After a long marketing or letter of intent negotiation process, it is tempting for both buyer and seller to take a quick look through a draft purchase agreement, verify that it contains the correct price, closing date, and list of purchased assets and sign off. Time is money, and neither party wants to lose the deal. With that said, the purchase agreement should contain much more than basic deal terms. It is far from standard, boilerplate legalese.
In most cases, it includes heavily negotiated provisions such as conditions that must be satisfied before the deal can close, due diligence obligations, and provision restricting the seller from engaging in certain lines of business after closing. However, no terms are more important than seller representations and warranties.
Protection against the unknown
Representations and warranties are promises that the seller makes to the buyer regarding the condition of the business being sold. Especially in situations in which a deal comes together very quickly, the buyer realizes that it simply cannot review and understand every aspect of the seller’s business.
What happens if, after closing, the buyer discovers that a significant piece of purchased equipment is not working properly, a major customer informed the seller prior to closing that it would be reducing its purchases from the business, or it turns out that, prior to closing, the seller’s operation of the business used materials that contaminated the purchased real estate?
Who should be responsible for these matters? On the one hand, every business is subject to uncertainty and the seller cannot control every outcome, but on the other hand, the buyer purchased the business for a price based on revenue numbers that included the major customer’s purchases and that did not include the expense of cleaning up contaminated real estate.
Fraud is difficult to prove
Without representations and warranties in the purchase agreement, if one of these events occurs, the buyer would not have a means to recover its additional costs or reduced business value from the seller unless it can prove fraud — that (1) the seller knew about these issues, (2) the seller either told the buyer that they did not exist or hid them from the buyer, and (3) the buyer relied on those statements. This is very difficult to prove because the buyer has to demonstrate the seller’s intent — its state of mind. If there is a significant issue, but the seller does not know about it, the seller is off the hook.
Common representations and warranties
Representations and warranties are a way to protect the buyer against unknown issues and liabilities and to allocate the risk between the buyer and seller. In a typical purchase agreement, among other things, the seller represents and warrants to the buyer (promises) that:
• The financial statements the seller has provided are complete, accurate, and fairly represent the actual financial condition of the business.
• The company has paid all income, sales and use, property, payroll, and other taxes that it was required to pay, and there are no grounds for the tax authorities to put a lien on the assets of the business after closing.
• None of the purchased real estate is contaminated.
• The seller does not have reason to believe any customer or supplier will reduce the business it does with the company after closing.
• The business does not have any contracts with third parties other than those that have been disclosed to the buyer, and the seller is not in breach under any contracts in a manner that could allow the other party to terminate a relationship that the buyer wants to keep.
• There are no lawsuits against the business, and there is no reason to believe there might be a lawsuit filed in the near future.
these representations and warranties are incorrect, the buyer will often be able to recover its costs or damages from the seller. It does need to prove that the seller knew about the issue or that the seller intended to deceive the buyer. Because it was included in the purchase agreement, the buyer will simply need to prove that a representation or warranty was not correct.
Tailor representations and warranties to the specific situation
The main takeaway is that representations and warranties are a powerful tool for allocating risk. Sellers need to make sure they are not representing and warranting something that is not true (i.e. that there are no lawsuits when there actually is one), that is overly burdensome (i.e. that all accounts receivable will be collectible instead of that ninety-five percent will be collectible), or that is not applicable (i.e. that its financial statements comply with generally accepted accounting principles when they do not); the buyer will want to include very broad representations and warranties to make the seller responsible for as many unknown risks as possible.
Ben Streckert is an attorney with Ruder Ware.