Representations and Warranties
Deal Point Friction
You have decided to sell your company and with the expert assistance of an investment banker, like Aspen Mergers & Acquisitions, you have signed a formal Letter of Intent. You have waded your way through the rigorous financial, operational, legal, and environmental due diligence. Now the Buyer gives the first draft of the final sales agreement to your legal counsel. Your lawyer contacts you and informs you that he will have to perform a significant amount of edits to the agreement to make it fairer for you. You begin to get a sense that maybe the Buyer isn’t as even-handed as you thought that he would be. You need to relax and understand that this is normal and reasonable for the buyer’s lawyer to produce a draft that would be weighted in his client’s
"...it is normal and reasonable for the buyer’s lawyer to produce a draft that would be weighted in his client’s favor..."favor. Most of the items that need to be addressed can be quickly settled and the agreement will be much more representative of your interests. However, you should be prepared to experience some level of friction around the Representations and Warranties (r&w’s) clauses in the agreement.
In the r&w’s section, the Seller makes detailed statements about the legal and financial condition of the company, the property to be conveyed, and the ability of the Seller to consummate the transaction. The r&w’s reflect the situation as of the date of the signing of the agreement and, together with the exhibits and schedules that are attached to the agreement, are intended to disclose legal, operational, and financial aspects of the business to the Buyer. As you might imagine, the buyer would like to have as many r& w’s included in the agreement as possible while the Seller would like to minimize these. Naturally, this could lead to friction
"...the buyer would like to have as many r& w’s included in the agreement as possible while the Seller would like to minimize these..."between the parties at this point of the transaction. This is the point where the lawyers really begin to earn their fee.
You will begin to hear words and phrases that may seem somewhat foreign to you from a legal sense. You will encounter the word “material” as well as the phrases, “ordinary course of business” and “to the best of my knowledge.” These should be discussed in detail with your legal counsel. This is an area where a lawyer who has had previous transaction experience can be very helpful. The astute lawyer will endeavor to narrow the scope of his client’s r&w’s. How is this usually done?
The seller can use two general strategies to reduce his exposure attributable to r&w’s. First, he can refuse to make any r&w’s about specific items. For example, accounts receivable or the financial conditions of the firm may be excluded. It should be noted that attempting to exclude these items from the r&w’s will create a great deal of friction with the Buyer. Moreover, if the Buyer is utilizing any type of lender financing in the transaction, these financial institutions will require that extensive r&w’s be included in the final agreement as a condition of funding. A second, and more acceptable
"...it is important for both sides to recognize that the r&w’s are not a test of the integrity of the parties making them..."method of reducing the Seller’s exposure, is to refuse to make r&w’s about matters not “material” to the transaction. Continuing to narrow the scope of the r&w’s, you could disclose only “material liabilities” or “material litigation.” Likewise, your counsel may inject the phrase, “to the best of the Seller’s knowledge.” This wording will allocate to the Buyer all of the risks that no one knows about. The “best of knowledge” approach is a compromise to a Seller that adamantly refuses to indemnify the Buyer for breaches discovered after closing. At the very least, an indemnity (protection) should be forthcoming in respect to problems that the Seller knew about but didn’t disclose.
Finally, it is important for both sides to recognize that the r&w’s are not a test of the integrity of the parties making them. A party cannot be accused of dishonesty if it makes representation about which it is not certain. Naturally, if the Seller actually was aware of something and failed to present it accurately, this would lead to problems. In order to reduce legal exposure, it makes sense to try and verify the accuracy of the r&w’s as much as possible. Obviously, there will always continue to be some degree of uncertainty. However, if the parties recognize that the representations are not a test of integrity but a legal device for allocating risk, the process becomes more manageable and reduces the friction that always surrounds this part of a transaction.
Robert A. Veri