In the world of M&A, each party to a purchase agreement makes certain representations and warranties that serve to allocate risk between the parties and provide a basis for post-closing indemnification obligations. Although often used interchangeably, there are functional differences between a representation and a warranty. A representation is an assertion of past or existing fact given by one party to induce another party to enter into an agreement. A warranty is a promise that the assertion of existing fact or future facts are or will be true, along with an implied promise of indemnity if the assertion is false.
Representations and warranties are often heavily negotiated areas of an agreement. The number and nature of representations and warranties are specific to each party, the nature of the contract itself, and the subject matter of the contract or dealings.
A seller’s representations and warranties serve several related purposes. They serve as a disclosure about the seller and the seller’s business as of a specific date, give important information about the stock or assets being sold, provide a basis for the buyer’s right to terminate before or at closing, and affect the buyer’s right to indemnification by the seller and/or its principals. Representations and warranties could favor either a buyer or a seller depending on several factors including each party’s negotiating power, the nature of the transaction, and the trade in which the parties operate.
Standard representations relate to due organization, valid existence and good standing, power and authority to operate the business and to enter into the agreement, and compliance with laws. Other representations and warranties relate to the subject matter of the agreement, such as title to assets, liens and encumbrances, intellectual property rights, taxes, and litigation. Rather than omitting representations and warranties in their entirety (which will likely raise red flags to the other side), a seller should attempt to qualify its representations and warranties. This can be accomplished in a number of ways.
For instance, because it is not always possible to account for every single item that should be listed in an agreement, a seller may attempt to limit representations and warranties to apply only to things and matters that are “material” and to add “knowledge” standards to limit the statement of fact to things that the seller actually knows of or should have known of. Another option is to limit representations and warranties to apply only to certain time periods (e.g., “within the past three years”). Most importantly, a seller should disclose as many exceptions to facts or conditions that are inconsistent with the general statement of fact made in any corresponding representation or warranty. This reduces the potential for future claims of breach of representations and warranties based on non-disclosure of material conditions. A combination of the concepts above can be proposed by the seller as well. For example, “[e]xcept as set out on Schedule X.XX, there are no pending, and to seller’s knowledge, threatened lawsuits, actions or other proceedings or governmental investigations relating to the [s]eller’s properties or business” could be added to a representation and warranty involving litigation and other actions to avoid making an absolute statement of fact.
On the other hand, a buyer wants the seller’s representations and warranties to be unqualified and as broad as possible. Broader representations and warranties often requires a seller to disclose more information during contract negotiations and due diligence and can provide a greater foundation for buyer’s termination and indemnification rights in the event of a post-closing breach. Disclosure schedules are also utilized by the buyer as they can require a seller to list out certain important business items, such as required permits, third-party consents, and employee benefit and compensation information. By requiring the seller to list out these types of items, the buyer can utilize the disclosure schedules as a checklist of items to be tracked and completed leading up until closing. When signing and closing are not on the same day, a buyer will look to insert a “bring down” condition of the representations and warranties to ensure that the seller’s representations and warranties made as of the signing date are true and accurate as of closing date.
Representations and warranties can be as complex or as simple as agreed upon by the parties but, more often than not, they are the legal basis for the parties’ willingness to complete an M&A transaction.