20/09/2022 Guarantees for contingencies in SPA contracts
In company sale and purchase agreements (SPA), it is essential to define the liability regime of each of the Parties for contingencies that may arise during the due diligence process or after the closing of the transaction. To this end, the SPA establishes a series of Representations and warranties and specific damages (Indemnities), for which the seller or the buyer will be liable in each case.
Parties often have an interest in obtaining security for the counterparty’s liabilities stipulated in the contract. For this purpose, various legal instruments exist, such as a guarantee, escrow, or the increasingly common W&I insurance. It should be noted, however, that in some cases the contracting parties opt directly for a price adjustment and waive the need for collateral. It is common, for example, to dispense with guarantees when the acquisition of the company is carried out by the company’s management (MBO), as they are considered to be responsible for management, and are aware of the potential contingencies.
Warranties can be for both the seller and the buyer. Here are the most common ones:
The guarantee allows the transaction to be backed by the solvency of a third party, usually a financial institution. By means of the bank guarantee, a guarantee is constituted in a payment obligation in favour of any of the parties, so that the bank will respond in the event of a payment obligation arising from any of the contingencies regulated in the contract.
It will normally be a guarantee on first demand, and without the benefit of excusion, which facilitates immediate payment by the credit institution. The guarantee is a separate contract from the SPA. Unlike the surety, which is an accessory guarantee to the main contract, the guarantor cannot raise against the beneficiary of the guarantee the defences of the guaranteed party to the contract of sale, but only the defences reflected in the guarantee policy.
The use of a bank guarantee entails a series of expenses and commissions, so that, alternatively, or in addition, a personal guarantee can be provided by a natural or legal person, which will usually be either the parent company of either of the parties or the natural person partners who are the owners of the parties. In any case, the maximum amount of a bank guarantee is usually adapted to the maturity of the guarantees for contingencies, as well as to the statute of limitations of the different liabilities, which will allow the financial costs of the guarantee to be progressively reduced.
Price retention and Escrow contract
Another common form of collateral is the use of escrow contracts. Escrow is nothing more than a deposit in the name of a third party (Escrow Agent) appointed by the parties. The amount in escrow is usually an amount withheld from the agreed purchase price, which will be delivered to the seller only when the condition agreed in the contract has been fulfilled (normally the expiry of the term fixed to respond to a certain contingency).
It is advisable to regulate in detail the functions of the Escrow Agent with regard to the administration of the amount delivered, as well as the process for resolving disputes in the event of disagreements over the fulfilment of the agreed condition. In Spain, this function of Escrow Agent has traditionally been attributed to Notaries, financial institutions or law firms, and is generally a less costly option than the guarantee granted by means of a surety.
In recent years, insurance policies have become increasingly common in M&A transactions (W&I Insurance). This insurance usually covers the liability of the selling party in case of breach of the Representations and Warranties given in the contract.
Insurance is usually taken out by the buyer, with the premium being deducted from the purchase price, so that the insurer is directly liable for the buyer’s claim when the contingency becomes apparent. A distinction is made between insurance with or without recourse, depending on whether the seller’s liability can be claimed above a certain threshold. On the other hand, when the policy is contracted by the seller, the seller is still liable to the buyer for the breach of the R&W, but will have the right to claim the insurer to cover the amounts claimed, as regulated in the policy.
In both cases, taking out the insurance involves integrating the insurance company underwriting the W&I insurance into the sale process, including due diligence and the drafting of the Representations & Warranties clauses. This is a disadvantage that is compensated by the solvency offered by the insurance company once the operation has been completed. It is particularly advantageous to take out insurance when there is a multitude of sellers, and the liability is joint and several. It is also very useful when the parties are going to maintain a future business relationship and want to avoid friction arising from the acquisition process, or for funds that disinvest and return the profitability to their investors.
In any case, the coverage of the policy usually excludes the payment responsibility of the insurer in several cases:
- Those contingencies known at the time of underwriting the policy.
- Obligations and commitments of the sellers regarding the management of the business during the interim period or after the closing date.
- Damage derived from criminal acts of the insured person.
- Contingencies of an environmental, fiscal or money laundering prevention nature.
The negotiation and drafting of warranties are an essential part of the sale and purchase process and should in no case be understood as a substitute for proper due diligence. In our experience, it offers the opportunity to collaborate with the third-party guarantor to define in more detail the object of the contract and the responsibilities of each party.
At AGM Abogados we specialise in the sale and purchase of companies. If you would like more information, please contact us.