2016.08.20
Jaime Cheng
For anyone familiar with the sale of a company, the lengthiest section, and perhaps most taxing part, of a purchase agreement is typically the section on representations and warranties. The density and the complexity of the representations and warranties section would tempt most readers to gloss over this section. However, this section merits a thorough and comprehensive review by the parties given that the purpose of the representation and warranties serves the buyer in several important respects.
The first is that the representations and warranties provision serves to act as a disclosure by the seller of the target companyÕs condition before the parties sign the purchase agreement. If the condition of the target company does not fully correspond to the statements made by the seller in this section, a well-advised seller will list these exceptions a disclosure schedule. The buyer may then reassess its willingness to acquire the share of the target company from the disclosed information.
Further, it also allows the buyer to walk away from the transaction. A general condition to a buyerÕs obligation to purchase the share of the target company is that the representations and warranties in the purchase agreement are accurate. This allows the buyer to not buy the shares of the target company if it discovers (in its due diligence investigation or otherwise) that the facts surrounding the transaction prove to be unfavorable.
The representations and warranties also serve as an allocation of economic risk. If the buyer discovers that there is a breach after the closing, the buyer may claim for damages from the seller under the indemnification provision of the purchase agreement.
What are representations and what are warranties? Technically, representations are statements of the past or existing facts. It is a statement that induces the other party to enter into the contract. An example of a representation is a statement such as, ÒSeller represents that the books of account, minute books, stock record books, and other records of the target company provided to the buyer are complete and correct.Ó Warranties, on the other hand, are assurance of a particular fact or sets of facts and an agreement to make the buyer whole if those facts turn out to be untrue, e.g., ÒSeller warrants that the target company has good and marketable title to the assets and that there are no liens encumbering those assets.Ó Depending on the jurisdiction, whether a statement is characterized as a representation or a warranty may result in different remedies. This distinction has become less pronounced as indemnification provisions of the agreement are usually negotiated as exclusive remedies for misrepresentations and breaches of a warranty.
While the scope and the breadth of the sellerÕs representations and warranties in a stock purchase agreement depends on the relative bargaining powers of the buyer and the seller and varies depending on the particular transaction and business of the target company, the typical representations and warranties include the following:
– Due organization and good standing of target company
– Enforceability of contract and legal authority to perform the contract
– Capitalization of the target company
– Financial statements of the target company being true and correct
– Target Company does not have any undisclosed liability
– Ownership of all assets it purports to own and sufficiency
– Target CompanyÕs intellectual property/products do not infringe the intellectual property rights of others
– No legal proceedings pending against the company
– Material contracts
– Employee matters
– Target companyÕs compliance with applicable laws
To support its rationale for why broad and comprehensive representations and warranties are reasonable, the buyer will often argue that the target company/seller is in the best position to know the condition of the target company, and therefore, it should disclose any risks and bear the liabilities arising out of any misrepresentations. There are several ways that the target company/seller may limit the scope of representation and warranties.
A. Disclosure Schedules.
Disclosure schedules allow the seller to list any situations or conditions of the target company that would make the representations and warranties untrue. Disclosure schedules are typically organized into sections corresponding to the representations and warranties made in the purchase agreement. From the sellerÕs perspective, any disclosure made into any representation and warranty should also act as a disclosure for any other relevant representation and warranty regardless of whether the disclosure is again stated as a disclosure for the subsequent statement. The buyer would often resist such application and require that for an item to act as an exception to a statement, it must be disclosed in the corresponding statement.
B. Knowledge Qualifiers.
Knowledge qualifiers shift the risks towards the buyer as, to recover damages, the buyer must, besides showing that the statement is untrue, show that the seller had knowledge of it.
An example of how a knowledge qualifier is used in a statement such as, Òto the knowledge of the seller (1) no action, arbitration, audit, hearing, investigation, litigation, or suit has been threatened against the target company, and (2) no event has occurred or circumstance exists that may give rise to or serve as a basis for the commencement of any such proceedingÓ. In this scenario, if the buyer later discovers that an undisclosed investigation had been commenced against the target company, for a buyer to prevail on a claim against the seller for breach of the foregoing statement, the buyer will also be required to show that the seller was aware of such investigation at the time of making this statement. It would also be prudent to define what qualifies as Òknowledge.Ó From the sellerÕs perspective, the seller would want to limit it to the facts it is actually aware of. The buyer will typically require that ÒknowledgeÓ includes constructive knowledge or imputed knowledge, i.e., the seller will be deemed to have knowledge where discovery or awareness of the fact would be reasonably expected with the exercise of due care or investigation.
In the case where the seller is not a natural person, persons whose knowledge would be deemed ÒsellerÕs knowledgeÓ would need to be further defined. The seller would want to limit these individuals as much as possible, such as to the officers of the seller, whereas, it can be expected the buyer would want to expand the scope to include any person within the sellerÕs organization.
C. Materiality
Materiality qualifiers are thresholds qualifiers.
In representations and warranties regarding compliance, the seller can reduce its disclosure obligations and its exposure by limiting them to ÒmaterialÓ compliance. For example, the seller may restrict the representation and warranty on compliance with laws as follows: ÒThe target company is in material compliance with each legal requirement that is or was applicable to it or to the conduct or operation of its business or the ownership or use of any of its assets.”
In representations and warranties regarding disclosure, a materiality threshold limits the scope of the information disclosed, e.g., providing that all material contracts are listed in the disclosure schedule with Òmaterial contractÓ being defined as any contract with an amount or value over a specified dollar amount.
Materiality is also often used to refer to the effect the stated fact has on the target company. For example, the Company is duly qualified to transact business and is in good standing in such jurisdiction in which the failure to so qualify would have a material adverse effect.Ó
As a note, while materiality qualifiers are often negotiated into the agreements, there is a trend that aggressive buyers are negotiating Òmateriality scrapesÓ into the indemnification provision, which in effect excludes the materiality qualifiers in the representations and warranties in determining the buyerÕs indemnification rights after closing. Therefore, if such a term is present in the indemnification provision, the effectiveness of the materiality qualifiers are limited, and the seller is advised to review the disclosures made in light of the specific language of Òmateriality scrapeÓ rather than just wording in the representations and warranties.