Warranties on an indemnity basis: a question of damages
For practitioners negotiating the terms of a share purchase agreement (SPA) or other transaction agreement, an issue that often arises is whether warranties given in the agreement ought to be backed by an indemnity. Clauses of this kind give rise to two issues: how much the buyer can recover over and above its common law rights, and the circumstances that will affect the amount the buyer can recover if a warranty is breached.
Warranties and indemnities
In the context of an SPA, warranties are statements made by the seller about a particular state of affairs of the target company or the business. The transaction documents typically include a warranty that each warranty is true, accurate and not misleading on the date of the relevant agreement. Damages for the breach of a warranty are determined in accordance with common law principles for breach of contract.
An indemnity places an express contractual obligation on one party to compensate the other party for a defined loss or damage. In some cases, a buyer may seek to preserve its right to claim for damages on a contractual basis and also claim damages for breach of warranty on an indemnity basis. In the context of an SPA, this would mean that if a warranty were untrue or misleading, the seller would have to pay: the amount necessary to put the buyer into the position it would have been in if the warranty had been accurate; and any loss incurred by the buyer as a result of the warranty being untrue or misleading, including its costs of pursuing a claim under the relevant agreement (see “Recovering legal costs”).
Damages at common law
At common law, damages should place the buyer in the same position as if the contract had been performed. This involves comparing the position the buyer is in and the position it would have been in but for the breach of warranty. In the context of mergers and acquisitions, the analysis will turn on the difference between the actual value of the target company and its value had the warranty been true; that is, the diminution in value of the target company. The buyer must satisfy both the “but-for” test of factual causation and legal causation, which imposes on the buyer a duty to mitigate its loss and to show that the loss is not too remote.
The impact that this may have on recovery for the buyer is illustrated by Oversea-Chinese Banking Corporation Limited v ING Bank NV ( EWHC 676). Oversea-Chinese Banking argued that the general measure of damages at common law is a prima facie rule from which the courts can depart. It sought damages on the basis of an indemnity that it said it would have obtained had a contingent exposure to losses arising from the collapse of Lehman Brothers been provided for in the target company’s accounts. This exposure resulted in the target company making a settlement payment of $14.5 million. The court rejected this argument and held that, in the event that a breach has had no impact on the value of the target company, as in this case, the buyer has suffered no loss of bargain.
Indemnities and damages
As an indemnity creates a contractual obligation on one party to compensate the other party for a defined loss or damage, it is often regarded as a debt claim and therefore the ordinary common law rules relating to calculating damages, such as remoteness and the duty to mitigate, do not apply. For example, in Royscott Commercial Leasing Limited v Ismail, where a lessee agreed to indemnify the landlord if the landlord incurred certain expenses, the Court of Appeal held that, as an indemnity is a debt claim, the landlord had no obligation to mitigate those expenses (unreported, Court of Appeal, 17 May 1993). Royscott was applied in subsequent cases including Codemasters Software Co Ltd v Automobile Club de l’Ouest and ABN Amro Commercial Finance Plc v McGinn ( EWHC 3194 (Ch);  EWHC 1674 (Comm).
Indemnities may be considered desirable for this reason and because of the inherent limitation in the measure of damages at common law, as illustrated by Oversea-Chinese Banking, with the result that the buyer may not always have sufficient protection at common law for breach of a warranty. However, the Royscott line of authority should be read in light of the House of Lords’ earlier ruling in Firma C-Trade SA v Newcastle Protection and Indemnity Association (The Fanti), which has not been overturned or received negative judicial treatment ( 2 AC 1). The House of Lords held that if a contract of indemnity is characterised as an action for unliquidated damages there will be a duty to mitigate.
The Court of Appeal’s comments in Total Transport Corporation v Arcadia Petroleum Ltd (The Eurus) cloud the picture further ( EWCA Civ 2754). In the context of an indemnity against breach of contract, the court commented that the word “indemnity” is used in two senses: either to mean damages or to mean an obligation to pay all losses, whether or not they were in the reasonable contemplation of the parties. The court noted that while there is little authority to support the latter meaning (and did not consider Royscott) the word is often used in that sense. In Total Transport, which concerned remoteness of loss following a breach of a charterparty clause, the court did not see sufficient indications that the parties intended to exclude the usual common law rules.
A matter of interpretation
Ultimately, whether or not an indemnity will operate in the second sense identified by the Court of Appeal in The Eurus will come down to the drafting of the clause. In Durley House Ltd v Firmdale Hotels Plc, the High Court highlighted that contracts should include express drafting to deal with indemnity arrangements such as to whom, when and how the indemnity will be paid ( EWHC 2608 (Ch)). To this may be added specific exclusions in relation to mitigation and remoteness.
The more explicit the clause is in what it covers and how it is intended to operate, the greater the party’s chance of being able to rely on it as a true indemnity. Moreover, if the indemnity relates to a specific cause and a specific amount, there is a stronger argument that this gives rise to a debt claim.
Wood v Capita Insurance Services Ltd highlights the perils of imprecise drafting ( UKSC 24; see News brief “Contract interpretation: the Supreme Court’s last word (for now)?”). In this case, there was no doubt over the existence of the indemnity at issue in the SPA between the parties. However, the indemnity did not protect the buyer from sums that the target company paid in redress following its self-reporting to the then Financial Services Authority. The clause, in the Supreme Court’s view, was not drafted with precision and its meaning was opaque. The court observed that it was not contrary to business common sense for the parties to agree wide-ranging warranties, which were subject to a time limit, and in addition to agree a further indemnity, which was not subject to a time limit but would be triggered in only limited circumstances. The clause did not support the buyer’s position; neither did the contractual language used by the parties as a whole. Even though the agreement had become a poor bargain for the buyer, it was not the court’s function to improve that bargain.
Indemnities backed up by warranties
Practitioners should expect the courts to take a strict approach to interpreting a clause as an indemnity. After all, the common law principles governing the measure of damages for contractual breach have been developed over time to provide what the courts perceive as sensible and fair solutions as to how a party should conduct itself and what it should be able to recover. Where the indemnity is simply against general breaches of contract, a party may struggle to persuade the court that it is a true indemnity.
To require the courts to depart from this measure will require the clearest of wording. This is a particularly acute issue if the indemnity may result in recovery over and above what a party may obtain as damages at common law. In this regard, practitioners should be mindful of the rule against penalties, as reformulated by the Supreme Court in Cavendish Square Holding BV v El Makdessi ( UKSC 67; see News brief “The rule on penalties: a new more flexible test”). An indemnity against a breach of contract will almost certainly be valid where it requires the paying party to pay only what the law would allow as damages for breach of contract. Beyond this, it may still be valid provided that the payment is proportionate to the receiving party’s legitimate interest in the performance of the contractual obligation.
Provided that these boundaries are respected, practitioners may draw some confidence from the fact that, while the courts will closely scrutinise the language used, they have shown themselves willing to uphold (or not interfere with) the bargain struck between parties, for better or worse, as Wood illustrates. The courts are likely to respect clear and unambiguous wording.
Another consideration for practitioners is whether to express the indemnity as a covenant to pay. While case law is far from settled on whether the rules relating to damages apply to indemnities, it is clear is that those principles do not apply to the recovery of a debt created by a covenant to pay. In AXA SA v Genworth Financial International Holdings Inc and others, the High Court considered whether a clause in an SPA should be construed as an indemnity ( EWHC 3376 (Comm)). The clause required the seller, Genworth, to reimburse the buyer, AXA, for 90% of customer redress payments arising from payment protection insurance (PPI) mis-selling claims against the target company. Genworth asserted it had no liability as, being an indemnity, there was an obligation on AXA to use all reasonable defences to the mis-selling claims. AXA had not done this and, in fact, would never have been able to as the PPI claims were made by consumers and the rules applying to handling those complaints did not allow defences to be mounted on the scale that Genworth demanded.
The court held that the language used was not an indemnity but a covenant to pay on demand. This was clear on both an analysis of the words used in the SPA and the context within which it was negotiated. The court rejected Genworth’s attempts to classify the clause as an indemnity and therefore apply the contractual principle of mitigation. It was a debt obligation and Genworth was obliged to pay.
If an SPA incorporates an indemnity that is drafted in precise and unambiguous terms in respect of particular issues and for particular amounts, the buyer may reasonably expect the indemnity to constitute a debt claim and therefore for issues such as causation, mitigation, remoteness or quantum not to be engaged. Depending on the sum involved, this may result in recovery beyond what it could obtain at common law.
Anything short of such drafting, including an indemnity for general breach of the agreement, and the buyer may find that the court simply applies the common law measure of damages, with the indemnity adding little or nothing to the agreement. In light of AXA, buyers may wish to consider expressing the relevant obligation as a covenant to pay in order to maximise their chances of relying on the clause as a debt claim.
Recovering legal costs
The issue of indemnities backing up warranties often arises where one of the parties is based in the US. US transaction agreements typically include general indemnities against breach because, in the US, a claimant will not usually be awarded its own costs in addition to a damages award. The issue is not so acute in the UK, where successful claimants can expect to receive a costs award in their favour. That said, costs awards will almost never be recovered fully and will depend on whether the court awards costs on the standard or indemnity basis. Given the court’s range of discretion, a claimant would be wise not to make an assumption on the level of costs it will recover. Even where the relevant contract has expressly stipulated costs on the indemnity basis, 100% recovery should not be expected as costs will still be subject to the reasonableness test under the indemnity basis set out in the Civil Procedure Rules.
This article was first published on Practical Law.