Introduction

When selling a business, sellers will often encounter a detailed list of warranties within the sale and purchase agreement (SPA) presented by the buyer. Seller warranties are statements of fact about the business that the buyer relies on when making their purchase decision. These warranties, while often negotiable, are a usual part of a business sale agreement.

For vendors selling a business, it is important to understand that these warranties carry potential risks if not carefully considered. This guide will help sellers beware of broad warranties and understand the risks associated with them in a business sale. By understanding these risks, sellers can better negotiate the terms of the business agreement and take steps to limit their potential liability.

Understanding Seller Warranties in Business Sales

What are Seller Warranties?

In the context of selling a business, seller warranties are statements of fact made by the seller about the business or company being sold. These warranties are included in the SPA and act as promises to the buyer regarding the state of the business. Seller warranties can be positive statements, such as confirming the business has complied with all relevant laws, or negative statements, like assuring there are no existing third-party claims against the business. Ultimately, these warranties are a set of representations about the business that the buyer relies on when making their decision to purchase.

Why Buyers Seek Warranties in Business Agreements

Buyers seek warranties in business sale agreements as assurances about the condition and operation of the business they are purchasing. These warranties provide buyers with a degree of comfort and are relied upon when deciding to proceed with the purchase. Warranties serve to allocate risk between the buyer and the seller. If a seller warranty turns out to be untrue, meaning the warranty is breached, the buyer is protected and may have recourse against the seller for resulting losses. Purchasers may claim damages if these representations or warranties prove to be incorrect after the sale is complete.

Risks of Broad Warranties for Business Sellers

Potential for Financial Loss from Warranty Breaches

Seller warranties are statements of fact made by a seller about the business being sold within a business sale agreement. If a seller warranty is breached, meaning it turns out to be untrue, the seller becomes responsible for the buyer’s resulting financial losses. This liability can create a significant financial risk for sellers. Purchasers are entitled to seek damages if the representations or warranties provided by the vendor are found to be incorrect.

The financial impact of a warranty breach can be substantial, potentially leading to significant damages awarded against the seller. For a purchaser to successfully claim for breach of warranty, they must demonstrate actual financial loss resulting from the untrue statement. Warranties that are overly broad or not carefully considered can create significant financial risks for sellers. These risks are particularly pronounced in warranties concerning:

• Accuracy of financial information: If financial statements provided as warranties are inaccurate, sellers may face claims for substantial damages reflecting the business’s true financial position.
• Compliance with laws: Warranties assuring compliance with all applicable laws can be problematic if there are undisclosed breaches, leading to liability for regulatory penalties or costs of rectification.
• State of assets: Broad warranties regarding the condition of plant, equipment, or intellectual property can expose sellers to financial loss if these assets are not as warranted.

Exposure to Legal Disputes and Costs

Unwary vendors may face legal disputes and court proceedings due to broad warranties. If a purchaser believes a warranty has been breached, they may commence legal action against the seller for breach of warranty or misleading conduct. This can result in significant legal costs for the vendor, regardless of the dispute’s outcome, in addition to potential damages. The possibility of facing litigation is a serious risk for vendors.

Purchasers have contractual remedies available if warranties are breached. While damages are the typical remedy, allowing the purchaser to recover financial compensation, purchasers might negotiate termination rights in the sale agreement for specific breaches of warranty. Therefore, it is vital for vendors to understand the potential for costly and prolonged legal disputes arising from broad warranties in business sale agreements.

Case Study: Evolution Traffic Control v Skerratt

Facts of the Case

The case of Evolution Traffic Control v Skerratt [2018] NSWSC 49 (Skerratt) underscores key risks tied to warranties and representations in business sales. In this matter, a purchaser acquired a trade training organisation via a share purchase agreement (SPA) for $10 million. The purchase price was based on a multiple of five times the business’s sustainable Earnings Before Interest and Taxes (EBIT), with the purchaser relying heavily on financial forecasts provided by the vendors.

These forecasts, however, assumed the business would maintain fifty additional government-funded student places from the previous year. Importantly, the vendors failed to disclose a condition set by the Western Australian government for ongoing funding—a condition that was practically impossible to fulfill by the time of the sale. When this critical information about the business’s future performance came to light post-completion, the purchaser initiated legal proceedings.

The purchaser’s claims against the vendors included:

• Misleading and deceptive conduct under the Australian Consumer Law (ACL).
• Breach of warranties stipulated in the share purchase agreement.
• Indemnity against loss, as specified in a clause of the agreement.

The purchaser sought to recover the difference between the initial $10 million purchase price and the actual value of the business at the time of acquisition, arguing that reliance on inaccurate financial forecasts led to financial loss and a dispute over the purchase price.

Key Takeaways for Sellers from Skerratt Case

The Skerratt case provides important lessons for sellers regarding representations about future performance and the scope of warranties in sale agreements. In this instance, the vendors could not demonstrate they had a reasonable basis for making representations about the business’s future financial performance, which negated the need for the Court to examine the warranty and indemnity arguments further. Ultimately, the vendors were ordered to pay approximately $4 million in damages.

Key lessons for sellers include:

1. Avoid representations about future business performance: Representing future financial outcomes poses significant risks, especially when those outcomes cannot be substantiated.
2. Limit warranties to verifiable facts: Warranties should be confined to facts that vendors can confirm with confidence. Broad warranties, particularly those that may be interpreted to cover future financial performance, create significant potential for liability.
3. Carefully draft sale agreements: Detailed, precise drafting ensures warranties are specific and not overly expansive, reducing the risk of misinterpretation or unintentional coverage of unpredictable risks.

The case highlights the overarching importance of precision and transparency in business sales to avoid costly disputes and liabilities.

Strategies to Safeguard Against Risky Warranties

Disclosure is Key to Limit Warranty Liability

Proper disclosure plays an important role in limiting warranty liability for sellers. By fully disclosing business-related information to buyers before signing the sale agreement, sellers can shield themselves from potential warranty claims. Once buyers are made aware of specific issues via disclosure, they cannot later claim a breach of warranty based on those same matters. For this reason, controlling the disclosure process from the outset is critical to avoid disputes over what was shared with the buyer. Consequently, obtaining legal advice during the disclosure process is equally essential. Contact Corestone Lawyers today for a free consultation and protect your interests with precision.

To enhance the protection offered by disclosure, sellers can take the following measures:

• Collect Relevant Information Early: Gather all critical business documents and details at the beginning of the sale process.
• Utilise a Data Room: Create a secure data room to grant buyers and their advisors access to accurate information about the business. Ensure the data provided is honest, non-misleading, and covers both positive and negative aspects of the business.
• Provide a Disclosure Letter: Deliver a disclosure letter before executing the SPA. This document should outline specific disclosures related to each warranty in the SPA, helping mitigate later claims.

Negotiate Limitations and Qualifications in the Sale Agreement

Sellers should also focus on negotiating limitations on warranty liability as part of the SPA. Including well-drafted limitations and qualifications can significantly reduce potential liabilities. These measures typically include:

• Monetary Caps: Establish a cap on liability, usually expressed as a percentage of the sale price. Different caps might apply to different types of liability.
• Claim Thresholds: Introduce minimum claim amounts and aggregate claim thresholds to prevent minor issues from resulting in claims.
• Time Limits: Define strict timeframes for buyers to notify sellers about warranty claims post-sale. Additionally, consider adding a separate time limit for initiating legal proceedings after such notifications.
• Qualifying Warranties: Use phrases like “to the seller’s best knowledge” to limit warranties to what the seller actually knows, thereby narrowing the scope of liability.

These strategies ensure a more balanced agreement and help sellers avoid open-ended risks.

Consider Warranty and Indemnity Insurance

Warranty and indemnity insurance offers another layer of protection for sellers in business transactions. This type of policy provides coverage for losses resulting from breaches of seller warranties.

Key considerations when exploring warranty and indemnity insurance include:

• Insurance Types: Both sell-side and buy-side warranty insurance exist, though buy-side insurance tends to be more common.
• Suitability: Whether warranty insurance is appropriate depends on the transaction’s size, specifics, and business nature.
• Policy Scope: Carefully review the insurance policy, as it might exclude certain warranties from coverage.

For sellers seeking additional financial protection, warranty and indemnity insurance can be a valuable tool to safeguard against potential risks arising from warranty claims.

Key Elements to Review in Warranty Clauses

Scope and Breadth of Warranties

Sellers must carefully review the scope of warranties in a sale agreement to ensure they are appropriately limited. Warranties should:

• Be specific and not overly broad or all-encompassing.
• Focus on issues that materially impact the business value.

Vendors should avoid agreeing to broad, catch-all warranties or those that make representations about the future performance of the business. Additionally, all warranties should be qualified with disclosures made during the due diligence period to mitigate risk.

Time Limits for Warranty Claims

Establishing time limits for warranty claims is a critical aspect of sale agreements. These timeframes specify:

1. Notification Periods: The length of time buyers have post-completion to notify the seller of a warranty claim.
2. Legal Proceedings: A separate period for buyers to commence legal proceedings after providing notice of a claim.

Time limits are essential in preventing vendors from facing prolonged exposure to liability. Many agreements define a claim period of one to two years after the business sale is completed. Clearly negotiated and documented time limits provide certainty and help manage risk effectively.

Liability Caps and Claim Thresholds

Monetary caps on liability and minimum claim thresholds are integral elements of warranty clauses. Sellers should focus on the following:

• Monetary Caps: These caps set a ceiling on the amount a buyer can claim for breaches of warranty, often tied to a percentage of the purchase price. However, different types of liabilities may be subject to different caps.
• Claim Thresholds: Minimum thresholds ensure buyers cannot pursue claims for trivial or immaterial issues.

By negotiating these provisions, sellers can significantly limit their financial exposure and ensure a more balanced warranty framework in the agreement.

Conclusion

Navigating seller warranties in a business sale agreement requires careful consideration from vendors to mitigate potential risks. Broad warranties can expose sellers to significant financial and legal liabilities, as highlighted in cases like Skerratt. By understanding the nature of warranties, the risks they pose, and implementing proactive strategies such as comprehensive disclosure, negotiating limitations, and considering warranty insurance, sellers can better protect their interests during a business sale.

To ensure you are adequately protected when selling your business, it is crucial to seek expert legal advice. Contact our experienced team at Corestone Lawyers today to discuss your sale agreement and learn how we can assist you in effectively managing warranty risks and achieving a successful business sale.

Frequently Asked Questions