The representations and warranties contained in an acquisition agreement are a minefield, and you, my good reader, are the unfortunate sniffer dog being sent into the minefield to locate the mines. It is often the longest section of an acquisition agreement, and the content and the scope of the representations and warranties are extensively negotiated between counsel to the purchaser(s) and seller(s), as well as between the purchaser(s) and seller(s).
This post will by no means be comprehensive. To write a comprehensive account of representations and warranties would require writing a book; I do not intend to do so at this time. This post will serve to highlight some of the key issues that a private equity professional ought to understand about representations and warranties in an acquisition agreement, and examine some salient representations and warranties in greater detail.
To structure this post, I have broken the topic into several sub-topics:
- Definitions and legal background: The basic legal framework and definitions for representations and warranties.
- The parties making the representations and warranties: The parties who make representations and warranties in a typical private equity transaction
- Objectives of the representations and warranties: The objectives of having representations and warranties, and some considerations that purchaser(s) and seller(s) will take into account when negotiating representations and warranties.
- Classification of representations and warranties: Not all representations and warranties are equal. Some are more equal than others.
- Knowledge: Knowledge, at law, has long had a special meaning.
- Materiality: When is a breach of a representation or warranty too small to bother with? Materiality tries to settle this question.
- Sandbagging: A special term of art in American M&A transactions, it is worth looking at this in some detail since it often becomes an issue for dispute.
- Survival of representations and warranties: How long do these representations and warranties last?
Definitions and Legal Background
What are “representations”? Under Anglo-American common law, a representation is a statement of present or past fact. For example, assume that the seller(s) provide the representation in an acquisition agreement dated April 30, 2016:
The Company has delivered or made available to Purchaser copies of the audited consolidated balance sheet of the Company and the Subsidiaries as at December 31, 2013, December 31, 2014, and December 31, 2015 and the related audited consolidated statements of income and of cash flows of the Company and the Subsidiaries for the twelve month periods then ended. Except as set forth in the Disclosure Schedule, each of the financial statements is complete and correct in all material respects and, except as may be indicated in the notes thereto, has been prepared in accordance with GAAP consistently applied by the Company.
This is a statement of past or present fact—the company has either delivered those financial statements or it has not; it is not a promise to deliver the financial statements,1 nor does it involve any statement of future “facts” (which are by definition unknowable).
A “warranty” is, strictly speaking, a promise that a fact is true. In New York, based on the seminal case of CBS Inc. v. Ziff-Davis Publishing Co.2, a “warranty” is a promise to indemnify3 the recipient if a statement of fact is false.
While “representations” and “warranties” sound similar, there are distinctions, particularly in the nature of the claims that can be brought in court for breaches of representations or warranties. In practice, though, they are often combined in the form of “[Someone] hereby represents and warrants to [Recipient]”, a phrase that is used almost as a matter of course by most M&A lawyers. As a general rule, this approach is the best approach for the recipient of the representations and warranties.
One last thing. I should note that in the United Kingdom and the majority of the Commonwealth of Nations, the distinctions are more sharply defined and are more readily accepted by practitioners and the judiciary. Thus, if your acquisition agreement is governed by English, Australian or Singaporean law,4 you should seek the advice of local counsel knowledgeable about such matters because the formal distinctions can matter when drafting and negotiating your acquisition agreement.5
The Parties making Representations and Warranties
Now that we know what representations and warranties are, and some of the matters that counsel think about when considering representations and warranties, we can turn to the next question: Who makes the representations and warranties in the acquisition agreement?
As a general rule, assuming a simple transaction among purchaser(s), seller(s), and a target company, there will be two sets of representations and warranties:
- The purchaser(s) to the seller(s)
- The seller(s) to the purchaser(s) with respect to the seller(s) and with respect to the target company and its subsidiaries
In a private equity transaction, the seller(s) and/or the company’s management are responsible for the bulk of the representations and warranties.
Objectives of the Representations and Warranties
What purpose do representations and warranties serve?
The fundamental idea behind representations and warranties are that there are certain facts about the purchaser(s), seller(s), and target company that are known to one party to the acquisition agreement but not to the other. These facts related to, among other things, whether the purchaser(s) are validly existing and have the authority to enter into the transaction, whether the seller(s) have legal and beneficial ownership of the target company, whether the sellers have the authority to enter into the transaction, and the financial and operational condition of the target company at the time of the transaction.
From the perspective of the purchaser(s), the representations and warranties provided by the seller(s) are a valuable source of information about the target company that supports the due diligence the purchaser(s) is conducting on the target company. The representations and warranties about the target company provide valuable information, the accuracy of which is backed by the “teeth” of indemnification and/or lawsuits for fraudulent misrepresentation.
From the perspective of the seller(s), the representations and warranties provided by the seller(s) generate a risk of legal liability, and the more general and unconstrained the representations and warranties, the more risk the seller(s) is undertaking.
Classification of Representations and Warranties
Representations and warranties are not all equal. Some are, in the words of George Orwell,
More equal than others. Determining which representations and warranties are more
equal than others is an art rather than a science, and must be done on a case-by-case basis.
That being said, as a rule of thumb representations and warranties can be classified into a number of categories:
- Fundamental representations and warranties: These representations and warranties deal with the most fundamental facts that must be true for the transaction to occur, and consist of capitalization and share ownership, due organization, due authority, no conflicts, valid and binding obligations, no litigation, and no insolvency.
- General representations and warranties: Everything that is not a fundamental, special, or tax representation, often including matters such as financial statements, corporate structure, the material contracts of the target company, and the accuracy and completeness of the target company’s books and records.
- Special representations and warranties: These representations and warranties relate to certain aspects of the target company that the purchaser(s) require further assurances on, for example environmental claims and liabilities, employee benefits, securities laws, or anti-bribery or foreign corrupt practices laws.
- Tax representations and warranties: The tax representations and warranties deal with matters such as whether the target company has filed all required tax returns, whether the target company paid all taxes due, and whether there are any tax audits, investigations, or litigation pending or ongoing. These representations and warranties will have different survival periods than other representations and warranties, due to the fact that tax authorities often have specific statutes of limitations dealing with the time limits for them to bring actions against companies.
There is simply not enough time (or space) to go into the details of every type of representation and warranty that can be found in a typical acquisition agreement—that would require pages upon pages of analysis. While I had considered highlighting some representations and warranties as examples that ought to be discussed, I have decided that it is not feasible without writing the equivalent of another three to four thousand words on this topic.
In my experience, thoughtful, experienced private equity investors and their counsel will spend a lot of time negotiating this. One of the ways that seller(s) can try to limit their exposure to liabilities arising from breaches of representations and warranties is by explicitly stating that a representation or warranty is made subject to the knowledge of the seller(s) or of the target company, depending on who is giving the representation or warranty. For example:
To the Knowledge of the Company, each item of Company Intellectual Property set forth in Schedule 6.10 is valid and enforceable… To the Knowledge of the Company, no Person is infringing, diluting, misappropriating or otherwise violating any Company Intellectual Property, and no such claims have been made against any Person by the Company.
The first question that needs to be answered is which representations and warranties will be qualified by “knowledge”? This is the threshold question, and while the seller(s) will want to have as many representations and warranties qualified by knowledge, the purchaser(s) will have the opposite goal. Determining which representations and warranties will be qualified is as much an art as a science, and will often boil down to an intense session of “logrolling”.
Once the parties agree on which representations and warranties will be qualified by knowledge, the problem then becomes, what exactly is “knowledge”?
At law, one can classify knowledge into:
- Actual knowledge: The knowledge in fact possessed by someone. For example, if a breach of an environmental regulation was made at a factory in India and covered up by management in India, such that the news of that breach never reached senior management in the U.S., the U.S.-based CEO of the company would not have “actual” knowledge of the environmental regulation breach.
- Constructive or imputed knowledge: The knowledge that someone would have obtained after some reasonable level of diligent inquiry, or the knowledge that someone would be expected to know in his or her capacity as an officer, director, or employee. For example, if a breach of an environmental regulation at a factory in India resulted in the factory being shut down for a month, even if the CEO did not have actual knowledge of the breach, if he had made reasonably diligent inquiries, he would have known (“constructive knowledge”) that there was an environmental regulation breach in India.
The majority of acquisition agreements these days will contain an explicit definition of knowledge, simply because to do otherwise is to have future disputes (at a time when the parties are already no longer on amicable terms) about what exactly is meant by knowledge.
The definition of “knowledge” is often found in the Definitions section of the acquisition agreement.9 To make this concrete, I present two examples of definitions of “knowledge” that I have encountered in my private equity career, one for “actual knowledge” and the other for “constructive knowledge”.
For the purpose of this Agreement, Sellers’ knowledge shall be deemed to be limited to the actual knowledge as of the Closing Date of Anthony Stark, Virginia Potts, and Obadiah Stane, without giving effect to imputed knowledge or giving rise to any duty to investigate.
Constructive or imputed knowledge:
“Knowledge” means, with respect to the Company and the Subsidiaries, the actual knowledge as of the Closing Date of Anthony Stark, Virginia Potts, and Obadiah Stane, and the knowledge that each such person, would have reasonably obtained after making due and appropriate inquiry of their respective direct reports with respect to the particular matter in question.
The seller(s) will seek to limit knowledge to actual knowledge; the purchaser(s) will seek to expand knowledge to include constructive knowledge. Unless there is a significant imbalance in bargaining power, the result will often be some level of constructive knowledge, though the seller(s) will attempt to limit the scope of this as much as possible.
Once the parties fix on an understanding of what “knowledge” means, the next question that must be dealt with is whose knowledge? A target company does not know anything; the directors, officers and employees of the target company do. When specifying that something is “to the Knowledge of the Company”, to which of these directors, officers and employees does the acquisition agreement refer?
The seller(s) and the purchaser(s) are at cross purposes here: the former wishes to limit the group of individuals specified and (in larger companies) limit the knowledge of each individual to matters within his or her functional role, while the latter would wish to expand the group of individuals and not limit the knowledge of each individual to matters within his or her functional role. Similar to the definition of knowledge, this issue is often a heavily negotiated issue, and the end result almost always satisfies neither the seller(s) nor the purchaser(s).
A representation and warranty may be qualified by “materiality”, for example:
There are no material restrictions on the ability of the Subsidiaries to make distributions of cash to their respective equityholders.
In my opinion, “materiality” (if not carefully defined) tends to create more problems than it solves. I’ve been guilty of using it myself, so I cannot say “never” use it, but be very careful when proposing or agreeing to the use of a “materiality” qualifier.
The problem is simple. What, exactly, is material? What dollar amount? What percentage of the total revenues, EBITDA, units produced? What kind of an event counts as “materially” impacting the ability of the target company to conduct its business? It is all well and nice to agree to insert the word “material” into a provision of the representations and warranties when both parties are still on relatively amicable terms; it is quite another to figure out what is actually meant by “material” when one is in the middle of a dispute. And forget about case law: there isn’t much help from learned judges about what materiality means, since it is ultimately a question of fact that has to be determined on a case-by-case basis.
When it comes to materiality, I prefer to either reject the materiality qualifier (if I’m with the purchaser(s)) or define specific thresholds at which something is “material” at the outset (if I’m with the seller(s)). That way, there is no fraught argument over what is or is not “material” since either there is no materiality qualifier, or it is clearly defined in a way that can be objectively tested.
There is another possible solution to the issues raised by materiality, the “materiality scrape”, which I will not discuss in detail here.10 It suffices to note that if there is a materiality scrape in the acquisition agreement, it will, for the purpose of determining whether a breach of a representation or warranty has occurred, permit a party to disregard any materiality qualifiers that would otherwise apply.
The purchaser(s) conduct quite extensive due diligence on the target company and its business before closing the transaction. In the course of this due diligence, the purchaser(s) could discover facts about the target company and its business that are not known to the seller(s), including facts that might enable the purchaser(s) to bring indemnity claims against the seller(s) under the acquisition agreement. The term “sandbagging” refers to the practice of a purchaser(s) discovering a breach of a representation during due diligence, keeping silent about the breach until after the acquisition agreement is signed, then bring an indemnity claim based on that breach.
As a matter of law, not every jurisdiction allows sandbagging. New York and Delaware do, and they are the jurisdictions chosen for the majority of private equity transactions in the U.S. English law, under the doctrine of “purchaser’s knowledge”, does not allow sandbagging: a purchaser is prohibited from seeking indemnification or suing for breach of a representation or warranty if the purchaser had knowledge, prior to closing, of such breach of a representation or warranty in the acquisition agreement.
As one might expect, seller(s) will find the prospect of sandbagging unappealing. There are two reasons for this:
- Permitting sandbagging creates an unfair situation for the seller(s). It is unfair for the purchaser(s) to conduct due diligence, unearth facts that would be a breach of a representation or warranty, stay silent about the breach, acquire the business knowing that one of the representations or warranties is inaccurate, and then bring an indemnity claim against the seller(s).
- Not permitting sandbagging forces the purchaser(s) to discuss issues discovered in due diligence with the seller(s) and come to an agreement on how to allocate the risk between the parties.
The purchaser(s), on the other hand, will argue that sandbagging is necessary for the following reasons:
- Permitting sandbagging eliminates post-closing disputes about what the purchaser(s) knew and avoids putting an additional hurdle in the way of the purchaser(s) claiming for a breach of the representations and warranties.
- Not permitting sandbagging can be a disincentive to the purchaser(s) doing a thorough job on due diligence. Full and robust due diligence and resolution of open issues before closing the transaction promotes certainty post-closing by limiting the likelihood of post-closing indemnification claims since the risks will be priced into purchase price as a result of the purchaser(s) due diligence.
- The appropriate method for charging purchaser(s) with knowledge of matters to prohibit a claim for indemnification is through the disclosure schedule.11
The acquisition agreement can expressly permit sandbagging, expressly prohibit sandbagging, or remain silent with respect to sandbagging and allow the laws of the jurisdiction that govern the acquisition agreement to decide. The last broad industry data point for U.S. M&A transactions involving private companies was the ABA survey in 2013 (covering transactions done in 2012), which shows that staying silent is the most common approach, followed by pro-sandbagging provisions.12
|Position of Acquisition Agreement on Sandbagging||Percentage (%)|
Survival of Representations and Warranties
The representations and warranties will be time limited: they survive for a fixed period of time, after which the purchaser(s) are no longer able to rely upon them to make a claim for indemnification. The time limit for the survival of representations and warranties can be a topic of extensive negotiation, which often ends with certain representations and warranties lasting longer than others.
While each transaction is unique, there are some rules of thumb that I find works pretty well for estimating where most negotiations between parties of roughly equal negotiating power and who are advised by counsel of roughly equal quality will end up.
- Fundamental representations and warranties: Indefinite13
- General representations and warranties: 12 – 24 months, with 18 months being the most common midpoint, thus enabling the purchaser(s) to have one full audit cycle to discover any breaches of the representations and warranties
- Special representations and warranties: The length of time specified in the applicable statute of limitations for a claim to be brought for the subject of the representation, for example the length of time that the Department of Labor has to bring an action for a breach of ERISA
- Tax representations and warranties: The length of time specified in the statute of limitations for the tax authorities to bring an action against the target company, plus an additional amount of time in order for the recipient of the representation and warranty to bring a claim
And we are through the mine field. Or at least, the tiny section of the minefield that I can cover in a post. There are still many traps and pitfalls for the unwary. When it comes to representations and warranties, even the best private equity investor will find himself or herself lost without good counsel.
Other Posts in the SPA Series
- Stock Purchase Agreement Series — Overview
- Stock Purchase Agreement Series — Purchase Price
- Stock Purchase Agreement Series — Representations and Warranties
- Stock Purchase Agreement Series — Indemnities
- Stock Purchase Agreement Series — Closing Conditions
- Stock Purchase Agreement Series — Covenants
- A promise to do something or refrain from doing something is a “covenant”, and we will cover this in some detail in another post. ↑
- 75 N.Y.2d 496 (1990). ↑
- In this case, indemnify simply means “pay compensation to”. ↑
- I am loathe to mention Canada because I have little knowledge of whether Canada has shifted towards a more American view of the distinctions, or if it has retained a closer adherence to UK common law. ↑
- Notably, a lot of U.K. sellers will try to remove the word “representation” and its derivatives from the representations and warranties section to minimize the risk of a claim in tort for misrepresentation under the UK Misrepresentation Act 1967. ↑
- Proving fraudulent misrepresentation is, however, a fairly tough prospect in most cases because it requires the plaintiff to prove four elements: (1) knowledge or conscious ignorance of the falsity of the statement; (2) an intention to induce the plaintiff to rely on the false statement; (3) justifiable reliance by the plaintiff on the false statement; and (4) damage suffered by the plaintiff as a result of the reliance on the false statement. ↑
- This would likely be the case in the UK as well, at least in the more commercially sophisticated courts, and is one reason why one would layer on defenses against this such as express contractual exclusion of tortious claims and rescission of contract. ↑
- I will discuss indemnification in its own separate blog post at some point in the future. ↑
- I often tell people that one of the most important, if boring, parts of an acquisition agreement is the definitions section. When I read a stock purchase agreement, I always print a separate copy of the definitions section, because I know I will be referring to this section frequently. ↑
- I may revisit this topic as a separate “miscellaneous” provision of an acquisition agreement in the future. Call it part of the equivalent of a 2nd year, more sophisticated, level of understanding of an acquisition agreement. ↑
- The disclosure schedule is an important annexure to the acquisition agreement. It sets out a list of disclosures against the representations and warranties in the acquisition agreement. If a matter is properly disclosed in the disclosure schedule, it bars the purchaser(s) from claiming indemnification for that matter. ↑
- Note that the ABA survey is limited to publicly reported transactions, and thus does not include the majority of private equity transactions that are not required to be reported. ↑
- In practice this will be limited to the length of time specified in the statute of limitations for contract claims in the jurisdiction whose laws govern the acquisition agreement. For New York, that is six years, in Delaware it is three years (or 20 years if the transaction involves at least $100,000 and the parties expressly agree to extend the statute of limitations), while in California it is four years. ↑