A Guide to Acquisition Agreements - Representations and Warranties
In these provisions, the parties make statements of fact to each other. Representations and warranties aren’t enforceable promises. So, on the face of things, this might sound like a repetition of the recitals. The difference is the role representations and warranties play in the rest of the contract. They serve two separate and functions which I’ll detail below: Forming a basis for liability if the actual facts don’t match what the receiving party expected, and setting the conditions for closing the acquisition.
You’ll notice that the seller’s representations and warranties are usually much longer and more detailed than the buyer’s. The reason is that the buyer’s assessment of the deal usually depends on facts that the seller is in the best position to know. Unless the buyer is paying with its own stock (in which case the seller has to understand a lot about the buyer to figure out what that’s worth) or the buyer’s ability to pay is in serious doubt (in which case the seller has to understand the buyer’s financial position to determine if the buyer is likely to be able to close), the reverse usually isn’t true.
The Role of Representations and Warranties in Prompting Disclosure
The most obvious role of representations and warranties is to set out the premises the parties relied on in agreeing to the deal and allow them to make claims each other if the actual facts turn out to be different. Claims are usually limited in important ways in a separate section on remedies and indemnities (discussed in another post here).
Representations and Warranties Qualified and Unqualified by Actual Knowledge
In thinking about this aspect of representations and warranties, it’s important to distinguish between forcing a party to disclose what it knows and allocating the risk of facts that neither party knows. For instance, the seller will generally represent that it doesn’t actually know of any threatened but unfiled legal claims against it. The point of that representation is to force the party to disclose any claims it actually knows about. Most of the representations and warranties, however, aren’t qualified by a party’s actual knowledge. They often concern matters that can’t be known for sure. For instance, the seller often represents that it holds all the intellectual property rights it needs to conduct its business. Someone could have filed for (or even obtained) patents that would block the seller from continuing its business without the seller’s knowledge. If that turns out to be the case, the question is not whether the seller lied (it didn’t), but rather who, as between the buyer and the seller, bears the risk and to what degree.
Misconceptions About Representations and Warranties – They Aren’t Insurance and They Shouldn’t Be Limited to Fraud
I emphasize the difference between forcing disclosure and allocating risk, because allocating risk because buyers and sellers tend to fight over allocating risk and the fights are often based on misconceptions. Often, sellers talk about “protecting” themselves, as if the sellers were writing them an insurance policy. On the other hand, sellers often feel it’s unjust to ask them to be responsible for anything they didn’t actually know about.
Both attitudes miss the main point of most representations and warranties, whether they are stated in terms of actual knowledge or risk allocation: to force disclosure. There are some exceptions that I’ll discuss below. Aside from those, however, the remedy for breach of representations and warranties only needs to be serious enough to give the party making them a meaningful incentive to disclose. Remedies far short of making the other party whole are often sufficient to incentivize disclose. A buyer who tries to go beyond that is looking to buy an insurance policy from a non-professional, unregulated insurer. The likely result will be a hard fought negotiation over an extremely expensive and not particularly reliable “policy.” By contrast, a seller who tries to stop short of agreeing to an adequate incentive to disclose (for example, as I’ll discuss further below, by limiting all representations and warranties to actual knowledge) is usually needlessly raising buyer suspicions that the seller has something to hide. If the buyer isn’t trying for total accountability and the seller isn’t trying for total impunity, the negotiations are usually easier and the end result makes more sense for both sides. Of course, if one party has a clear negotiating advantage, it can and often will force a resolution entirely in its favor.
By the way, if you doubt me about the insurance issue, ask your insurance broker about getting “representations and warranties” insurance. It’s available. It’s also very expensive. Buyers who look into it rarely want to pay for it. I understand that part of the expense comes from the insurance company’s uncertainty about the facts. Except in cases of fraud, however, sellers are typically only a little bit better off in this regard. It’s the unknowable that’s the problem.
So if representations and warranties are mostly designed to produce disclosure, why aren’t they mostly stated in terms of actual knowledge? The answer is that actual knowledge is a lot easier to say than to prove. Most of the time, it’s a lot easier to determine what the objective facts were than what was in anyone’s head. A major reason why parties want representations and warranties, backed by indemnity obligations, rather than simply relying on the general laws against fraud, is that proving fraud means proving what someone knew and intended. That’s notoriously difficult and expensive, even in relatively clear cases.
It’s worth mentioning that representations and warranties themselves are customarily stated in fairly broad, general terms. The specifics are in “disclosure schedules” attached to the contract. Most of the schedules take the form of exceptions to the representations and warranties in the contract. So the contract might say that there are no employee benefit plans except as specified in the schedules. The relevant schedule will then list all of the employee benefit plans. Some representations and warranties simply reference a disclosure in the schedules. For example, the representation and warranty might state that all material contracts are listed on a designated schedule. The upshot is that it’s unwise for either the buyer or the seller to treat the disclosure schedules as a “detail” that the lawyers will attach to the contract at the last minute. The party receiving the representations and warranties has to rely on the disclosure schedules and the party making the representations and warranties has to stand behind them. So both parties should be interested in completing the schedules as early as possible in the negotiation and making sure that senior people have reviewed and understood them.
Materiality and “Material Adverse Change”
Materiality is usually an important concept in a business sale agreement. Everyone knows that the representations and warranties (and, for that matter, compliance with the parties’ promises) generally won’t be perfect and that it really shouldn’t have to be. Materiality adds the reasonable wiggle room that everyone wants and expects. That said, everyone also realizes that someone acting in bad faith may try to turn reasonable wiggle room into unreasonable wriggle room, so everyone is rightfully nervous about materiality.
Sometimes the lawyers will fight, line by line, over whether specific representations and warranties should be qualified by materiality. Although the motivation is understandable, the practice is inefficient and generally counterproductive. It’s usually better to leave materiality out of the actual representations and warranties and put it into the provisions that key off of them: the closing conditions, the termination provisions and the remedy and indemnity provisions. That saves time because there are less discrete items to negotiate. It also concentrates everyone on what’s actually at stake, which tends to produce a better thought out result.
The concept of a “material adverse change” (sometimes a “material adverse effect”) has a similar function. It often appears in representations and warranties (e.g. there hasn’t been a material adverse change since the date of the last balance sheet). It also often appears separately as a condition to closing (i.e. the buyer doesn’t have to close if there’s been a material adverse change between signing and closing).
Negotiations over defining “material adverse change” usually focus on two areas: Changes that aren’t significant enough to justify the buyer walking and changes that aren’t specific to the seller (e.g. a general downturn in the economy that also happens to affect the seller’s business). Because the definition should, ideally, be tailored to the specifics of the seller’s business and the buyer’s business objectives, you should understand this definition in detail.
The Role of Representations and Warranties in the Parties’ Obligations to Close
In addition to prompting disclosure and setting the parameters for claims, representations and warranties also set conditions for the parties’ obligations to close. Typically, a party will not have to close if the facts at closing diverge materially from the representations and warranties (even if they were all true at signing). The idea is that representations and warranties are supposed to set out the premises of the deal. So if the facts diverge from them too much between signing and closing, the party relying on them can often back out. I’ll discuss this further in another post.
Exclusivity of Representations and Warranties
It’s worth emphasizing one final point about representations and warranties: A properly drafted contract will make the list of representations and warranties exclusive. In other words the list of representations and warranties also determines what the seller has not represented (everything else).
Although the contract almost always states that the representations and warranties are exclusive, there are several ways in which a contract can blur this exclusivity. The most common is the so-called “10b-5 Rep” (named for the standard for federal securities fraud on which its language is usually based). This representation and warranty states that the party has not made any untrue statement of a material fact or omitted anything that makes its statements misleading. Another common end-run is a representation and warranty that the diligence materials the seller provided the buyer were complete and did not omit anything material. There are other variations on these themes. The result is to expand and blur the bases for making claims of breach and/or refusing to close well beyond what is expressly stated in the contract. For that reason, parties that have negotiating power try to avoid making this type of representation and warranty.