04 Nov 2008

Warranties - What? Why? And for how long?

by Nikki Robinson, Alexandra Grey, Brendan Dobbie

Warranties are not only a way of protecting parties to a sale in the future, but can be a way of drawing out all issues at the time of sale.

What are warranties?

Warranties are contractual statements of fact. One party warrants to the other that the state of things is as represented in the statement, with the only exceptions being those disclosed. For instance, a vendor warrants that its hotel has building approval, except for a specific exclusion relating to one structure without approval. The warranties are found in the sale agreement, and the exclusions often listed in a disclosure letter.

If the hotel turns out not to be as warranted, the purchaser can claim damages for breach of the warranty.

Purchasers themselves also give warranties to vendors, but fewer of them. These sometimes include a warranty that the purchaser has reviewed all the documents presented to it by the vendor or sought FIRB approval. This stops the purchaser being able to later claim that it wasn't aware of key circumstances.

Because warranties are about protecting parties when problems arise, they are drafted to have effect even after completion of the sale.

Why are warranties important?

The better you understand the possible risks in the deal, or relating to the hotel you are buying, the better you can draft warranties that protect against the issues you have identified. As vendor, giving warranties is also a way of ensuring you obtain the maximum value of your asset, where the purchase has not had time to conduct a thorough due diligence or the vendor does not want tot make all of its financial information available. However, a warranty is only as good as the entity giving it. If the party giving the warranty has a low capitalisation (ie. a $2 company), or becomes insolvent following the sale, then making a claim for breach of warranty will not get you very far.

Warranties are also important as they can be bargaining chips in negotiating the terms of the sale.

The tension between vendors and purchasers - why do both sides agree?

There is an inherent tension underlying contractual warranties. Neither party wants to shoulder all the risk, but equally, neither party wants to be so self-interested that the other side walks away from the deal. The benefit of protracted negotiations over warranties can be minimal, especially if the warranties eventually agreed on are not supported by security arrangements to ensure a warranty claim can be paid out, should a breach occur.

For example: a vendor will seek a warranty that the purchaser has read everything provided to it by the vendor, has made its own inquiries into all aspects of the hotel business and is npt relying on anything the vendor has said. The purchaser, obviously, will want avenues to claim against the vendor, and so will want a warranty that all information provided was correct and that the hotel is as warranted by the vendor in all respects. It is unlikely that either position will win outright. Negotiations will result in a suite of warranties from each side falling somewhere in between their polarised self-interests.

In trying to sweeten a deal, a vendor should not provide a warranty if its own knowledge or records do not allow the vendor to be confident in stating the fact contained in the warranty or attesting to the level of quality of the information provided. For example, vendors who have owned, but not operated a hotel, should take particular care in giving warranties that that in any way relate to the hotel's operation. Not only can breach of a warranty lead to paying damages to the purchaser, but providing a false warranty can be misleading and deceptive conduct, which could land a vendor in court embroiled in trade practices litigation.

Generally, a vendor's warranties will be more numerous, and cover specific aspects of a hotel property and business. A purchaser will often not warrant more than that it has power to make the agreement and that the agreement is a binding contract.

What aspects of hotel businesses can warranties protect?

For purchasers, warranties should be as extensive and specific as you can get the other side to agree to. The process of due diligence may reveal risks which should be covered in warranties, and a purchaser should not accept a warranty inconsistent with that which the due diligence has revealed.

Sale agreements will include warranties that the vendor has the power to enter the agreement and that the vendor has title to the land it is selling. Some title warranties are implied by statute and so offers the purchaser some protection (for whatever the warranting entity is worth) even if a title warranty is not spelt out in the contract.

When selling a hotel, the following areas are often dealt with in warranties. You will see warranties can permeate almost all aspects of the hotel property and business, and may include:

  • power and capacity of parties (including trustee, custodian or RE capacity)
  • land title and encumbrances, and right to transfer
  • land use and development, including third parties' consents, approvals and notices
  • buildings and utilities
  • access
  • leases, subleases and licences
  • agreements about the land or business, including service agreements and operator agreements
  • environment and compliance
  • general legal compliance and litigation
  • employee entitlements, including superannuation contributions
  • stamp duty
  • tax liabilities
  • other debts, obligations or liabilities
  • accounts and records
  • insurance
  • due diligence information.

Where there are exclusions to the general position asserted in a warranty, these will be either drafted into the warranty itself, or listed in a disclosure letter provided to the purchaser during the due diligence process. A disclosure letter can be a neater way of covering a range of exceptions, rather than having those exceptions listed in the warranty clauses of the contract.

To illustrate, a vendor warrants in the sale agreement that it does not know of any outstanding claims of liability or litigation on foot, but an exception is read into this from the revelation in the disclosure letter that one employee has a claim (the disclosure may also cover whether the claimed damages are immaterial or give a cost estimation). The purchaser should carefully review the exceptions, and assess whether they exclude almost everything from an apparently general warranty, leaving the warranty hollow.

When will warranties be useless?

Despite the breadth of concerns warranties can cover, it is essential warranties you receive are coupled with a measure to secure your entitlements upon any breach. Without some form of security, you may make a valid breach claim against a $2 subsidiary company or a now-insolvent vendor, and have a warranty worth little more than the paper it is printed on (and certainly less than the cost of having the contract drafted). The risk of empty warranties is of particular concern to purchasers, as they receive the benefit of most of the warranties.

Other actions a prudent purchaser in our hotel sale scenario may take in order to protect itself include:

  • Retain part of the purchase price. Keep this in an escrow account and have your solicitors release the money to the vendor after a set period of time, minus anything due to you as damages for a breach of warranty.
  • Get a guarantee from the parent company (the one with the assets).
  • Take a charge over the vendor's assets.

How can vendors protect themselves from a long future of expensive warranties claims after selling a hotel?

Vendors too want to protect themselves. Primarily, their commercial concern is the open-ended expense of future breach of warranty claims. Vendors have two tools to contain their exposure: time limits on when a claim may be brought and caps on the liability or damages that may be paid out. Often a sale agreement will include a combination of these provisions.

Time limits can relate to all the warranties in the sale agreement, or differ for different types of possible breach. Core concerns and problems more likely to show soon after purchase, like those relating to title, development or third party contracts, may have shorter limits, and issues like outstanding tax liability may have longer windows in which the purchaser can claim a breach.

Caps also can be set at an overall, aggregate maximum figure, or be different for different warranties claims. Most often, a cap will be a flat sum, and often it will be equivalent to the purchase price, but caps can also be tailored to reflect different proportions of a set amount. Whatever the figure chosen, vendors should be wary of purchasers being put in a position where they can make more by claiming a breach than by performing the contract, or by running the hotel they have bought.

Vendors also want to shield themselves from inexpensive but numerous claims about minor breaches. It become costly in terms of time and resources to deal constantly with $1000 or $2000 issues. As such, many warranty provisions will include an aggregate threshold: the aggregate of the claimed liabilities must reach a set amount before the claim for breach of warranty can be brought against the vendor.

Except in fire sale situations, a vendor will always provide warranties in addition to the title warranty so as to maximise the price. A purchaser should always be vigorous in its due diligence and seek to obtain comprehensive warranties from a vendor under a sale agreement, such that where breach of those warranties occurs which severely impacts the operation of the business, or the value of the asset, there is a clear path to the courts to encourage a wayward vendor to compensate the purchaser for such a breach.

However practically speaking, once the sale has been completed, unless there is a fundamental breach of warranty that goes to asset value, or the ability of the purchaser to operate the hotel, it is time-consuming, expensive and in many cases soul-destroying, to bring a substantive breach of warranty claim against the vendor. As such, the negotiations of warranties in sale agreements is often used as a means of drawing out all issues that the purchaser should be aware of in the sale context, to ensure that by the time negotiations are complete and the keys are handed over, they are familiar with the condition of the asset and satisfied that the purchase price reflects value for money.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.