M&A Vocabulary – Experts explain: “Indemnity vs. Warranty” in common law

One of the key areas when negotiating an M&A deal—especially a share deal—is allocating the risk in case the buyer of a company does not get what they hoped for. In practice, one common issue is that even after the most thorough due diligence, the buyer may not have enough time and detailed knowledge to assess all risks associated with the target; another is that due diligence may have identified risks that may or may not materialize only after closing the transaction.

Such risks can either be addressed commercially, i.e., by reducing the purchase price—which is likely to be very unpopular with the seller—or legally, by agreeing on corresponding warranty rights between buyer and seller in the share purchase agreement.

In particular in Anglo-Saxon contracts under common law jurisdictions, the term indemnity comes up in this context and must be distinguished from a warranty. While a warranty is a contractual assurance by the seller regarding a characteristic or the condition of the company being sold, an indemnity is a promise by the seller to hold the buyer harmless with respect to a specific risk. An indemnity therefore gives the buyer a tool to protect against known or identified risks. Examples include tax risks, potential product liability cases, or environmental law risks.

An indemnity has the following advantages over a warranty:

• in the event of a loss, there is typically no duty on the injured buyer to mitigate damages
• the seller does not have to have caused the loss; the occurrence of the defined loss is generally sufficient
• the loss incurred is reimbursed 1:1 and does not have to be quantified; for example, a liability of EUR 5,000 arising from product liability is reimbursed 1:1, whereas the same liability may be disregarded under a warranty if it has not resulted in any loss to the buyer. This is the case, for example, if a company has been purchased for several million euros and the comparatively small product liability case does not change the value of the company.

From the seller’s perspective in particular, it is important to review the wording of an indemnity carefully. While the buyer will insist on drafting the wording of an indemnity as broadly as possible, the seller should—so as to avoid unnecessary liability risk—consider the following points:

• a precise description of the liability to be covered by the indemnity
• a time and monetary cap on the indemnity
• in the case of liabilities that may arise from third-party claims (e.g., product liability), linking the indemnity to control rights regarding the dispute with the third party, in order, for example, to prevent an unreasonably high settlement.

It is also possible (and particularly common in the US) to put the entire share purchase agreement on an indemnity basis, so that any breach of the share purchase agreement triggers indemnity liability.

Finally, the buyer must bear in mind that an indemnity can only be as good as the seller’s financial strength after closing the transaction. Accordingly, solutions should be considered in which parts of the purchase price are held in escrow accounts to secure any claims. Another option would be to take out insurance for the relevant default risks.

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