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Retention accounts for warranty and indemnity claims: protect your money from the outset

11/03/2015 | Jon Lovitt

For any party buying or selling a company, the negotiation of warranties and indemnities in the sale and purchase agreement (“SPA”) is understandably a high priority. The purpose of warranty and indemnity provisions is to create certainty for buyers about the state of the company being purchased. As well as forcing disclosure of information about the company by the seller, they provide a mechanism by which the buyer can claim for compensation if the seller is in breach of the provisions in the SPA.

Often an account is set up by the buyer in which an agreed sum is held to cover relevant claims by the buyer under the warranties and indemnities in the SPA. The seller will not, however, want the buyer to have unfettered access to the money retained in this account. As highlighted by the recent High Court case Bir Holdings v Balraj Mehta, sellers must ensure that carefully drafted provisions are included in the SPA setting out the circumstances in which the buyer can deduct sums from the retention account.

Background

Warranties and indemnities

Warranties and indemnities are statements given by sellers to buyers in relation to the state and affairs of the company being sold. If a seller is in breach of a warranty, the buyer is entitled to be returned to the position he would have been in had the warranty been true. In practice, this means that the buyer can claim damages for an amount representing the reduction in value of the shares purchased as a result of the breach. A breach of an indemnity, however, entitles the buyer to claim on a pound for pound basis for any loss accruing from the seller’s breach. Whereas a seller can limit his exposure under warranties by disclosing against them, indemnities are not disclosed against. An indemnity would usually be given instead of a warranty where, for instance, the buyer knows of a specific problem that may arise and expects the seller to compensate him if the event does occur.

Escrow accounts

The most expedient way for a buyer to claim compensation for a seller’s breach of the warranties and/or indemnities in an SPA is by making a direct deduction from an account already set up to deal with such claims. SPAs usually make provision for escrow accounts to be set up at completion. The buyer places an agreed sum into the account and the buyer is then able to make deductions from this sum in accordance with the terms of the SPA.

The amount to be held in escrow pending any warranty or indemnity claims will usually depend on the size of the transaction and the relative bargaining power of the parties. Sellers will understandably want to receive as much of the consideration as possible at the time of completion, particularly where other sums are being retained by the buyer, such as any money held back pending certain trading or profit targets being hit in the future. Buyers on the other hand are likely to want the escrow pot to be as large as possible and to be held for as long as possible to ensure that, if the seller is in breach of any of any warranties and/or indemnities, there is money readily available to compensate the buyer for loss suffered as a result of the breach.

Bir Holdings v Balraj Mehta [2014] EWHC 3903 (Ch)

 Facts of the case

Bir Holdings v Mehta involved the sale of shares in a company which ran a nursing home. Under the SPA, £687,000 was payable to the sellers on completion and £250,000 was to be placed into an escrow account. This account was available for a set period after the sale of the company, after which time any remaining balance was to be transferred back to the seller.

Under the terms of the SPA, the buyer could deduct money from the account for any “relevant” claims. The buyer made six claims under the SPA amounting to a sum total of £293,159. As a result, all the money in the escrow account was deducted by the buyer.

No implied term of accuracy

The seller disputed these payments, alleging that although the SPA provided that deductions could be made from the escrow account for any “relevant” claims, there was an implied term that any deductions had to be “accurately calculated and based on factual substance”.

Judgment

The court rejected this argument and held that the terms of the SPA did not provide that the buyer had to explain the merits of any claim. Nor did it give the seller any rights to object to the substance or the value of such claims. The provisions of the SPA relating to the escrow account were clearly intended to be favourable to the buyer and the court was unwilling to interpret the SPA any differently.

Comment

The underlying message for sellers is that protections must be built into the SPA which clarify the circumstances in which a buyer can deduct money from an escrow account. Sellers will want to ensure that buyers can only deduct money for claims that have been “substantiated”. The definition of a substantiated claim will be a matter for negotiation, but may include circumstances in which the seller agrees that the buyer is entitled to deduct money from the escrow account, or where a court or appointed adjudicator decides that the deduction is permissible under the terms of the SPA.

Although it is often reasonable for buyers to demand that money be retained in an escrow account to cover claims under the SPA, sellers should be alert to the potential dangers of buyers obtaining unfettered access to the retained monies. Protections should therefore be built into the SPA from the outset to avoid unreasonably frivolous deductions.

 

This bulletin should not be taken as definitive legal advice. Please contact Jon Lovitt on 020 7955 0880 or jonl@rosenblatt-law.co.uk for further advice.

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