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Warranties, Representations and Indemnities

June 2010 - EU & Competition. Legal Developments by Vegas Lex Law Firm .

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Warranties, Representations and Indemnities under the English law in Structuring Cross-Border M&A Transactions.

It is a very-well established fact that most of the transactions undertaken by Russian entrepreneurs with respect to both assets located in Russian and abroad are structured under foreign law. The law of England and Wales known for its flexibility and proving its worth in structuring complex transactions with multi-jurisdiction parties is frequently chosen as applicable law. This refers to both share purchase agreements with respect to shares in the charter capital of the acquired undertakings and post-acquisition structuring, including determination the rights and obligations of the parties by means of shareholders' agreement and in investment contracts.

Merger and acquisition transactions are often exercised under tight deadlines, which make it impossible for the buyer to scrutinize the asset finding out its true value and the risks inherent in such an acquisition or making a thorough examination on all the hidden pitfalls. At the same time, the buyer, who may subsequently act as a party under the shareholders' agreement, would like to enjoy a certain level of protection in case any negative discoveries on the already acquired asset cause material damage or make both business operations on the whole and daily management of the acquired asset more difficult.

Under said circumstances, the claims for damage brought by the aggrieved party (buyer) may have good chances of success, if the executed legal documents make it possible to determine the basis for liability, trigger events, damage assessment procedures and the way to claim damages. One of such ways of minimizing the risks of damages is to include the Warranties, Representations and Indemnities clause into the agreements.

Many practicing lawyers face difficulties trying to determine the distinction between said instruments and their functions in the contractual context. There is even a point of view that no difference exists between warranties, representations and indemnities. However this is not exactly correct.

The warranties are the statements made by the alienating party on the characteristics and features of the asset in sold. The warranties serve a two-fold purpose: on the one hand, should they be breached, the seller undertakes to compensate damages to the buyer as caused by the breach of statements regarding the asset and, therefore, have a compensation function; and, on the other hand, provide a definite scope of information to the buyer about the asset (information function). The compensation for damages caused to the aggrieved party in case of breach of warranties by the seller, including the grounds, proving procedures, etc., pertain to the contractual liability. To obtain compensation, the three key elements should be met:

  • contractual promise;
  • fact of breaching the contractual promise;
  • fact of harm resulting from the contractual promise breach.

For the purpose of assessing the damage, the courts follow the principle, under which the aggrieved party in the contractual obligation will be taken in the position it would have been had the breach of contract not occurred.

In practice, it is often the case that the indicated purchase price is much lower than the real value of the acquired asset. This is what the English law calls a "good bargain". In this case, it is essential to understand the real value of the acquired asset. The value of the asset may be estimated by an independent appraiser or determined by the parties themselves in the text of the agreement. To appraise the damages, the courts would most likely base the calculation on the difference between the asset's cost paid by the purchaser under the sales contract and the actual value of the acquired asset.

The representations, like the warranties, are the undertakings made by the selling party on the facts relating to the asset sold to the buyer. By giving such representations to the buyer, the seller ‚Äėforces' it to rely on these representations in its further operations and to count on their truthfulness. The functions of the representations are analogous to those of the warranties, i.e., in addition to damages compensation, the representations serve also to provide a certain scope of information on the sold asset to the buyer. The main difference between the representations and warranties is that, in case of breach of representations, the damage compensation procedure will be based on the rules applicable to the tort liability. Besides, in case of breach of representations, the aggrieved party will be obliged to prove that it did rely on the received undertakings in its business activity.

When evaluating the damage in case of breach of representations, the courts would follow the rule under which the aggrieved party must be put in a position it would have been had the tort not occurred. In practice it frequently means that all the funds transferred by the aggrieved party under the transaction must be paid back to it. The method of protecting the aggrieved party based on the breach of representations would be more acceptable in case of the so called bad bargain, when the buyer pays more than the actual value of the acquired asset.

The indemnities are different from the above instruments primarily due to them being a simple promise to pay the damages in the amount, which is often determined by the parties in the agreement, under any given circumstances. In this case, it is not required to prove that the misstatements have been made by the seller on the transaction date. The aggrieved party simply needs to demonstrate that a certain event has happened and bring its claim for damages. As a rule, in this case, the value of the claimed compensation is not subject to court assessment and is awarded to the aggrieved party without a sophisticated chain of evidence required from the aggrieved party. This damage compensation method is the simplest and the most convenient for the buyer. Yet, the sellers would often oppose to including this clause into the agreement and prefer to get along with warranties and representations only.

As already mentioned, each of the reviewed instruments has a definite function in the contractual relationships. The use of any given protection method may be conditioned by specific circumstances and, it must be acknowledged, that the combination of all the three instruments in a contractual relationship between the parties secures the maximum protection for the aggrieved party against any potentially negative consequences that may arise from the breach of contract by the other party.



By Anna Ovcharova. LLM. Vegas Lex.