What is a warranty in a business sale? Caveat emptor, disclosure and breach of warranty

If you are buying or selling a business, warranties will play a key part in the sale and purchase agreement. A warranty is a contractual promise by the seller that certain information about the business is true. For a buyer, warranties are the main way of shifting risk back onto the seller under a legal system that otherwise expects you to look after yourself. For a seller, they are the promises you can be sued on if they turn out to be wrong.

What is a warranty in a business acquisition?

In an acquisition, a warranty is a contractual promise made by the seller to the buyer. Its purpose is to assure the buyer that specific statements about the business are accurate: that the accounts are right, that the company owns what it says it owns, that there are no undisclosed debts, and so on.

The warranties sit inside the sale and purchase agreement, which is the contract that transfers the shares or the assets from the seller to the buyer. They are not a side letter or a comfort statement. They are terms of the contract, and that is what gives them teeth.

Caveat emptor and due diligence

Why does this matter so much? Because when it comes to buying a business, the English law principle of caveat emptor applies. Caveat emptor means "buyer beware". The buyer is the one expected to investigate the business they are looking to buy and to work out whether it is a good idea to buy it. That investigation is due diligence.

This is different from consumer purchases. When you buy a consumer product you have legal rights, for example the right to expect the product is fit for purpose. A buyer of a business has no equivalent safety net. If you do not ask the question, and the seller does not promise an answer, the problem is yours.

How warranties reduce due diligence risk

In practice, warranties make due diligence less costly and less extensive, and they reduce the risk to the buyer.

Take a simple example. Rather than trying to establish for yourself whether the company has always paid its taxes to HMRC, you can ask the seller for a warranty stating that it has, and that there is no money owed to HMRC. The seller's promise does part of the work that your own investigation would otherwise have to do.

That does not mean you skip the checks. You should still try to verify that what the seller is promising is actually the case. A warranty is a remedy if something goes wrong, not a substitute for looking. But the combination of reasonable due diligence plus a strong set of warranties is far better protection than either on its own.

Negotiating warranties: buyer versus seller

The two sides want opposite things from the warranty schedule, and that is where the negotiation happens.

• Acting for a buyer, I advise clients to make sure the warranties are extensive and comprehensive. The more the seller promises, the more the buyer can rely on and the more it can claim for if a promise is untrue.
• Acting for a seller, I negotiate to make the warranties as narrow and as limited as possible. Every warranty given is a potential claim, so a seller wants fewer promises, more tightly worded.

Where the final position lands depends on bargaining power, the state of the business and how much each side knows.

Examples of warranties in a sale agreement

What kind of warranties would you want to see as a buyer? Common ones cover:

• Tax. That the target company has always paid what it owes to HMRC and has no outstanding tax liabilities.
• Ownership. That the seller owns the shares or assets being sold and is entitled to sell them.
• Financial statements. That the accounts give a true picture of the business.
• Compliance. That the business has complied with the laws and regulations that apply to it.
• Intellectual property. That the business owns or is entitled to use the IP it relies on.

Disclosures against warranties

Here is where warranties become genuinely useful as a tool rather than just a safety net. Suppose you ask for the HMRC warranty above, but the company has in fact had problems with HMRC in the past. The seller is unlikely to sign that warranty as drafted, because doing so would expose them to a claim. Instead, they will disclose the past issues against the warranty.

Disclosure qualifies the warranty. The seller is saying, in effect, "the warranty is true except for the following, which I am telling you about now." Once disclosed, the buyer cannot later sue on that point because it knew about it before signing.

For a buyer, that is an interesting dynamic. Asking for a broad warranty forces the seller to choose between promising something is true and telling you why it is not. Either way you learn something. Buyers can use warranties to elicit important information about the target business that might never have surfaced through questions alone.

Breach of warranty: what can the buyer claim?

Assume you have understood the importance of warranties, negotiated a good set into the sale and purchase agreement, and the agreement has been signed. Then it turns out that one of the seller's warranties was untrue.

That is a breach of warranty. It may give you, as the buyer, the right to sue the seller for compensation for the losses you have suffered as a result.

Back to the HMRC example: if the company you have bought did in fact owe money to HMRC and you now have to pay it, you may be able to claim that money back from the seller. The warranty converts a problem you inherited into a problem the seller has to pay for.

Next steps

If you are a buyer, make sure your solicitor drafts a comprehensive warranty schedule and reviews the seller's disclosures carefully, because what is disclosed is what you cannot later claim for. If you are a seller, review every warranty before you give it and disclose anything that would make it untrue. In both cases, speak to a corporate solicitor before the sale and purchase agreement is signed rather than after.