What is the Difference Between a Warranty and an Indemnity?

Warranties and indemnities are considered to be a staple feature of many contracts (especially in the case of mergers and acquisitions transactions), so much so that they are often given very little consideration by the parties. Broadly speaking, warranties and indemnities are intended to provide the parties with peace of mind, and protect specific parties’ interests.

Warranties provide assurances about the status of a party’s affairs (such as profitability and the existence of liabilities) and indemnities provide protection from specific risks coming to fruition (such as a law suit being initiated).

You may hear the terms “warranty” and “indemnity” used interchangeably. However, there are differences between these two concepts and they serve distinctly different purposes. Where a warranty or indemnity is used incorrectly, it may be unenforceable.

Warranties

A warranty is a contractual statement of a fact by one party to another, asserting that a specific state of affairs is true.

The purpose of a warranty is to allocate risk. The warranting party gives an assurance that the information set out in the warranty is true, and verifies this by assuming responsibility for the damages if that warranty is (or becomes) untrue.

Because not all statements of fact can be substantiated through due diligence investigations prior to a transaction being completed, warranties are useful for providing protection against these unsubstantiated aspects. Some parties also choose to include warranties about specific affairs that they have already conducted due diligence on, in case more information about that state of affairs comes to light later in a way that disadvantages them.

A breach of warranty is a breach of contract. If a warranty is breached (that is, if it is discovered to be untrue), then the injured party can claim damages from the warranting party. The aim of these damages is to place the injured party back in the same position that they would be in, had the breach of warranty not occurred. The specific calculation of damages and the factors taken into consideration will vary depending on the nature of the contract and the nature of the warranty that has been breached.

A breach of a warranty entitles an injured party to claim damages only. Unless specifically agreed, it does not entitle a party to terminate a contract. In this way a warranty is to distinguished from a condition, but that is the subject of another article.

The types of damages that are generally claimed are the losses flowing directly from the breach of warranty (direct losses) and losses that could reasonably be contemplated by the parties as being the probable result of the breach of warranty (indirect losses) but common law limitations of the damage not being too remote apply. Parties often seek to limit the type or extent of damages that can be claimed (for example, limiting damages to direct losses only) by including specific clauses in their contracts.

The injured party has a common law obligation to mitigate their damages. If they fail to do so, the damages that they can claim may be limited by the extent that they failed to mitigate their loss.

In the context of a business sale by way of share sale (as opposed to asset sale), an example of a breach of a warranty could be as follows:

  • a seller provides a warranty to a buyer that the business has no liabilities other than the liabilities that the seller has disclosed to the buyer;
  • after settlement, a liability of the business is discovered that the seller did not disclose to the buyer;
  • the business is responsible to pay that liability, even though it was not disclosed to the buyer;
  • assuming that the parties did not limit the warranty, the buyer will have a right to claim against the seller for that liability and any other indirect damage suffered by the buyer as a result of that liability (subject to mitigation and the the damage being not too remote).

In addition to the consequences under a contract for a breach of warranty, there may also be consequences under the Australian Consumer Law for a false or misleading warranty.

It is also worth considering whether a proposed warranty can be “closed out” during a due diligence period, to avoid the need to include it as a warranty. However, warranties do not replace the need to conduct thorough due diligence on the party that you are contracting with. They are simply there to serve as a safety net.

Indemnities

An indemnity is a “legal protection against liabilities arising from one’s actions”[1]. That is, one party (Party 1) promises to another party (Party 2) to accept the risk of the loss that Party 2 might suffer in a particular situation.

Indemnities are generally used by buyers to protect themselves against matters that are outside of their control. They are also commonly used to cover known risks (to be distinguished from warranties, which are commonly used to protect against unknown risks).

There are many different types of indemnities. Some include:

  • Bare indemnity – Party 1 indemnifies Party 2 against all loss that Party 2 might suffer, without limitation (but unusually limited to loss arising out of specified circumstances);
  • “Hold harmless” indemnity – Party 1 indemnifies Party 2 against the loss that Party 2 might suffer as a result of Party 1’s actions[2];
  • Proportionate indemnity – Party 1 indemnifies Party 2, with specific limitations (for example, the indemnity might exclude loss suffered by party 2 as a result of Party 2’s omission);
  • Third party indemnity – Party 1 indemnifies Party 2 against claims made against Party 2 by a third party;
  • Party/party indemnity – Each party indemnifies the other against loss caused to the other by the indemnifying party.

An indemnity provides compensation for a specific demonstrated loss. If an indemnified event occurs, the indemnified party is reimbursed for all loss suffered by them as a result of that event.

If the indemnified party invokes the indemnity, they are able to recover the value of their loss as a debt (rather than damages under breach of contract). This often simplifies the recovery process and makes it easier to obtain payment.

Unlike a warranty, there is no automatic common law obligation for the indemnified party to mitigate its loss, as long as the loss suffered by it is a loss that comes within the terms of the indemnity. Because of this, indemnifying parties often insert a specific clause in their contracts requiring indemnified parties to mitigate their loss.

The loss caused by a breach of an indemnity can often be easier to quantify than a loss caused by a breach of warranty as the counter arguments of mitigation and remoteness do not apply. The indemnified party can simply claim all of the loss actually suffered by it due to the indemnified event occurring.

Parties commonly misuse or over-use indemnities. Many indemnities are unnecessary, inequitable or drafted heavily in favour of the party with the greater negotiating power.

To avoid disputes regarding the application or scope of an indemnity clause, it is important to be very clear in the drafting of indemnities. Indemnities should not be boilerplate clauses as they need to be drafted to cater specifically to the matter being indemnified and the circumstances of the respective parties to the indemnity. Case law suggests that where an indemnity is unclear, it will be construed against the party seeking to reply upon it. Indemnities should include specifications of (without limitation):

  • who is protected;
  • who is liable for a breach of the indemnity;
  • the extent of the loss that is covered (consider using deliberate causative nexuses, for example “arising out of”, “caused by” or “in connection with” – noting that each of these nexuses would be used in different circumstances);
  • the event which triggers the activation of the indemnity (such as a breach of the agreement, or destruction of the asset in question);
  • any specific exclusions or limitations; and
  • whether the indemnity is in addition to or in replacement of other remedies that may be available to the injured party.

If you are the indemnifying party, you may also wish to consider:

  • specifying that you are not providing indemnities for events outside of your control;
  • carving out loss attributable to the actions or omissions of the indemnified party;
  • inserting an obligation for the injured party to mitigate their loss; and
  • including a limitation period in the indemnity.

It is also possible to take out insurance to respond to the cost of a breached warranty or indemnity. The cost of such insurance will of course depend on which party is being insured, the nature of the warranty or indemnity, the damage caused by a breach, the remoteness of the loss or damage suffered, and the calculated probability of such a breach coming to fruition.

Summary of Some Basic Differences Between Warranties and Indemnities

Warranties

Indemnities

Common law duty for injured party to mitigate its loss

No common law duty for injured party to mitigate loss, unless the contract specifically requires it

Sounds in damages only

Can sound in damages and sometimes termination if it is an essential term or condition or other remedy contemplated in the contract

Loss recovered as damages under breach of contract

Loss recovered as a debt due and payable (based on the scope of the indemnity)

 Conclusion

Warranties and indemnities can provide good peace of mind and a substantial safety net when utilised correctly. If you require assistance in drafting or reviewing warranties and indemnities, please contact one of our experienced commercial lawyers.

[1] Butterworths Concise Australian Legal Dictionary, definition of “indemnity”.

[2] Business Law textbook, page 904 at 13-365.

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