Indemnities: the importance of a clear and accurate legal drafting

A recent Supreme Court case which considered an indemnity in a business purchase agreement has reminded us of the importance of clear and accurate legal drafting.

Buyer beware!

In a business purchase the principle of ‘buyer beware’ applies, meaning that generally neither common law nor statute provides a buyer with protection  regarding the assets and liabilities in the target business. So a Buyer’s protection must come from the contract to acquire the business. But any contractual terms which do give protection are usually heavily negotiated between the parties and depend on the respective strengths of the parties’ bargaining positions. Where a buyer finds a specific area of concern in the target business, the most robust protection it can obtain is a contractual indemnity.

What is an indemnity?

This is where the parties agree that if a liability arises after completion of the acquisition which falls within the scope of the indemnified matters, the seller will reimburse the buyer for that loss on a pound for pound basis. This effectively shifts the risk relating to the indemnified matters from the buyer to the seller.

When compared to a buyer’s other main form of contractual protection – warranties – indemnities have several key advantages:

• to bring a successful breach of warranty claim the buyer must prove that there has been a breach of the warranty, that there has been a reduction in the value of the business caused by that breach and that the amount of that loss exceeds any limitation thresholds agreed between the parties. In the case of an indemnity, a buyer must only prove that it has suffered loss which falls within the scope of the agreed indemnity and will then be able to claim for that entire loss;
• in the case of a warranty the buyer has a common law duty to mitigate its losses but the law is less clear whether such a duty arises in the case of an indemnity, particularly where a court construes a breach of an indemnity as giving rise to a debt claim;
• any disclosures made by a seller will generally reduce or prevent a buyer’s recovery under the warranties, but will not affect a properly drafted indemnity; and
• the buyer’s knowledge will often prevent recovery under a warranty but not an indemnity.

A recent case

In Wood v Capita Insurance Services Ltd, the target company was involved in the insurance industry. From the buyer’s knowledge of the sector and its due diligence investigation into the target business, it identified that there was a particular risk that the company had been engaged in mis-selling insurance policies or products. So the parties negotiated and agreed an indemnity under which the seller would indemnify the buyer for the following matters which took place before the acquisition:

“…all…[losses]…suffered or incurred… by [the target] following and arising out of claims or complaints registered with the [Financial Services Authority or other regulator] against [the target]…pertaining to any mis-selling or suspected mis-selling of any insurance…”

After completion , the buyer discovered that the company had mis-sold insurance products and, to comply with its regulatory obligations, ensured that the company reported the mis-selling to the FSA (now the FCA). The buyer subsequently brought a claim against the seller under the indemnity. The seller argued that the indemnity only covered claims brought against the company by its customers, but the losses being claimed by the buyer arose from the company reporting the mis-selling to the FSA itself. The buyer argued that as multiple interpretations of the indemnity were possible the court should adopt the interpretation most consistent with business sense and it shouldn’t matter whether the losses arose from customer complaints or the company’s self-reporting.

The Supreme Court found that the language used in the indemnity was clear and unambiguous and did not permit the buyer to claim for losses incurred as a result of the company’s self-reporting. In those circumstances, consideration of business sense and other contextual factors could not allow the court to step in and save the buyer from having struck a bad bargain.

Summary

This case confirms that where a contractual clause is clear and unambiguous the courts are reluctant to consider circumstantial factors such as context, business sense and the intention of the parties, to change the interpretation. The judgment is a timely reminder of the importance of negotiating parties developing a clear understanding of the intended scope and purpose of a particular clause, clear and comprehensive instructions being relayed to the parties’ legal representatives, and clear, accurate and unambiguous legal drafting to give effect to the parties’ intention.