“Let’s just cover that in the contract” is a phrase which I hear a lot. There’s a common misconception that so long as an issue is written down in the relevant agreement, things will be fine. Unfortunately – that’s not a sensible commercial or risk management approach to take.
“Liars make the best promises.” Pierce Brown, Golden Son (2015)
Contracts are packed full of promises – we even give some of those promises special names, like ‘warranties’ or ‘indemnities’. In this article, I want to consider the main problems with three common types of promises, and recommend how to tackle them.
Warranties are (mainly) promises about facts. When you’re buying a business, you might want a promise that the seller owns the key trademarks, or that the financial statements are true (and prepared in a way which follows accounting standards). It’s sensible to ask for these promises – but it’s a mistake to stop there. Ask for the warranty, but test and verify (or disprove) the underlying facts. Sometimes you can check these facts yourself – anyone can do a Australian trademark search (for free), for example – and sometimes you will need assistance to investigate and form a view. The warranties are important – but you should never just accept them all at face value. In fact, if you investigate and discover that a few of the warranties which have been given are wrong – then that can be a big red flag which may discourage you from going ahead with the transaction.
Indemnities set out rules for carving up risk. I often see people – including experienced professionals who should know better – acting as though indemnities are magical, and can make a deal risk-free (spoiler: they can’t). A typical indemnity might see a party agreeing that they bear responsibility for claims in relation to a particular issue, and that sort of promise can be very helpful when there is a known risk of a claim. Indemnities are mainly about trying to guess what horrible events might happen in the future, do some planning for those things, and agree who should pay for them if they occur. The problems with indemnities start to arise when the recipient of the indemnity thinks that it ‘solves’ the claim risk and ‘protects’ them against potential claims – that’s just not true. An indemnity is only a contractual arrangement between the parties to the contract – it doesn’t affect the rights of third parties to bring claims, and it’s only as useful as the capacity to pay of the person providing the indemnity.
3. Promises about future performance
When selling a company, the seller might agree to accept most of the payment upfront, but agree to deferred payment for a portion of the price. The crucial question to ask in this situation is: “How will the seller actually go about collecting the deferred amounts (or get compensation), if the buyer won’t (or can’t) pay?” Promises of future performance can be fairly empty, unless they’re enforceable and there is some form of security for the promise. That security might be something specific like a charge over the shares sold, or something more general like a parent company guarantee.
“We promise according to our hopes, and perform according to our fears.” Francois de La Rochefoucauld (17th century)
How, then, should you approach promises about important topics? When tackling any negotiation – don’t just accept promises at face value. You must also think about:
- how to assess the facts;
- how to investigate;
- whether you can cover risks in other ways (such as insurance);
- what steps you will (or won’t) be able to take to enforce promises; and
- your counterparty’s capacity to pay.
If you’d like help assessing any of these things, give Stephen Robertson a call on (07) 3226 3903 or email him at email@example.com