DealMakers - Annual 2021 (February 2022)
Indemnities sailing into the sunset
by Lydia Shadrach-Razzino and Dale Hutchison
In a contract for the sale of a business, the sale of shares or other assets, it is a standard commercial practice to include a clause setting out a list of warranties given by the seller to the acquirer. It is often a point of huge contention in negotiation as to whether the seller is also prepared to give a list of indemnities, including, in particular, a general indemnity against any loss that might be suffered by the purchaser as a result of a breach of any of the warranties, in addition to a list of specific indemnities for known liabilities. The question often arises: what is the difference between a warranty and an indemnity? In this article, we tackle the sensitive issue of whether the indemnity is not redundant in such circumstances. Negotiations on warranties vs indemnities often lead to heated debates, and could be a stumbling block to concluding a transaction. We ourselves have been party to such debates, and question if it may be time to knock the wind from the sails of the heated exchanges on the topic.
During the course of negotiating a contract, a party will usually make a number of factual statements on which the other party will rely in deciding whether or not to enter into the agreement. For example, in the sale of a business, the seller might state that the business has no outstanding tax liabilities. Without more, such a pre-contractual statement of fact is a mere representation, giving rise to remedies for misrepresentation if the statement proves to be false: (i) cancellation of the contract if the statement was material and induced the contract, and (ii) delictual damages if the statement was made fraudulently or negligently. The false representation will not give rise to a claim for contractual damages unless the representation was incorporated into the contract as a warranty.
A warranty is a statement of fact that is guaranteed to be correct, and thus a term of the contract. It differs from a pre-contractual representation in that the maker of the representation assumes responsibility for the correctness of the representation: the common intention of the parties is that the statement forms part of the contract, such that, should the statement prove to be false, the person to whom the statement was made will have a claim for breach of contract. “We have to ascertain whether both parties intended to contract that the thing sold should be as represented, whether the seller intended to bind himself in law that the thing would comply with what he had stated, or at any rate, so acted as to estop himself from denying such intention”.(1)
An indemnity, on the other hand, is an undertaking or promise given by one party to “hold harmless” the other party should some specified event occur. The indemnity can take either of two forms: an undertaking not to sue or hold the other party liable should the event occur (the ubiquitous exemption clause, such as “parking at owner’s risk”); or a promise to compensate the other party if the event occurs. In the present context, we are concerned with this second type of indemnity; in particular, a promise to indemnify the purchaser against any loss that he or she might suffer in the event of a breach of a warranty given by the seller. Should the event in question occur, the person giving the indemnity must honour his or her promise to compensate the other party. A claim under an indemnity is thus a claim for specific performance, rather than a claim for damages; but if the promise is not honoured, a claim for damages will lie.
In a claim for damages for breach of warranty, the claimant will have to establish all the usual elements of a claim for breach of contract: breach, financial loss and causation. In principle, the claimant is entitled to be placed in the financial position that he or she would have occupied had there been no breach (that is to say, the representation must be ‘made good’). However, as a matter of fairness, this principle is subject to two limitations: the damages claimed must not be too remote; and the claimant must take reasonable steps to mitigate its losses.
On the other hand, in a claim for specific performance of the promise under an indemnity, what the claimant will have to prove will depend upon the wording of the indemnity. If the promise is to indemnify the other party against any loss suffered as a result of a breach of the warranty, the claimant will have to prove the same things that he or she would have had to prove had the claim been one for damages for breach of warranty (and the issues of remoteness and mitigation of damages will again arise, unless the wording of the indemnity precludes this). Such an indemnity thus serves little practical purpose, as it is a redundancy. On the other hand, if, for example, the promise is to pay a fixed sum of money should the warranty be breached, these issues can be avoided; but since the indemnity would amount to a penalty stipulation, the sum payable might be subject to equitable reduction by the court under the Conventional Penalties Act of 1962.
One could also include an undertaking in a contract pursuant to which the seller can undertake to make payment of the damages proved by the acquirer flowing from the breach of a warranty, thereby granting the acquirer a claim for specific performance under the breach of a warranty, making the need for an indemnity wholly more redundant.
We also note that underwriters of warranty and indemnity insurance are prepared to underwrite claims under indemnities for breaches of warranties, as the underwriter is not taking on more risk than it would by only underwriting a claim under a breach of warranty. Accordingly, it may be time to let go of the obsession with the requirement for an indemnity for a breach of warranties.
Shadrach-Razzino is an Executive | Corporate Commercial and Hutchison an Executive | ENSafrica.
1 Naude v Harrison 1925 CPD 84 at 90.