The primary transaction agreement in every M&A deal contains representations and warranties, colloquially referred to as “reps and warranties” or simply “reps,” from each party to the other. These are statements of past, present and sometimes future fact relating to the status, business, assets, liabilities, properties, condition, operating results, operations and prospects of the party making the statements, one or more companies under the party’s control or a group of assets and liabilities. Reps and warranties as a whole can be quite lengthy, often comprising from 15 to 30 pages of a transaction agreement and more still when you include the text incorporated by reference from the agreement’s Definitions section. A substantial amount of the time and energy involved in papering and negotiating the deal is usually devoted to reps and warranties.
Why do representations and warranties get so much attention?
Reps serve four primary functions.
First, they provide important disclosures from one party with an informational advantage to the other about the disclosing party and, in the case of the seller, the target company or assets. As you might expect, except in the relatively rare circumstance in which a portion of the purchase price is paid in buyer stock, most of this information relates to the target company or assets and flows from the seller to the buyer.
Reps and warranties may thus be thought of as an extension of the due diligence process—they ameliorate informational asymmetries between the parties. Frequently, parties will make meaningful discoveries through the process of drafting reps and warranties (and the associated disclosure schedules) that may materially alter the deal’s value proposition.
Second, representations and warranties may form the basis of a party’s right to terminate the deal prior to closing. Assuming a deal has a gap period between signing and closing, as most do, the principal transaction agreement will include conditions precedent that must be satisfied or waived before each party will be required to consummate the transaction. Among other things, these will generally require that the other party’s representations and warranties will have been true when made and remain true at closing. Otherwise, the non-breaching party will usually have the right to terminate the transaction agreements and walk from the deal. Thus, reps and warranties effectively enable a party to continue its due diligence during the gap period and also protect a buyer (or a seller receiving shares as consideration) from many intervening events or conditions that adversely impact the other party or the target.
Third, together with the parties’ indemnification rights, representations and warranties serve as a risk-shifting mechanism—inaccuracies may entitle the other party to monetary compensation for associated losses. (This applies only in private, rather than public, M&A transactions, where post-closing indemnities are exceedingly rare.) In many respects, this is the primary purpose of representations and warranties in private deals, as the buyer’s expectation that the seller, and not the buyer, will bear much if not most or all of the risk of losses resulting from false statements provides a great deal of comfort and increased certainty for the buyer, enabling it to price the deal more accurately and plan for post-closing operations.
Parties are well-served to remember this risk-shifting function during negotiations. It is not uncommon for one party to voice an objection to a proposed representation or warranty on the basis that “it just isn’t true,” “we can’t confirm this” or words to that effect, to which a well-trained M&A lawyer may quickly retort, “So what? My client shouldn’t bear this risk.” After all, the reasoning goes, reps and warranties are not only about what is and is not. They reflect the parties’ understanding of which party will bear the burden of losses that arise from certain events or circumstances.
The final key function of M&A representations and warranties is derivative of the prior two. The possibility that a counterparty may terminate the transaction or seek compensation from the disclosing party for breaches strongly incentivizes the party giving the reps to make sure they are in fact true (or will be when deemed made). By way of example, this means a party providing representations as to good standing, due authorization and absence of conflicts will in endeavor to ensure it or the target company is in good standing, has the authority to enter into the transaction and is not a party to any conflicting contracts. Thus, the desire to avoid the costs associated with a broken deal or breached reps often has salutary effects on the underlying substance of the deal.
What do representations and warranties say?
Reps and warranties may address a broad variety of subjects, from the target’s legal existence, good standing and financial statements to the buyer’s ability to finance the transaction and comply with its obligations under the agreement.
Here’s an example of a typical seller “absence of conflicts” rep:
“Assuming that all consents, approvals, authorizations and other actions described in Section 3.07 have been obtained, the execution, delivery and performance of this Agreement by Seller do not and will not (a) violate, conflict with or result in the breach of any provision of the Organizational Documents of Seller or the Company, (b) conflict with or violate (or cause an event which could have a Material Adverse Effect as a result of) any Law or Governmental Order applicable to Seller, the Company or any of their respective assets, properties or businesses, or (c) except as set forth in Section 3.06(c) of the Disclosure Schedule, conflict with, result in any breach of, constitute a default (or event which with the giving of notice or lapse of time, or both, would become a default) under, require any consent under, or give to others any rights of termination, amendment, acceleration, suspension, revocation or cancellation of, or result in the creation of any Encumbrance on any of the Shares or any of the Assets pursuant to, any Contract to which the Company is a party or by which any of the Shares or any of the Assets is bound or affected.”
Other reps like this one you may encounter in a typical private company stock purchase agreement would address all or some combination of the following subjects:
- organization and good standing
- authority and enforceability
- capitalization and ownership
- financial statements
- books and records
- accounts receivable and accounts payable
- absence of undisclosed liabilities
- absence of certain changes and events
- real property
- intellectual property
- material contracts
- tax matters
- employee benefits
- employment and labor
- environmental, health and safety
- compliance with law
- legal proceedings
- customers and suppliers
- product warranties
- product liability
- related-party transactions
- brokers and finders fees and
- full disclosure.
The transaction agreement usually contains reciprocal representations and warranties from the buyer to the seller. If the buyer is issuing shares as all or part of the purchase price, then its representations and warranties will mirror those of the seller fairly closely because the seller in that case would effectively be making an investment in buyer securities. More often, though, the buyer is paying cash and its representations and warranties are consequently significantly more limited in scope. After all, cash is cash.
Accordingly, in deals without stock consideration, buyer representations and warranties usually address some combination of the following topics:
- organization and good standing
- authority and enforceability
- absence of conflicts
- governmental consents
- legal proceedings
- investment intent
- brokers and finders fees and
- independent investigation.
What determines which representations and warranties are given in a deal?
The precise configuration of representations and warranties in a particular deal is a function of a number of factors in addition to whether part of the purchase price will be paid in buyer shares. These include:
- transaction structure – each transaction structure requires some differences in reps (e.g., valid issuance in stock purchases and sufficiency of assets in asset deals),
- whether the transaction is a public or private deal – public deals usually involve representations about a company’s Securities and Exchange Commission filings and afford buyers some additional comfort stemming from the requirements imposed on public companies by the federal securities laws and stock exchange listing standards,
- how thoroughly each party is able to conduct due diligence – generally, there is an inverse relationship between the amount of due diligence a party conducts and the scope of reps and warranties it will demand from the other side,
- specific issues identified during due diligence – if problems are discovered during diligence, such as a third party intellectual property infringement claim or an environmental hazard, enhanced representations in that area may be sought,
- the target company’s industry – areas of focus differ based on industry (e.g., technology deals are IP-centric and chemicals transactions require more environmental coverage),
- current market practice – norms evolve over time; what was standard 10 years ago may be unusual today,
- past practices of the parties and their lawyers – occasionally, a party can obtain example transaction agreements from prior deals and see what concessions may have been made in the past,
- the parties’ (and their lawyers’) respective preferences and priorities as informed by their past experience with other transactions – as with individuals, company preferences vary, especially if a party has suffered losses in prior deals,
- the parties’ desired allocation of post-closing risk in light of the expected impact of indemnification rights – indemnification rights may be more or less protective, depending on applicable baskets, caps, materiality scrapes, survival periods, credit-worthiness, guarantees, holdback, escrow, earnouts, rights of offset and other terms, and the greater a party’s exposure is to a potential indemnification claim the more likely the party is to resist broad representations,
- whether the parties will be obtaining representations and warranties insurance – such insurance can shift risk from parties to insurance providers, and insurance providers may themselves comment on the contents of representations and warranties,
- a buyer’s interest in maintaining optionality on the deal – more fulsome seller representations and warranties make it easier for a buyer to exercise walk rights,
- the parties’ relative bargaining power – where competition is high for a particular target, sellers usually enjoy greater success in resisting rigorous reps,
- definitions of pervasive qualifiers – terms like “knowledge,” “material” and “Material Adverse Effect” are used throughout representations and warranties to limit them, and how they are defined will determine where and how frequently each is used,
- the parties’ receptiveness to additional complexity and cost – longer representations and warranties generally require more time and legal fees to draft and negotiate,
- whether the seller has agreed to any broad “catch-all” type representations, such as so-called “full disclosure” or “10b-5” reps or open-ended compliance with law or absence of changes representations – if a seller has agreed to include broad representations that may form the basis of a variety of different claims, buyers will often be less insistent on other, more specific representations, and
- whether the buyer’s or the seller’s M&A lawyer prepares the first draft of the agreement – usually, a buyer-prepared first draft will have more extensive seller representations and warranties than a seller-prepared draft.
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In subsequent posts on The M&A Lawyer Blog, we’ll examine some of these topics more closely, including discussing the actual language of key representations and warranties, the definitions of pervasive qualifiers, the interplay with disclosure schedules, the significance of sandbagging and more.