual promises about the condition of the business which is being sold (the use of the term warranty in this context should not be confused with the more generic business use which is more like a product guarantee).

An example of a typical warranty would be:

Neither the Company, nor any of its Directors nor any person for whose acts the Company may be vicariously liable, is engaged or involved in any of the following matters:

(a) any litigation, or any administrative, arbitration or other proceedings, claims, actions or hearings (except for debt collection in the normal course of business); or

(b) any dispute with, or any investigation, inquiry or enforcement proceedings by, any governmental, regulatory or similar body.

It is vital that these warranties are thoroughly analysed by the seller, as the buyer may subsequently be able to bring a claim for breach of warranty and claim back from the seller part, all or potentially more than the overall purchase price paid for the business if any of these statements prove untrue.

What are the reasons behind a buyer asking a seller for warranties?

The reasoning behind the buyer asking for warranties from a seller is twofold.

The first is to allocate risk. The underlying principle of caveat emptor (“let the buyer beware”) applies to the sale of shares in a business. This means that it will be the company itself, not the previous owner, which is liable for any historic liabilities. Requiring a seller to give warranties will mean that if the seller does not make “fair disclosure” against those warranties (discussed in more detail below), one or more of which subsequently prove to have untrue, then the buyer may have a warranty claim against the seller, enabling it to recover some or all of the purchase price as compensation for the loss that it has suffered as a result of the breach of warranty.

The second, and in some ways more important reason, is for the buyer to elicit information about the company’s business from the seller before it completes the acquisition. If a seller is reluctant to give a particular warranty then this might indicate a potential problem with that aspect of the target business. The sellers will generally also provide a draft disclosure letter (discussed in more detail below) which sits alongside the SPA and sets out areas of inconsistency between the commercial warranties and the target business. This information (which will be made available prior to completion of the transaction), along with the results of the buyer’s due diligence enquiries, gives the buyer the choice of whether to proceed with the purchase, or alternatively to revisit the deal terms (i.e. price and risk allocation – for example by insisting upon specific indemnities which would result in the seller being liable to compensate the buyer on a pound-for-pound basis if any loss is suffered after completion pertaining to such indemnified risk).

How can a seller seek protection against a claim for breach of warranty?

There are various ways in which a seller can be protected against a claim for breach of warranty, including:

  1. negotiating the warranties contained in the SPA – which typically includes deleting unhelpfully open-ended or forward-looking warranties and qualifying warranties by the awareness of the seller or by setting materiality thresholds (although the reality is that the end position will always depend on the commercial bargaining strength of the respective parties);
  2. inserting limitation provisions in the SPA , such as time limits for bringing warranty claims and financial thresholds that need to be met in order to bring a claim;
  3. the seller preparing a disclosure letter, which is effectively a list of items that the buyer will not be able to bring a warranty claim in respect of; and
  4. where the sellers wish to mitigate their liability, or where the sellers are unable to give commercial warranties (e.g. where funds are distributing proceeds to investors immediately following the sale) warranty and indemnity insurance can be purchased to cover liability for a warranty claim (please read our introduction to warranty and indemnity insurance for further information in this regard).

Inserting an awareness qualification into a warranty such as “the Company has not suffered any breach of security leading to the unauthorised disclosure of personal data” pertaining to a company’s computer system, amends the warranty to include the wording “so far as the Seller is aware, the Company has not suffered…” This in effect provides a degree of protection to the seller, however it does not mean that the seller can ignore a warranty where there is an awareness qualification. The SPA commonly elaborates on what “so far as the Seller is aware” means in the context of the agreement; for example, it can mean that the seller has made due and careful enquiry of key named individuals in the target company. It is therefore important to ensure that the seller has done all that it can to be comfortable with a warranty and any possible risk, even if there is an awareness qualification.

The seller cannot as a rule rely on the fact that the buyer “knew about” the matter which makes the warranty untrue, inaccurate or misleading to qualify the warranty, unless it is clearly set out in the disclosure letter.

What is included in the disclosure letter?

The disclosure letter will generally include a range of more general disclosures (such as the accounts of the target business, or information which is publicly available at Companies House) and specific disclosures which relate to the particular circumstances of the business. If, for example, the seller knows that there is a breach of a particular warranty (and the reality is that the buyer is likely to be aware of this too from its due diligence and dealings with the seller) then this should always be disclosed to prevent the buyer subsequently bringing a warranty claim.

These disclosures are usually accompanied by a bundle of documents known as a disclosure bundle. The documents are sometimes in physical lever arch files, but more commonly now, the documents are held in an electronic web based data room and downloaded onto a CD Rom or USB at the completion of the sale.

Why is the concept of ‘fair disclosure’ so important?

There are various ways in which ‘fair disclosure’ may be defined in an SPA. This could be ‘full’, ‘accurate’, ‘fair’ or ‘specific’ disclosure – or a combination of these.

However where disputes have arisen over a breach of warranty, there are a number of practical examples that demonstrate the importance of understanding the concept of ‘fair disclosure’ to achieve the desired protection for the seller. The risk for a seller will be that whilst it has disclosed something in general or high-level terms, the level of detail given does not meet the standard of ‘fair disclosure’ and the buyer is therefore able to bring a successful warranty claim.

A buyer’s concern when negotiating the definition of ‘fair disclosure’ will be to ensure that it has received updated or supplemented information on areas of concern that may not have been fully understood during the initial due diligence process (our overview of legal due diligence provides further background on this particular stage of the acquisition process). The reality is that a buyer will almost invariably be more interested in extracting information that bringing a (potentially costly and time-consuming) claim several months or even years down the line – particularly where the seller will have ongoing involvement in the target business.

Examples of interpreting ‘fair disclosure’ in practice

In 2019, several claims were brought against a seller for breach of warranty after the shares acquired in the target companies were rendered worthless due to serious financial and operational issues in the target companies. The seller had warranted that it was not aware of any matter that might give rise to litigation and that the target companies had not breached any material contracts. The buyer claimed the target companies had been suffering operational failings which amounted to breaches of material contracts and that the seller knew this. The seller had referred to specific operational issues in the disclosure letter, including reference to potential disputes.

It was decided that due to the scope of the wording provided in the acquisition documentation as to what ‘disclosure’ amounted to, the seller was not liable under the warranty claim, and that a sensible and practical approach had been given to the disclosure process considering the scale of the business. Although it provides comfort that where a large volume of documentation is involved, the principle of fair disclosure is still considered legitimate, it must however be genuinely fair. This means that information contained within an obscure part of a document or correlating information lying in a separate document that relates to a different area of the business must be brought to the buyer’s attention.

The requirement to specifically notify the buyer of information can be seen in previous cases regarding claims for breach of warranty (Levison v Farin [1978] 2 All ER 1149 and Daniel Reeds Ltd v EMESS Chemists Ltd [1995] BCLC 1405) that have also supported the view that for a disclosure to be fair, it must draw the buyer’s attention to the relevant facts and ensure those facts are disclosed against, rather than simply enabling the buyer to make an inference of a particular issue.

However the buyer (with support of its accountants and legal advisers, for example) must still check and satisfy itself that information provided by the seller is sufficient for the buyer to understand the relevance of the disclosure, especially where there is a commercial issue of particular importance, such as pertaining to the operational or financial successes of a business.

Does this mean general disclosures should never be used?

General disclosures tend to be commonly used in commercial deals, although these are usually heavily negotiated and the extent to which general disclosures may be accepted is a matter for each particular transaction.

If, for example, the disclosure letter says that all documents in a disclosure bundle or data room are to be generally disclosed, this places the onus on the buyer to read all of the data room documents and be comfortable with their contents. This general disclosure is not always accepted due to the allocation of risk upon the buyer (particularly if the data room is extensive, for example, or there are hundreds of commercial contracts). Where this kind of general disclosure is not accepted, the seller needs to be sure that suitable specific disclosures are made to mitigate the risk of a claim for breach of warranty.

Although general disclosures are a helpful tool, they are not to be relied upon by a seller, as where a seller is aware of information that is contrary to a warranty, this should be provided as a specific disclosure against a particular warranty in order to limit the seller’s risk for breach of warranty after completion of the deal. Similarly, as discussed above, a seller should not assume that because something has been disclosed in due diligence meetings or correspondence that it will be treated as ‘fairly disclosed’ – these disclosures should all be formally documented in the disclosure letter.

What is the relationship between giving replies to due diligence enquiries and making specific disclosures?

Although there may be a degree of overlap between the due diligence process and the disclosure exercise, they are separate stages within a transaction and the disclosure exercise must not be ignored, even if a seller thinks that information has already been provided in response to initial queries from the buyer pertaining to the target company.

Whilst due diligence may seemingly cover many of the same areas of the business as are warranted in the SPA (such as property, employment and insurance), the due diligence replies given by the seller generally do not constitute formal disclosure against the warranties. In order to suitably qualify the warranties in the SPA, some information may need to be repeated in the specific disclosures from the due diligence replies already provided, disclosing against a specific warranty, to manage the seller’s risk for breach of warranty accordingly.

This repetition can be tedious for all involved – including the parties and their lawyers – but this should not detract from the importance of the exercise.

How best is it to approach the disclosure process now?

There is no definitive structure that can be used to approach the disclosure process in every transaction; it is tailored on a case by case basis. However, once the warranties are close to being agreed in the SPA and a seller reaches the stage of having to work through each of the warranties in detail and work out which need to be disclosed against, it can be helpful to consider:

  1. Have you provided sufficient information? Whether you are looking through company records or historic invoices to provide the buyer with additional evidence, does the disclosure you are making contain enough information to allow a buyer to identify the nature and scope of the matter and the impact it may have on the business?
  2. Have you met the necessary standard of disclosure? The amount of information that you need to disclose will depend upon how disclosure is defined in the SPA. If in doubt, it is always best to provide as much information as possible; better to disclose too much than too little!
  3. Do you need a second opinion? Perhaps a team member in your business has mentioned a commercial matter to you that does not seem too significant, or you note that your insurance policies are due for renewal in the coming weeks but that due to cash flow these can wait to be renewed until next month. Although these may not usually be a cause for concern, they may be relevant to a particular warranty, and disclosure might be required. Ask for a second opinion to get an objective view on whether these issues should be disclosed. It will also be necessary for you to sit down with your lawyers and run through the disclosure exercise to assess the level of detail required.

What do I need to look out for as a buyer when navigating the disclosure process?

As a buyer, it is important to approach the disclosure process from the perspective that it is an opportunity for you to obtain as much information as possible on the mechanics of a business, its pitfalls and successes, and any particular areas of concern. Although a buyer provides the initial set of warranties for the seller to consider, many of these warranties will most likely be amended and/or deleted by the seller’s lawyers to try and reach a position that limit’s the seller’s risk.

The buyer’s lawyers can then look to address these amendments and any further information that has been provided in the disclosure letter to apportion risk appropriately. This may include narrowing the scope of a particular warranty to exclude a particular area of concern for the seller, but leaving the buyer the protection otherwise provided by the warranty.

It is therefore important to liaise regularly with your lawyers throughout the disclosure process, and indeed the transaction generally, to ensure that as a seller, you have identified areas of particular risk or sought clarity over whether a matter is worth disclosing to the buyer to compound the level of protection sought against a possible warranty claim. As a buyer, you will work with your lawyers to reach a position whereby you feel risk has been apportioned appropriately between buyer and seller and that you are comfortable with the level of protection you will receive going forward after completion of the acquisition.

 Please do contact us if you would like further information and advice on the warranty and disclosure process. We would also be happy to discuss how we can assist you as buyer or seller throughout the acquisition or disposal process more generally.

This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.