Devil in the details: indemnities vs warranties in M&A

Introduction

In an economy that is still recovering from the COVID-19 pandemic and other global challenges, companies are adopting an increasingly risk-averse approach to the M&A environment. Two common safeguards used to mitigate risk are indemnities and warranties. The fact that both warranties and indemnities seek the same result – compensating an innocent party that has suffered damages – often leads one to question whether it is necessary to include both indemnities and warranties. Warranties and indemnities play significant but different roles in managing risk and liability, and it is therefore important to understand how they compare.

Underlying difference between warranties and indemnities

Warranties and indemnities primarily differ in the legal remedy used when a claim is triggered. A warranty is a contractual statement that a certain situation is true. If it is not true, this is a breach of the contract, and the appropriate remedy is one for contractual damages. A warranty is not an under-taking to make the situation true and, therefore, the remedy of specific performance is normally not possible nor appropriate. Conversely, an indemnity is an agreement between the parties that the indemnifying party will compensate the indemnified party for any losses suffered as a result of a claim by a third party. The appropriate remedy for an indemnity claim is, therefore, one for specific performance in terms of the contract.

Practical significance of the difference

Whether claiming damages or specific performance – the end result seems to be the same, namely compensation for a loss.

However, practical differences arise from the rules that apply to claims for contractual damages, which do not apply to claims for specific performance. Two legal rules, amongst others, apply to contractual damages –
• a party may only claim contractual damages that were reasonably foreseeable and not too remote; and
• the amount recoverable as contractual damages is limited to the innocent party’s actual pecuniary damage.

Amongst the legalese, two issues of practical significance arise that limit the amount that an innocent party may claim as contractual damages.

Contractual damages must be reasonably foreseeable and not too remote
Contractual damages are limited to damages that the contracting parties reasonably foresaw as a probable consequence of the breach in question. Damages that were not reasonably foreseeable may not be claimed unless such damages were expressly or tacitly agreed to by the parties. Consequently, assessing contractual damages is a tedious task that normally devolves into arguments over which damages were reasonably foreseeable and which are too remote. It is unlikely that the innocent party will ever be able to fully recover the actual damages suffered. This rule applies to warranty claims (claims for contractual damages), but not to indemnity claims (claims for specific performance). Since this rule does not apply to an indemnity claim, it is usually possible for the party to recover its loss on a Rand-for-Rand basis when claiming under an indemnity, provided that this is permitted by the wording of the contract.

Contractual damages are limited to the innocent party’s actual pecuniary damage
The innocent party’s actual pecuniary damage is the difference between the actual purchase price and what the purchase price would have been if the warranty was actually true, which the courts have determined would be its market value. This rule becomes problematic when a party pays a bargain price. Since the innocent party paid less than the market value, the fact that an untrue warranty reduces the market value does not necessarily result in the innocent party suffering claimable damages. The innocent party only suffers a loss if the market value is reduced below the actual bargain price that it paid. This is not a problem faced by indemnity claims, as the party is able to claim any damages they have suffered, whether actual pecuniary damages or not, provided that this is permitted by the indemnity clause.

Why still have warranties?

From the above discussion, indemnities clearly provide benefits that warranties do not. However, both are important to mitigating risk. Warranties induce parties to stand behind their word, and are therefore worth their weight in gold in the event of litigation. Indemnities also usually only apply to third-party claims, rendering them unsuitable where there is no third-party claim but only a loss suffered between the parties (e.g. where the purchase price would have been less, simply because the quality of the assets is not that which was warranted).

Conclusion

There is, therefore, a clear distinction between warranties and indemnities, and the seemingly identical end result is not as identical as it seems. Both warranties and indemnities should be included in M&A deals in order to effectively manage and mitigate risk. Each has its own role to play, and the party that understands these roles will have the upper hand.

Keagan Hyslop is a Candidate Attorney and Roxanna Valayathum a Director in Corporate & Commercial | Cliffe Dekker Hofmeyr.

This article first appeared in DealMakers, SA’s quarterly M&A publication.

DealMakers is SA’s M&A publication.
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