M&A Vocabulary – Explained by the experts: Indemnity vs. Warranty under Common Law

In this ongoing series, a number of different M&A experts from the global offices of Rödl & Partner each present an important term from the English specialist language of the mergers and acquisitions world, combined with some comments on how it is used. We are not attempting to provide expert legal precision, review linguistic nuances or present an exhaustive definition, but rather to give a basic understanding or refresher of a term and some useful tips from our consultancy practice.

One of the key areas in the negotiation of an M&A deal – especially one that involves a share deal is the allocation of risks in the event that the buyer of a company did not receive what he was expecting. On the one hand,  the problem frequently arises in practice that even after the most careful due diligence, the buyer still does not have sufficient time or detailed information to evaluate all the risks relating to the target company, and on the other hand, it may be that the due diligence itself identified risks that will only materialise (or not) after closing the transaction.

Such risks can either be handled commercially, by reducing the purchase price – very unpopular with the vendor – or legally, by agreeing suitable warranty rights between vendor and buyer as part of the Share Purchase Agreement.

Especially in contracts under Common Law in Anglo-Saxon legal systems, the term indemnity frequently appears, which needs to be distinguished from a warranty. While a warranty is a contractual assurance by the vendor in relation to the properties or the condition of the company being sold, an indemnity is a promise by the vendor to hold harmless the buyer for a particular risk. The indemnity therefore provides the buyer with a tool to protect himself from a known or identified risk. Examples of this might be tax risks, potential product liability cases or environmental law risks.

An indemnity offers the following benefits compared to a warranty:  

• in the event of a claim, there is usually no obligation on the part of the buyer suffering the damages to minimise them
• the vendor does not have to have caused the damage, the manifestation of the defined damage is generally sufficient
• the damage arising is compensated 1:1 and does not have to be quantified, e.g. a payable of EUR 5,000 due to product liability is reimbursed 1:1, while the same liability may be disregarded under a warranty, if it has not led to any damages for the buyer. This is the case, for example, when a company has been purchased for several million Euro, and the comparatively small product liability case does not change the value of the company.

From the vendor's perspective especially, it is important to check the wording of an indemnity very carefully. While the buyer will insist that the wording of an indemnity should be as broad as possible in order to avoid unnecessary liability risks, the vendor must consider the following points: 

• a precise description of the liability which is to be covered by the indemnity
• a limitation in both time and value of the indemnity
• in the case of liabilities that may arise from claims by third parties (e.g. product liability), linking the indemnity to rights to conduct the dispute with the third party, in order to – for example - prevent an excessively high settlement.

It is also possible (especially in the US) to place the entire share purchase agreement on an indemnity basis, so that any violation of the share purchase agreement triggers an indemnity liability.

Finally, the buyer must remember that the indemnity is only ever as good as the financial resources of the vendor after closing the transaction. Therefore, solutions should be considered in this context involving parts of the purchase price being held in escrow in order to secure any claims. Taking out an insurance policy for the default risk involved would be another option.