Warranty and indemnity agreement:
threshold, cap and duration

What is a warranty and indemnity agreement and what does it cover?

A free-standing contractual obligation. The warranty and indemnity agreement (garantie d'actif et de passif) is not a statutory warranty but a creation of practice, and its binding force rests on article 1103 of the French Civil Code. It is never implied: what the agreement does not say is not covered. That autonomy explains why the courts read it literally, without adding any protection the parties have not stipulated, and why loose drafting invariably works against the party who accepted it without reading it line by line.

What is the difference between a liabilities warranty and an assets warranty?

Liabilities warranty and assets warranty: the first covers any increase in liabilities whose cause or origin predates the sale and which did not appear in the reference accounts. The second covers the overvaluation or the disappearance of an asset, typically an irrecoverable trade receivable, obsolete stock or a fixed asset that does not exist. Brought together in a single instrument, they form the warranty and indemnity agreement, commonly referred to by its French acronym GAP (garantie d'actif et de passif) in sale and purchase agreements.

Do the statutory warranties of the French Civil Code protect the buyer of securities?

Statutory warranties do not apply. The chambre commerciale (the commercial division of the Cour de cassation, the French supreme court for civil and commercial matters) holds consistently that the warranty against latent defects under article 1641 of the French Civil Code does not apply to a sale of shares: the defect affects the business, not the securities themselves, which are the sole subject matter of the contract. The warranty against eviction under article 1626 of the French Civil Code affords the buyer no greater protection against a deterioration in the target's financial position. That is precisely the void the contractual warranty fills, and it is the reason why acquisition due diligence and the GAP are negotiated together: the audit determines what the warranty must cover.

Which accounts is the basis of the warranty set against?

Representations and basis of the warranty. The seller's undertaking operates in two stages: a list of representations (accounts giving a true and fair view, no unprovisioned litigation, tax and social security compliance, ownership of the assets, validity of the material contracts), then the obligation to indemnify if one of those representations proves inaccurate. The basis is always set by reference to dated accounts, the annual accounts for the last financial year ended or interim accounts drawn up at the closing date. A sale and purchase agreement which does not precisely identify the reference accounts deprives the warranty of its measuring standard.

The seller's representations cover five constant areas, which the sale and purchase agreement must set out one by one.

1. The accuracy of the reference accounts, which must give a faithful picture of the target's financial position at the date chosen.
2. The absence of unprovisioned litigation, whether court proceedings, customer claims or pending administrative procedures.
3. Tax and social security compliance, returns filed within the time limits, taxes paid and contributions settled.
4. Ownership of the assets, securities, fixed assets, stock and intellectual property rights, free of any undisclosed security interest.
5. The validity of the material contracts, commercial leases, customer and supplier contracts, financing arrangements and change of control clauses.

Should a reconstitution warranty or a value warranty be preferred?

What does a reconstitution warranty pay out?

Reconstitution warranty (garantie de reconstitution): the indemnity matches, euro for euro, the amount of the liability that comes to light or of the missing asset, regardless of the shareholding held or of the valuation adopted. It is paid to the company, whose net assets are restored as if the liability had never existed. This is the most protective arrangement for the buyer, but it indirectly benefits all the shareholders, including those who did not acquire their shares from the seller.

How is the indemnity under a value warranty calculated?

Value warranty (garantie de valeur): the indemnity is calculated according to the impact of the liability on the value of the shares sold, and is therefore proportionate to the percentage acquired and sometimes adjusted by the valuation multiple. It is paid to the buyer. Where the company has been valued on a multiple of gross operating surplus (excédent brut d'exploitation), a recurring liability of 50,000 euros affects value well beyond its nominal amount: a value warranty with a multiplier effect is then the appropriate tool, and it is a negotiating point that sellers underestimate.

Who receives the indemnity and how is it taxed?

Beneficiary and tax treatment of the indemnity. The choice of beneficiary is not neutral. Paid to the company, the indemnity is in principle taxable income, unless it is analysed as an additional capital contribution (supplément d'apport). Paid to the buyer, it is analysed as a reduction in the acquisition price, which lowers the cost base of the shares and therefore the future capital gain. Symmetrically, on the seller's side, the indemnity adjusts the sale price and gives rise to a correction of the capital gain declared. This treatment is secured by an express characterisation clause, failing which the French tax authorities will apply their own.

How should the threshold, the deductible and the cap on the warranty be set?

Four distinct amounts make up this structure. Confusing them is the leading cause of disputes over interpretation.

1. The trigger threshold, the aggregate amount of claims below which the warranty does not apply.
2. The deductible, the share which remains definitively borne by the buyer and is deducted from each payment of compensation.
3. The de minimis, the amount below which an individual claim is not counted towards the aggregate.
4. The cap, the maximum amount the seller may be required to pay, unless a carve-out from the cap is expressly stipulated.

What is the trigger threshold and at what level should it be set?

Trigger threshold (basket): the aggregate amount of claims below which the warranty does not apply. It keeps low-value disputes out and in practice stands at between 0.5% and 1% of the price. The decisive question is whether, once the threshold is crossed, compensation covers the whole of the claims or only the excess. A sale and purchase agreement which states that "the warranty applies once the threshold is reached" without specifying the basis opens up a dispute over interpretation which the seller will lose, since article 1602 of the French Civil Code requires the seller to explain clearly what it undertakes.

What is the difference between a deductible and a de minimis?

Deductible and de minimis: the deductible is the sum which remains definitively borne by the buyer, by contrast with the threshold, which is no more than a trigger. The de minimis, for its part, sets aside individual claims below a given amount, usually 5,000 to 15,000 euros. Confusing these three mechanisms is the most frequent drafting error, and it is a very costly one: a threshold treated as a deductible cuts its own amount from the compensation on every claim.

What cap should be adopted and in which cases should it be carved out?

Cap on the warranty: expressed as a percentage of the price, it commonly stands at between 10% and 30% depending on the quality of the due diligence, the size of the transaction and the balance of bargaining power. Two exceptions must be negotiated as early as the letter of intent: the carve-out from the cap for fundamental representations (title to the shares, capacity, absence of security over the shares) and the carve-out in the event of fraud or dol (fraudulent misrepresentation) on the part of the seller, which applies in any event under article 1137 of the French Civil Code. A limitation of liability clause does not withstand fraudulent conduct.

How should these amounts be brought together in a single clause?

Bringing the three thresholds together. Threshold, deductible, de minimis and cap must be quantified in one and the same clause, with a worked numerical example inserted into the sale and purchase agreement. That example, rarely used in France although it is standard in common law documentation, by itself removes most of the later disputes over interpretation.

How long should a warranty and indemnity agreement last?

Is there a statutory duration for the warranty?

No statutory duration. Statute sets no duration for the warranty and indemnity agreement: the parties determine it freely. In the absence of any stipulation, the claim is time-barred after five years under article L. 110-4 of the French Commercial Code, which exposes the seller far beyond what the seller believes has been accepted. Any agreement silent as to duration is therefore an agreement unfavourable to the seller.

How should the tax and social security warranties be aligned with the reassessment periods?

Alignment with the reassessment periods. The accepted practice is to align the duration of the tax and social security warranties with the authorities' reassessment periods (délais de reprise): article L. 169 of the French Tax Procedure Code (Livre des procédures fiscales) allows a reassessment until the end of the third year following that in respect of which the tax is due, article L. 176 of the French Tax Procedure Code applies the same rule to value added tax, and article L. 244-3 of the French Social Security Code confines the action for recovery of contributions to a three-year period. An eighteen-month tax warranty mechanically leaves the purchaser exposed for the residual period.

From when does the warranty period run?

Starting point of the period. The period runs in principle from completion of the sale, not from discovery of the liability. A distinction must therefore be drawn between the duration of the warranty, which limits the triggering events covered, and the notification period, which limits the time available to the purchaser to bring a claim. The sale and purchase agreement must expressly provide that a valid notification sent before the term preserves the right to indemnification, even if the tax audit continues after the warranty has expired.

What is the purpose of a price adjustment clause in a sale?

How does a price adjustment differ from the seller's warranty?

A different logic from that of the warranty. A price adjustment clause does not penalise an inaccurate representation: it mechanically adjusts the price by reference to aggregates recorded on the date of completion, most often net cash and normalised working capital. It operates in both directions, upwards as well as downwards, whereas the warranty and indemnity agreement operates only for the benefit of the buyer. Treating the two instruments as one leads to the same discrepancy being compensated twice.

What do net cash and normalised working capital cover?

Net cash and normalised working capital. The price is set on a “cash free, debt free” basis: the enterprise value is fixed at signing, then converted into the price of the shares by adding available cash and deducting net financial debt as at the closing date. Normalised working capital, calculated on an average of the last twelve or twenty-four months, corrects the effects of seasonality and prevents the seller from artificially improving its cash position by delaying supplier payments.

Who settles a disagreement over the closing accounts?

The procedural mechanics of the adjustment. The buyer draws up the closing accounts within thirty to sixty days, the seller has an equivalent period in which to submit its comments, and any disagreement that persists is settled by an independent expert appointed by agreement between the parties or, failing that, by the president of the tribunal de commerce (commercial court). That expert, acting as a third-party valuer (tiers arbitre) within the meaning of article 1592 of the French Civil Code, issues a decision that binds the parties save in the case of gross error. The sale and purchase agreement must state the applicable accounting standards and provide for the principle of consistency of accounting methods: without that specification, the expert will be settling a dispute over the accounting framework rather than a difference in figures.

What share of the price remains in escrow until the accounts are finalised?

Interaction with the transaction timetable. Part of the price, usually 5% to 10%, remains in escrow until the accounts are finally settled. This holdback is additional to the escrow allocated to the warranty and indemnity agreement and does not merge with it: a single escrow account funded for two distinct purposes creates a confusion of allocation which the buyer invariably pays for.

How can it be ensured that the seller will actually pay under the warranty?

Why is a warranty without security worth almost nothing?

A warranty without security is worth nothing. A seller who has banked the price and reinvested it no longer offers any solvency. Securing the warranty is therefore the real issue in the negotiation, far more than the headline cap: a warranty of 30% of the price without security is worth less than a warranty of 10% backed by an escrow. This point is dealt with at the letter of intent stage, never at signing.

Three instruments make it possible to back the warranty with security, in increasing order of cost and of protection.

1. Contractual escrow, which locks up a fraction of the price in the hands of a third party until the warranty expires.
2. The on-demand bank guarantee, which requires a bank to pay on first demand without raising the defences arising from the underlying contract.
3. Warranty and indemnity insurance, which transfers the risk of a claim to an insurer, in return for a premium and a retention borne by the insured.

How does a contractual escrow of the price work?

Contractual escrow (séquestre conventionnel): a fraction of the price is deposited in the hands of a third party, a lawyer or a bank, under an agreement which sets out the release events, the drawdown procedure and the treatment of interest. Escrow has the advantage of simplicity and the drawback of tying up the seller's cash. Putting it in place requires a rigorous tripartite agreement: a badly drafted escrow makes it necessary to apply to the court to release the funds, which defeats its purpose.

What does an on-demand bank guarantee give the buyer?

On-demand bank guarantee (garantie bancaire autonome): governed by article 2321 of the French Civil Code, it requires the bank to pay on first demand, without being able to raise the defences arising from the underlying contract. It is the most protective instrument for the buyer, but it uses up the seller's credit lines and its annual cost is significant. An abusive or manifestly fraudulent call remains the only limit, which requires particular care on the seller's part over the drafting of the conditions for calling the guarantee. The security and financing issues raised by the transaction must be dealt with together.

When should warranty and indemnity insurance be used?

Warranty and indemnity insurance (W&I): taken out by the buyer or by the seller, it transfers the risk of a claim to an insurer, in return for a premium of 1% to 2% of the insured amount and a retention. It has become established on mid-sized and larger transactions, in particular where the seller is an investment fund which must distribute the sale proceeds without retaining any contingent liability. Taking it out calls for good quality due diligence: the insurer systematically excludes the risks identified during due diligence, which then return to the scope of the contractual warranty or of the price negotiation.

How is the warranty and indemnity agreement invoked?

How should a claim be validly notified to the seller?

Formal requirements for the notification. The claim clause requires notification by registered letter with acknowledgement of receipt or by service through a commissaire de justice (French judicial enforcement officer), within a period of fifteen to thirty days from the date on which the triggering event became known, together with the supporting documents and the quantification of the claim. These formal requirements are not a mere formality: the case law penalises late or incomplete notification with forfeiture of the right to indemnification where the clause expressly so provides.

A valid notification brings together four elements, the absence of any one of which is enough to trigger forfeiture where the clause so provides.

1. A form providing proof, a registered letter with acknowledgement of receipt or service through a commissaire de justice.
2. Compliance with the period, of fifteen to thirty days from the date on which the triggering event became known.
3. The supporting documents, a proposed reassessment notice, a writ of summons, a formal notice or an expert's report, depending on the nature of the triggering event.
4. The quantification of the claim, together with the contractual basis relied on within the seller's representations.

Can the seller take part in a subsequent tax audit?

Handling tax audits and tax litigation. The seller retains a direct interest in the dispute, since the seller will bear its cost. The sale and purchase agreement must therefore organise the seller's involvement: immediate notice of the receipt of a proposed reassessment notice (proposition de rectification), disclosure of the written submissions, the right to conduct the defence or, at the very least, to be consulted before any settlement. A buyer who accepts a reassessment on its own runs the risk of the seller disputing the very principle of indemnification, by arguing that the waiver of the available remedies cost the seller a real chance of obtaining a discharge.

Within what period is a claim under the warranty time-barred?

Limitation of the claim under the warranty. Unless otherwise stipulated, an action to enforce the warranty falls under the five-year limitation period in article L. 110-4 of the French Commercial Code, which starts to run on the day the holder of the right became aware of the facts enabling that right to be exercised. An action based on dol (fraudulent misrepresentation), by contrast, is time-barred five years after the deception is discovered, under article 2224 of the French Civil Code, which often makes it more effective than the contractual warranty once the latter has expired.

Does dol allow a claim despite the expiry of the warranty?

Dol, a parallel route and not a subsidiary one. Fraudulent concealment by the seller (réticence dolosive) bearing on a factor decisive for consent gives rise to a right to annulment of the contract or to damages on the basis of articles 1137 and 1112-1 of the French Civil Code, and the cap on the warranty is no bar to it. The Vilgrain judgment (Cass. com., 27 February 1996) of the Cour de cassation (the French supreme court for civil and commercial matters) established the duty of loyalty owed by a selling director, while the Baldus judgment (Cass. civ. 1re, 3 May 2000) is a reminder that the duty to inform does not extend to the estimation of value, a rule now codified in article 1112-1, second paragraph, of the French Civil Code. The boundary between lawful silence and fraudulent concealment is the most active area of litigation in share sales.

What mistakes should be avoided when negotiating the warranty?

Five mistakes recur in almost every disputed matter.

1. Leaving the warranty to the drafting of the sale and purchase agreement, when the balance of bargaining power shifts as soon as exclusivity is signed.
2. Lining up representations with no remedy clause, which deprives the buyer of any right to indemnification.
3. Treating the non-compete as an ancillary matter, when the loss of the customer base is never made good by the liabilities warranty.
4. Omitting the anti-double-recovery clauses, which exclude double indemnification of a liability already insured, provided for or recoverable from a third party.
5. Overlooking the transferability of the warranty in the event of an onward sale of the shares or of a contribution to an acquisition holding company.

Why should the warranty be locked in before exclusivity?

Negotiating the warranty after the letter of intent. The balance of bargaining power reverses at the point of exclusivity. A buyer who has not secured in the letter of intent the principle of the escrow, the cap and the duration of the tax warranties will have to wrest them at a time when the seller knows that the buyer will no longer walk away. These three parameters are locked in before exclusivity, not after.

Is an inaccurate representation enough to give rise to a right to indemnification?

Confusing representations with the warranty. An inaccurate representation gives rise to a right to indemnification only if the warranty clause covers it. Sale and purchase agreements that line up pages of representations with no remedy clause, or that confine the warranty to a "tax or social security liability", leave outside its scope claims before the conseil de prud'hommes (the French employment court), reassessments of social security contributions on benefits in kind, and off-balance-sheet commitments.

What happens if the seller's non-compete is forgotten?

Neglecting the non-compete clause. The best liabilities warranty does not make up for the loss of the customer base. The seller's non-compete and non-solicitation undertaking, limited in time, in territory and in scope of activity, is negotiated at the same time as the warranty: see the seller's non-compete clause.

How can double indemnification for the same liability be avoided?

Forgetting subrogation and double recovery. The sale and purchase agreement must exclude double indemnification where the liability is covered by insurance, by a provision recorded in the reference accounts or by a claim recoverable from a third party. Failing that, the buyer is paid twice, which fuels litigation more surely than the liability itself.

Does the warranty transfer where the target is resold?

Disregarding what becomes of the warranty on an onward sale. The warranty and indemnity agreement is in principle granted intuitu personae for the benefit of the buyer alone. If the buyer contemplates an onward sale or a contribution to an acquisition holding company, the clause must expressly provide for its transferability to successors in title and to subsequent transferees, failing which the warranty lapses in the restructuring. This point is particularly sensitive where the acquisition forms part of a multi-stage sale and acquisition strategy.

Frequently asked questions on the warranty and indemnity agreement