Posted: 08 / 08 / 2024
What are warranties?
A warranty is a contractual statement of assurance confirming that a certain state of affairs / position exists in the business and is specified by the seller to the buyer in the share purchase agreement (SPA).
An SPA will contain a number of warranties which may cover a variety of functions relating to the business including ownership, financial and tax matters, employees, insurance, commercial, intellectual property, real estate, litigation amongst others.
Generally, there are two types of warranty in the context of a transaction:
- Specific warranty, being a warranty for a particular item. e.g. warranty for tax litigation matters.
- Overall warranty, being general warranties covering broader aspects, i.e. a warranty relating to true and fair nature of the financial statements used as the basis for the transaction.
Warranties are typically heavily negotiated, and a seller will usually aim to limit the warranties provided. A seller will often seek to include a limit on liability such that any individual claim must have a minimum value (known as the de-minimis) and this will often sit alongside an aggregate threshold (known as the basket) where any claims meeting the de minimis threshold are first pooled and can then only be claimed against once the basket threshold is exceeded.
If a warranty is found to be inaccurate after the acquisition, i.e. if the warranty is breached, the buyer may be able to take legal action and recover damages from the seller. If the SPA does not contain adequate warranties (including representations), it may be difficult to identify and to hold the seller accountable for warranty breaches.
Example of warranties:
- the company’s financial matters and financial information, including completeness and consistency of accounts and compliance with applicable laws and standards
- potential material transactions entered by the company
- the company’s employees, including the headcount and salaries
- the company’s compliance with tax obligations, including, for example, the timely filing of tax returns, payments of tax due, any penalties, use of tax-avoidance mechanism
- any pending tax litigation involving the company
Common pitfalls
- Insufficient scope / disclosure of warranties i.e. not adequately defined or disclosed
- Ambiguous language / wordings in warranty i.e. generic and not described accurately
- Materiality qualifiers / capping limits not set appropriately
- No warranty for items not covered in due diligence
- Time limits of warranty being too short
- Too many excluded liabilities and disclosures qualifiers
Best practice in avoidance of disputes
- First and foremost, it is essential to ensure that the warranty schedule is clearly drafted and that it is accurate, factually correct and clearly understood by the buyer and the seller.
- Warranties should include related statements and representations and should be disclosed in the warranty schedule in as much detail as possible.
- A comprehensive due diligence of warranties is recommended.
- Materiality qualifiers, capping amounts and time limits should be adequate.
- Holding back a part of consideration in escrow account to safeguard against breach of warranty.
Warranted financial statements
Warranted financial statements (or similar) relate to the financial information which possibly forms the basis of the transaction value. This could be audited financial statements, or it may be unaudited figures prepared by the company’s accountant, for example management accounts.
In particular, the latter can be a subject of dispute, on the basis that there is more scope for manipulation & these have not been audited.
Example warranties
A selection of examples of warranties in relation to financial statements or financial information is as follows:
“The Accounts”: the unaudited financial statements of the Company (prepared under section 394 of the CA 2006) for the accounting period ended on 31 December XXXX, including the statement of financial position as at the 31 December XXXX, copies of which are included in the Disclosure Bundle.
The Accounts show a true and fair view of the state of affairs of the Company to which they relate as at the Accounts Date, and of its profit or loss and total comprehensive income for the accounting period ended on the Accounts Date.
The Accounts include all known liabilities and all provisions as required by section 21 of FRS 102.
“Management Accounts” have been prepared on a basis consistent with that employed in preparing the Accounts and fairly represent the assets and liabilities and the profits and losses of the Company as at the date and in respect of the period to which they relate.
Next in our M&A Disputes series…
Warranty Disputes | Read here →
Contact
Mark Strafford, Head of Civil Forensic Accounting
