Warranties – adequate protection for the buyer of a business? Tax (Law), England

Why are warranties in a UK agreement to buy a business important?  The answer is: if the seller provides warranties to a buyer, this reduces the inherent risk in an acquisition.   Warranties in business sales are contractual statements as to the condition of the target business.  Their importance is underlined by the fact that when buying a business (whether one is buying shares or the assets of the business) the principle of caveat emptor (buyer beware) applies – English law provides no statutory or common law protection for the buyer as to the nature or extent of the assets and liabilities it is acquiring.

On a share purchase the buyer acquires an entity complete with all of its assets, rights and liabilities, both past and present. Unless impacted by change of control provisions in contracts to which it was a party, the change of ownership should not affect any of the target company’s rights or obligations, which will continue to exist following the acquisition. Warranties are as important on an asset purchase, even though the buyer does not inherit all the liabilities of the business.

Warranties can, and usually will, encompass a wide range of important areas, including but not limited to the accounts of the business, finance/banking, property, employees, commercial contracts, IP, IT and tax and will be a key focus in the negotiations, with the buyer’s solicitors seeking to secure as much protection as possible for the buyer and the seller’s solicitors seeking to reduce the nature and/or extent of the warranties provided by the seller.  In some instances, there may be a valid argument that the warranties should be much less extensive – for example, if the buyer(s) has previously managed the business and should therefore know if there are any “skeletons in the cupboard”.

But do warranties really provide the buyer with proper protection?  Are warranties an effective replacement for due diligence, for example?  The answer is an unequivocal “no”; warranties are very important and they should reduce risk for the buyer, but if a buyer discovers something, through its due diligence, prior to completion which justifies, say, a £100,000 reduction in the purchase price, that is much more valuable than, through its warranties, having a potential right of action for £100,000 because litigation in the UK is expensive and the outcome is rarely guaranteed..

Furthermore, in addition to the fact that warranties (unlike indemnities) put the onus on the buyer to prove the breach and show a quantifiable loss, there are other limitations in warranties; in addition to the fact that they will usually be limited to those facts within the seller’s knowledge and which have not been disclosed to the buyer, there will almost invariably be caps on the amounts that can be claimed under the warranties and time limits to give notice of warranty claims and/or initiate legal proceedings in relation to those claims.

Trap in enforcing warranties:  The issue of whether or not a warranty claim was time barred arose in a recently heard UK High Court case (Aegeus (UK) Limited v Kwik-Fit Limited), in which the preliminary issue to be decided was whether the warranty claim by the buyer was time barred.  Time periods had been specified in the agreement for (i) a potential claim to be notified and (ii) proceedings in relation to that claim to be issued.  As would be expected, these time periods were considerably shorter than the statutory limitation periods, but long enough for any issues to come to light.  In this case, the seller claimed that it had not been served with the claim in time, using the concept of “deemed service” under the CPR (as the times for service were not specified in the agreement), even though it knew that proceedings had been issued.   The court took a commercial approach and allowed the warranty claim to proceed.

Sound bite: This decision places emphasis on the importance for all parties of expressly specifying how legal claims and other legal process are to be served for any contractual purposes, such as a contractual limitation period.  And from a practical point of view, it underlines the importance of thorough upfront due diligence and not relying too heavily on warranties.  Although this decision favoured the buyer, as recipient of the warranties, in litigation there will always be uncertainty as to the outcome  so the ability to sue for breach of warranty should not be viewed as a substitute forthorough due diligence.   Further details on issues to consider when buying are business are set out here: http://www.gannons.co.uk/expertise/business-law/buying-a-business/

Marc Mediratta is a commercial partner at our London offices and regularly provides advice to both buyers and sellers of businesses including international transactions which involve a UK business.