Top tips in negotiating contractual indemnities and warranties

Whether you are buying a business, procuring goods or seeking a service for your business, indemnities and warranties can help manage risk for both parties. This is why they are often the most negotiated provisions in commercial contracts; and they need to be, as poorly drafted provisions can expose parties to unnecessary legal and financial risks.

Understanding the distinction between indemnities and warranties and knowing how and why they need to be negotiated carefully can be the difference between getting a deal done, protecting a party’s liability and losing commercial trust. To ensure the effectiveness of these provisions, there are many considerations both clients and law firms need to navigate.

In this blog we highlight some key considerations, and why you need a solicitor on board as soon as possible.

Indemnities vs warranties: what is the difference?

An indemnity is a promise from the seller or supplier to compensate the buyer for specified losses or liabilities should particular events occur. The main purpose of an indemnity is to allocate financial risk against a defined event or loss and, while it seeks to protect the buyer, the inclusion of one can also serve to protect the seller or supplier, if diligently drafted.

A warranty is a contractual promise that a particular statement or fact is true, which the buyer would be entitled to rely upon. Usually given by the seller or supplier, such promises can be in relation to conditions of goods, businesses, or standards applied to services.  In contrast to the indemnity, if the warranty turns out to be untrue, the remedy is not direct reimbursement, but rather the pursuit of a breach of contract claim. The main purpose of a warranty is to provide assurances about performance, compliance and capability to the buyer.

Should you have either or both indemnities and warranties?

Since both indemnities and warranties address different risks, it is both usual and appropriate in most cases to include both. However, the decision to do so depends on the risks of each party and respective bargaining powers. For example, while a subcontractor may warrant to take due care with their services, they may not be able to provide an indemnity to cover the breaches of any subcontractor because their insurance may not cover this.  

From the buyer’s perspective, having both provisions creates layered protection and among other things:

• encourages the seller to exercise transparency and full disclosure;
• gives the buyer peace of mind and access to strong remedies; and
• helps improve bargaining power if the buyer is alerted to any weaknesses through the warranties.

For the seller, while they are the ones giving both the warranties and indemnities, it is possible that having both these provisions can help serve to:

• build buyer confidence;
• speed up closing the deal; and
• provide a clear limitation on the seller’s liabilities, thereby reducing risk of unwanted claims down the road.

Key considerations when negotiating warranties

Before any warranties can be given or asked for, due diligence must take place. This would allow the buyer to establish any operational or commercial risks it would like addressed by the seller or supplier. Therefore, it follows that any warranties must be specifically drafted for each contract, rather than the parties relying on boilerplate language.

Typically, as experts in this field, we see warranties around:

• goods conforming to certain specifications;
• services being performed against professional standards or reasonable care;
• all third-party licences being in place if works are not original;
• personnel having any required qualifications specific to the contract;
• adherence to specific laws and regulations;
• disclosure around ongoing claims or disputes, if applicable; or
• promises around timing of services, if considered critical to the performance of the contract.

The wording needs to be certain and clear to enhance the protection to the buyer and to make enforceability easier.

On the topic of enforceability, warranty negotiations do not stop at the warranty wording but can also extend to what remedies should be tied to them. By default, if a warranty transpires to be untrue it would constitute a breach of contract and the buyer would have to pursue damages via a breach of contract claim through the courts where causation would have to be proved. However, it is possible that parties agree that a breach of warranty should give rise to remediation obligations or even termination rights instead or first (though sellers or suppliers could be advised to resist these).

The seller or supplier will not want the contract terminated easily and so further negotiations may ensue around classifying some warranties as ‘material’ and others as ‘non-material’ and whether some are ‘remediable’ and others not. For example, if a seller warrants it has no outstanding loans, a breach of that may be agreed to be a material breach and one that should lead to termination as it exposes the buyer to undue financial risk. By contrast, if a seller warrants that it shall at all times have a food safety certification in place and it falls behind with this, this could be negotiated to be remediable.

Another important consideration when negotiating warranties is clearly defining the consequences of a breach. In other words, outlining what exactly should happen if a warranty is breached will serve to give the buyer more comfort and certainty, and it gives the seller more incentive to ensure its warranties stay true and accurate (if they are to be continuing ones rather than just given on the day the contract is entered into).

Examples of considerations around warranty breaches include:

• the consequences for immaterial warranty breaches;
• the need for ‘cure periods’ which allow for the breaches to be remedied in a certain period;
• the form of any remediation;
• options if remediation does not occur; and
• any other protections given to the buyer in addition to the damages recovery route.

Key considerations when negotiating indemnities

Indemnities, like warranties, also need defining with clarity when being negotiated and drafted into your contracts. The key elements to focus on include: deciding what events will trigger liability, whose conduct is covered, what the liability is, and to consider any exclusions to incorporate.

From the seller or supplier’s perspective, the narrower the indemnity the better and so it is important to strike a commercial balance when negotiating. This is why proportionality is a key consideration for legal experts when drafting these provisions. If the drafting is perceived to shift all the risk to one party, such clauses could be contested in court as a penalty and therefore are at risk of becoming unenforceable. Examples include wording that says liability is ‘regardless of fault’, or that indemnities should cover losses whether they are ‘foreseeable or not’. Generally, the broader the language, the more risk for a dispute.

So, how do you strike the balance with indemnities? A few of the key considerations include:

• Looking at what indemnities should cover. Items such as legal or professional fees, remediation costs, settlement costs may form part of the seller or supplier’s liability. On the other hand, it is also prudent to consider if any specific exclusions should apply such as the indemnified party’s negligence or misconduct.
• Crafting the indemnity triggers. Depending on the nature of the commercial contract, indemnities may be triggered by a breach of confidentiality, breach of intellectual property rights, data protection breaches, physical damage or personal injury, reputational damage or even material warranty breaches. It is important to identify and clearly define the triggers.
• Consideration of whether to include indirect or consequential losses. Clearly, limiting an indemnity to just direct losses would protect the seller or supplier, but due consideration must be given to the risks the buyer is exposed to. For example, if a data breach goes on to impact the buyer’s customer contracts and therefore its income, would it be reasonable to include those indirect losses?
• Inclusion of financial caps. Unlimited indemnities, unless very tightly and narrowly drafted, would inevitably be seen as being disproportionate and therefore it is advisable for the parties to agree on some financial cap. The caps can be approached in different ways: for example, an overall cap, a cap limited to the seller’s insurance available limit, different caps attributed to different elements of the indemnities, exclusions of some areas from the cap, a cap on claims per year or for the whole duration of the contract.

These considerations demonstrate the need for legal expertise for clarity in assessing risks; in the negotiating process; in drafting to avoid ambiguity; in defining obligations and risk allocation; and in balancing the risks of both parties in a strategic yet fair manner. This is where our team of solicitors can help you safeguard your business successfully.

For further information, please contact a legal adviser in our Company and Commercial team.

This article is for general information only and does not constitute legal or professional advice. Please note that the law may have changed since this article was published.