“Strict” warranty liability: A risky convention | In Principle

In M&A practice, and elsewhere, share transfer agreements customarily provide for the seller’s warranty liability, for example, for breach of representations and warranties. This type of liability is grounded on principles of freedom of contract stemming from Art. 353¹ of the Polish Civil Code. Although warranty liability is commonly referred to in Polish as “strict” (i.e. based on assumption of risk—na zasadzie ryzyka), strict liability is a completely different construction, expressly provided for by the Civil Code. Thus commercial practice is imprecise in this regard. In extreme cases, using this wording in contracts can generate problems, including interpretive disputes over the basis of liability under such agreements.

Without going into a detailed analysis of the term “liability” and its relationship (including possible differences) with the term “debt,” it is first necessary to clarify the nature of strict liability and warranty liability.

Strict liability

Strict liability is liability for damages which may arise directly from the relevant provisions, particularly the Civil Code (e.g. Art. 430, 433–436 and 474), or adopted by the parties’ agreeing to modify the general principles of liability (Art. 473 §1).

Due to the peculiarity of strict liability and the potentially wide scope of its application, as well as the diverse set of regulations providing for it (in various legal acts, not only the Civil Code), it is difficult to characterise.

Nevertheless, strict liability can be summarised as a secondary (derivative) obligation in the nature of damages which must be paid by the obligor regardless of whether the obligor is at fault. Thus if the obligor proves that it was not at fault for occurrence or non-occurrence of specific circumstances resulting in breach of an obligation, that will not relieve the obligor of liability.

Strict liability is not absolute. It is possible to exclude it (relieving the obligor from liability) in statutorily or contractually defined exonerating circumstances, which may vary depending on the specific regulation providing the basis for such liability. For example, pursuant to Civil Code Art. 435, a person running an enterprise on his own account, or an establishment powered by forces of nature, is not liable for personal or property damage caused by operation of the enterprise or establishment if the damage is:

• Due to force majeure
• Solely due to the fault of the aggrieved party (in such a case, in addition to proximate cause, the objective irregularity of the party’s behaviour is sufficient)
• Solely due to the fault of a third party for whom the person running the enterprise or establishment is not responsible.

Warranty liability

Unlike strict liability, warranty liability is based on a warranty agreement between the warrantor and the beneficiary of the warranty (we discussed warranty agreements in the context of a lump-sum payment under a warranty agreement in the article “Payment under a warranty agreement—an alternative to a contractual penalty”).

The essence of a warranty agreement is that through a contractual stipulation (e.g. representations and warranties), the warrantor promises (warrants) to the beneficiary that a certain circumstance, event or state of affairs at the time the contractual stipulation is made either exists or does not exist, or will or will not exist in the future. At the same time, the warrantor undertakes that when the stipulated factual state proves to be untrue or does not materialise in the future (i.e. when it turns out that a given circumstance, event or state of affairs is or in the future becomes different from that stated in warranty), the warrantor will make the performance provided for in the warranty agreement, e.g. will pay the beneficiary an amount of money or restore the state that would have existed if the warranty risk had not materialised. In other words, the warrantor assumes the responsibility for materialisation of the warranty risk provided for in the warranty agreement.

Contrary to popular belief, the warrantor does not undertake to ensure or cause the warranty risk not to materialise. Under the warranty agreement, the warrantor only undertakes to make a performance in the event of occurrence of the warranty risk, the materialisation of which is the grounds for bringing into effect the obligation to perform under the warranty. Therefore, the warranty risk is objectively material (similar to a condition) to the substance of the transaction, i.e. the warranty agreement. This leads to the conclusion that under a warranty agreement:

• The warrantor’s primary obligation is to make the performance under the warranty agreement if the risk materialises, not to bring about non-occurrence of the risk, and
• Materialisation of the warranty risk does not automatically mean that the warrantor of any of its other (primary) obligations has breached those obligations, for which the warrantor could be liable for contractual damages, as, in addition to performance under the warranty agreement, no other primary obligation under the concept of warranty liability exists (although, for the sake of clarity, we note that in our opinion, breach by the warrantor or a third party of another obligation could be the warranty risk).

Thus, the warrantor’s performance obligation and liability under the warranty agreement is primary (not derivative or secondary, which would subsequently arise from breach of another (primary) obligation borne by the warrantor and arising from the warranty agreement).

It should also be noted by the way that as in the case of exonerating circumstances in the construction of strict liability, so also in the case of warranty liability the principle of freedom of contract allows the parties to a specific agreement to provide that the payment under a warranty agreement will not be made despite materialisation of the warranty risk, if contractually stipulated circumstances occur that exclude the warrantor’s obligation to perform.

“Strict” warranty liability vs. warranty liability

In commercial practice, some transaction agreements employ wording suggesting “risk-based guarantee liability” or equivalent, without specifying what this liability actually consists of, even by mentioning specific characteristics.

In extreme cases (for example, if the agreement is silent on the principles of liability or the manner of performance), this approach to structuring an agreement can lead to conflation of the conceptual framework from two separate regimes. This can result in confusion of liability rules or make it impossible to determine how the obligor should perform, generating disputes over contract interpretation.

But the difference between the two types of liability is fundamental, and fairly simple to explain.

First of all, the payment under a warranty agreement is not compensatory in the classic sense under the civil law, which would arise from contractual liability (including strict liability), although it must be admitted that it serves a similar function. Formally, making the original payment under the warranty is the essence and proper content of the legal relationship linking the warrantor and the beneficiary, and not a means of redressing the damage suffered as a result of breach of some earlier (original) obligation of the warrantor, which is simply not present in the concept of warranty liability.

In the case of “risk-based” liability, remedying damage is a secondary performance of a compensatory nature, owed to the creditor by virtue of the obligor’s liability for breach of a specific primary obligation. But in the case of warranty liability, the payment under a warranty agreement is a primary obligation to be performed by the warrantor if the warranty risk materialises.

For these reasons, principles such as “fault” or “risk” do not apply to the case where the warranty risk covered by the obligation to provide the payment under a warranty agreement materialises, since such liability constructions will be taken into account only when considering the potential consequences of the warrantor’s breach of its primary obligation, i.e. to provide the payment under the warranty. However, they will have some significance too, especially when the object of the payment under the warranty agreement is the obligation to restore the state of affairs that would have existed if the warranty risk had not materialised.

Therefore, in principle, performance under a warranty agreement itself should be evaluated in the light of Civil Code Art. 354 and 355, i.e. the warrantor should perform its obligation in accordance with its content and in a manner consistent with the socio-economic purpose of the obligation and principles of social policy, established custom, and due care.

On the other hand, it is only in the event of breach of the warrantor’s primary obligation, i.e. to pay under the warranty agreement (e.g. in the event of nonpayment by the warrantor, or failure to pay the full amount), that any principles of liability, whether based on fault or risk, can be discussed at all.

Conclusions

We believe that the problematic method of formulating contractual provisions on liability in commercial practice discussed above may arise for two main reasons:

• Either the transaction documents are prepared based on the incorrect assumption that through the warranty the warrantor undertakes to prevent the warranty risk from materialising (which is not justified, given the general characteristics of the concept of warranty liability), or
• The term “risk-based guarantee liability” is used in transaction documents too succinctly and sometimes even erroneously, in cases where it attempts to synthesise the very concept of warranty liability, which is immanently linked to the concept of “warranty risk” (in turn, this means that the contract should clarify the principles of such liability).

Even if the provisions of an agreement are formulated defectively, this does not automatically mean that they are ineffective. Under the general rules of interpretation (Civil Code Art. 65), a statement of intent is interpreted as required by the circumstances in which it was made, principles of social policy, and established custom. Additionally, the mutual intent of the parties should be sought, and the purpose of the agreement, rather than relying on its literal wording.

But in any case, due care must be exercised in drafting contractual provisions, in particular those laying down rules for liability different from the general rules under the Civil Code. Indeed, warranty liability is an example of a concept departing from the general rules.

Krzysztof Drzymała, attorney-at-law, Marika Grzybowska, M&A and Corporate practice, Wardyński & Partners