IMPORTANT CONSIDERATIONS WHEN DRAFTING CERTAIN COMMERCIAL AGREEMENTS
When drafting certain commercial agreements (including sale of business, sale of shares, subscription, sale of property and other form of agreements), you are faced with a myriad of provisions to consider.
This article intends to provide a high-level overview of the nature of and, in some instances, the differences between warranties and indemnities and other provisions normally associated with it.
A warranty is a factual statement which, should that statement be untrue, may cause the provider thereof to be in breach of contract and or become liable to the party for whose benefit the warranty is provided.
Characteristics commonly associated with warranties:
- It is predominantly aimed as a function to elicit disclosure
- Warranties are made either at the time the agreement is entered into or at such dates as defined in the applicable agreement
- Warranties may be expressly included in the agreement or could otherwise be implied by law
- The onus is on the party for whose benefit the warranty is provided to show that a warranty is untrue, a breach of contract occurred and to prove quantifiable loss
In certain instances, the counterparty to an agreement may seek further protection through the insertion of indemnities. In such instances, the party that provided the warranty further undertakes as an independent obligation to “make good” any losses or damages suffered by the counterparty.
Characteristics commonly associated with indemnities:
- Indemnities are aimed at apportioning risk and liability between the contracting parties
- Indemnities provide the counterparty with certainty around being compensated in defined circumstances in which a breach of warranty may not necessarily give rise to a claim.
- Indemnities create an independent and primary obligation on the party providing the indemnity
- A claim under an indemnity is likely to be easier to establish than a claim under a
breach of warranty
Differences: Warranties v Indemnities
- Recovery of Losses
The extent of the loss suffered due to a breach of warranty shall be equal to the diminution in the value of the asset acquired. Such loss may be determined either by agreement, through the appropriate dispute resulution mechanisms available to the parties or will ultimately be determined by a relevant court of law. This will also have a bearing on whether a party will be able to recover interest and or costs incurred in pursuing the warranty breach.
In the instance of an indemnity, the counterparty will be able to recover any losses sustained or costs incurred without having to prove that there is any corresponding loss or diminution in the value of the asset acquired. The parties may also expressly agree that all costs (including interest at a prescribed rate) shall be reimbursed to the counterparty in such instances.
It is advisable that an agreement which contain warranties and indemnities should clearly stipulate that there may be no duplication of recovery. For example, with an indemnity that creates a primary obligation, there is usually a rand-for-rand compensation for losses. However, the agreement may also contain a price adjustment clause that may operate independently from the indemnity. The situation may result in the counterparty being compensated unfairly if the provisions under the price adjustment clause are invoked due to a breach of warranty and the counterparty is able to pursue a claim under an indemnity.
- Foreseeability and Remoteness
Contractual principles relating to foreseeability, contemplation and remoteness will regulate the type of damages that a party may claim resulting from a breach of warranty, whereas a claim under an indemnity will generally not be subject to these principles.
- Obligation to Mitigate
Where a party has a claim under a breach of warranty, that party has a positive obligation to mitigate his/her own loss. In other words, a party cannot merely sit back and rely on its warranty claim only to recover losses. In the instance of a claim under an indemnity, no such obligation to mitigate his/her own loss exists.
General Drafting Considerations
- Generally, although it may constitute a material provision of an agreement, a breach of warranty will not entitle the counterparty to terminate the agreement. A right to terminate the agreement should there be a breach of certain material warranties should however be considered and included in the agreement (if appropriate in the circumstances).
- The contracting parties may agree to certain limitations on the liability of a party and the recovery of damages, which may include:
- Drafting and attaching a disclosure schedule in terms of which a party discloses certain information against specific warranties. The agreement should specifically provide that any warranties will be qualified by the disclosures set out in such a schedule and that no claim may be brought in where such disclosures subsequently results in a breach of warranty. In the instance of an indemnity, one should stipulate whether a party will remain indemnified against any loss that might arise from the circumstances duly disclosed. Usually a party will not be prevented from claiming under an indemnity regardless of disclosure.
- Providing that a claim resulting from a breach of warranty shall only arise where the quantum of the claim exceeds a pre-defined minimum amount. In other words, if a party is deemed to be in breach of a warranty and the quantum of the possible claim as a result of the breach of warranty is below the minimum claim amount, then no liability will arise.
- Placing a cap on the maximum quantum of damages that may be claimed.
- Warranties are only true at the moment they are given, so the beneficiary thereof may have an interest in having them repeated at certain key dates.
- A party's knowledge relating to a breach of warranty prior to entering into an agreement needs to be addressed clearly. In other words, will a party be entitled to claim for a breach of warranty if that party knew about the breach of warranty prior to entering into the agreement?
- It should be considered whether appropriate gross-up provisions should be included to ensure that, if any damages paid is treated as taxable income in the hands of the recipient thereof, the liable party should be obliged to gross up the damages to cover any such liability.
- One should also consider whether security is required to ensure a party’s performance under an agreement. What would constitute adequate security would be dependent on the facts at hand. It may include a staggered payment of consideration, a corporate or bank guarantee or (although not yet common in the South African context) even warranty and indemnity insurance.
- Where multiple parties are providing warranties, there should be clarity over who is liable. The counterparty will usually require that they will be liable jointly and severally – this ensures maximum flexibility for the party instituting claims. It is also common for warranty and indemnity providers to enter into a contribution agreement under which they agree, as between themselves, to share any liability in specified proportions.
As seen from the above, when entering into any commercial transaction, there are a number of technical provisions to consider and to address in the agreements that give effect thereto. It is advisable to consult a suitable qualified and experienced legal advisor to advise on and assist in guiding you through this minefield.