What do French warranty and indemnity provisions contain?

Buying shares means buying a company with everything it did before the sale. A tax reassessment covering an earlier financial year, an employment dispute born under the former management or an overvalued inventory burden the buyer even though they originate in the seller’s period. The warranty and indemnity provisions organise the allocation of that risk.

1. Why a contractual warranty is necessary

The seller’s statutory warranties, such as the warranty against hidden defects, relate to the thing sold, that is the shares, and not to the assets and liabilities of the company whose capital they represent. They are admitted only within narrow limits in share deals. Claims based on fraud or mistake remain available, but they require difficult proof and lead to the annulment of the sale rather than to an adjusted indemnity. Hence the use of a contractual, precise and quantified warranty.

The buyer should therefore never rely on general law to cover a liability revealed after the sale: whatever is not written into the warranty is, in practice, for the buyer’s account.

2. Liability warranty, asset warranty: reconstitution or value

The terminology covers distinct mechanisms, which must be named precisely in the agreement.

• The liability warranty covers the appearance of a debt or charge whose cause predates the sale and which was not booked or provisioned.
• The asset warranty covers the reduction of a declared asset: an unrecoverable receivable, an overvalued inventory, a non-existent asset.

Whatever its object, the warranty designates the beneficiary of the indemnity, and that designation drives the regime. A so-called reconstitution warranty (garantie de reconstitution) provides for the indemnity to be paid to the company itself, restoring its net assets up to the revealed liability. A so-called value warranty (garantie de valeur) provides for it to be paid to the buyer, compensating the loss of value of its shares, most often in proportion to its stake. The choice has practical and tax consequences for the treatment of the indemnity; it is settled with the transaction’s tax adviser.

Before drafting, the parties must name the mechanism chosen and designate the beneficiary of the indemnity, because these two choices drive the tax treatment of the indemnification and the way it is computed.

3. The seller’s representations

The warranty rests on a series of representations by which the seller describes the company as at the date of sale: existence and capital, accuracy of the reference accounts, tax and employment position, key contracts, ownership of assets and intellectual property, pending or foreseeable disputes, regulatory compliance. Any inaccuracy in a representation gives rise to indemnification within the agreed limits.

The precision of these representations determines the real scope of the warranty: a broad representation protects the buyer; a representation qualified by listed exceptions protects the seller.

The seller should re-read each representation as an undertaking for which it will answer on its own assets, and have every known exception recorded in the disclosure schedules; the buyer should resist knowledge qualifiers so wide that they would empty the warranty.

4. The parameters of the warranty

• The deductible. The aggregate amount of losses below which no indemnity is due. The agreement states whether, once the deductible is exceeded, the indemnity covers the loss from the first euro or only the excess. The difference is substantial.
• The de minimis threshold. The minimum amount of an individual loss for it to count, so as to exclude minor claims.
• The cap. The maximum amount of indemnification, generally expressed as a proportion of the purchase price.
• The duration. The period during which the buyer may notify a claim. A short general period often coexists with specific periods, aligned with the reassessment periods of the tax authorities and social security bodies for those heads of risk.

Market practice also sets two categories apart. So-called fundamental representations, such as the existence of the company, title to the shares or the regularity of the capital, generally sit outside the general cap and follow their own duration. Risks identified in due diligence, already known and often quantifiable, leave the general warranty and are covered by specific indemnities, payable from the first euro, outside the deductible and the cap.

These parameters are negotiated together, not one by one: before the discussion, each party should have quantified the deductible-and-cap combination it can accept in view of the price and of the risks identified in due diligence, and settled what belongs to the fundamental representations or to a specific indemnity.

5. Making a claim

The warranty is only worth its procedure. The agreement sets the time limit and form of the notice, its content, and the rules applicable where the claim comes from a third party: information of the seller, the seller’s right to conduct or monitor the defence, prohibition on settling without its consent. Failure to comply with these forms may deprive the buyer of its right to indemnification: the notice must be prepared with the same rigour as the agreement.

As soon as a risk materialises, the buyer must reopen the agreement before acting: the time limit, form and content of the notice are conditions of its indemnification; the seller, for its part, should insist on strict compliance with the procedure before any discussion on the merits.

6. Securing payment

A warranty is only worth the seller’s ability to pay. Three forms of security are customary.

• An escrow over a fraction of the price, released in tranches as the warranty periods expire.
• An autonomous guarantee, often payable on first demand, granted by a bank (article 2321 of the French Civil Code).
• A vendor loan, where part of the price is paid on deferred terms and may be set off against indemnities due.

Warranty and indemnity insurance, usually taken out by the buyer, may also replace all or part of the seller’s exposure in transactions of sufficient size.

The buyer should require security calibrated on the cap and duration of the warranty; the seller should negotiate staged releases, so as not to immobilise part of the price beyond what is necessary. See also: escrow or first-demand guarantee, securing French warranty claims.

7. What gets negotiated

The seller seeks to narrow the warranty: representations qualified by its knowledge, exclusion of matters disclosed in due diligence, high deductible and threshold, low cap, short duration. The buyer seeks the opposite, plus specific indemnities for the risks identified in due diligence, outside the deductible and the cap. The point of balance depends on the price, the quality of the due diligence and the balance of power. This is the heart of the negotiation of a share deal.

Each party should enter the negotiation with its own hierarchy of concessions: knowing what it will give on duration to obtain on the cap, and conversely, serves better than defending every clause at the same price.

Frequently asked questions

This information is general and does not constitute legal advice. Every transaction calls for its own analysis.