The buyer in a share purchase transaction receives very little protection under the general law from defects in the assets it is acquiring, or unexpected liabilities or other issues affecting the underlying business of the target company, hence the principle of caveat emptor (buyer beware applies).
It is therefore customary for buyers to seek contractual assurances from the seller in relation to such matters. These assurances typically take the form of warranties or statements of fact which are given by the seller to the buyer as at the date on which the share purchase agreement is exchanged and completed. The buyer is then entitled to rely on the warranties as being true.
Warranties have two main functions. First, they are a means of allocating risk between the buyer and the seller as they provide the buyer with a remedy (i.e., a breach of warranty claim) if the statements made in the warranties are untrue and subsequently the buyer suffers financial loss.
Secondly, the warranties act as a means for the buyer to elicit information from the seller about the target company. The seller will be required to disclose information about any known problems to the buyer which relate to the subject matter of a particular warranty in the disclosure letter.
There are various ways in which a seller can protect against a claim for breach of warranty, including negotiating the warranties contained in the share purchase agreement, inserting contract limitations in the share purchase agreement (such as time limits and financial thresholds), and disclosing against the subject matter of a particular warranty in the disclosure letter.
The disclosure letter sits alongside the share purchase agreement and sets out areas of inconsistency between the warranties and the target business. Generally, the buyer will not be able to make a claim against the seller for a breach of warranty where the seller has already disclosed the matter giving rise to the breach in the disclosure letter. To avoid falling foul of a breach of warranty claim even where a disclosure has been made, the seller should take extra care to ensure that they have made the disclosure with sufficient detail to meet the necessary standard of disclosure.
In a recent high court case, Equitix EEEF Biomass 2 Ltd v Fox [2021] EWHC 2531 (TCC), the seller was found to be liable for the breach of various warranties in a share purchase agreement for the acquisition of an energy company and the buyer was awarded damages of £11 million (the full amount of the liability cap available under the share purchase agreement).
The warranties that were found to be breached included those relating to the target company’s compliance with its environmental permit, the condition of its plant and equipment, the status of its material contracts and the reasonableness at completion of the projections and forecasts in the Target’s financial model that had been provided to the buyer during the transaction negotiations.
As part of the defence, the seller argued that the buyer’s warranty claims were excluded because the matters giving rise to them had been disclosed. However, the court found in favour of the buyer on the basis that none of the matters giving rise to the established breaches of warranty had been disclosed with sufficient detail to enable the buyer to reasonably identify the nature of the matter disclosed and to make a reasonably informed assessment of the scope of the matter disclosed. On the contrary, the court found the true position was kept from the buyer, and it was deliberately told a good deal less than it needed to know because of a concern that it would withdraw from the transaction.
For the buyer, where the disclosure process draws certain matters to the buyer’s attention which could have an impact on how it views the commercial viability of the target business, the buyer may seek to revisit the commercial terms, request additional contractual protection in the form of indemnities, or in extreme cases, where the risks are too large and difficult to mitigate, withdraw from the transaction entirely.
Where the seller is reluctant to give a particular warranty, then this might raise alarm bells and indicate a potential problem with that aspect of the target business that the seller is unwilling to disclose prior to completion. In these circumstances, the buyer should seek to understand the reason as to why the seller will not agree to a particular warranty.
It is important for both buyers and sellers to engage with their legal teams 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 particular matter should be disclosed and as a buyer, that you have apportioned the risk appropriately between the buyer and the seller and that you are comfortable with the level of protection you will receive after completion.
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