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Friday, December 15, 2017

M&A Representations & Warranties: “Risk”y Business


In the sale of a privately-owned company, the purchase & sale agreement serves two key purposes. First, of course, it states the purchase price to be paid for the stock or the assets of the business and the terms and conditions of how and when that price is to be paid. Second, the agreement allocates risk between the seller and the acquirer.

M&A purchase & sale agreements include a negotiated list of representations and warranties – statements of fact about the business being sold relating to its ownership, assets, liabilities, financial statements, taxes, operations, employees, and more. The negotiated set of reps and warranties (and conversely, the topics not warranted by the seller) serve to allocate between the parties the risks – both known and unknown – about the company, its business activities, and the transaction.

Known facts about the business are disclosed to the buyer through the seller’s reps and warranties and through an accompanying set of disclosure statements which list all known exceptions to the reps being made: for example, “Except as set forth on schedule 3.2, there is no litigation currently pending or threatened against the Company”. By making the seller liable if its factual disclosures are not correct as of the closing date, the purchase & sale agreement encourages full disclosure regarding the topics covered by the reps & warranties, and gives the buyer some legal comfort that what it has been told about the business during its due diligence review is accurate. (Note that the number and scope of the seller’s representations & warranties will differ based on the transaction structure: in a stock purchase & sale the buyer inherits all liabilities of the company, so it will require a lengthier set of representations than in an asset purchase & sale, in which the buyer only assumes the specific list of liabilities defined in the purchase agreement.)  Representations & warranties and disclosure schedules reduce the information imbalance between buyer and seller, allowing the buyer to make an informed decision about proceeding with the acquisition.

Along with encouraging disclosure of known facts, reps & warranties also serve to allocate risks relating to facts not known or knowable by either party at the time of the transaction. For example, the acquirer may require the seller to represent that there are no environmental issues with the real property on which the company’s facility is located: “There are no hazardous materials on, in, under or affecting the facility or operations at or on the facility.” It may later be found that, unknown to the seller, a previously undiscovered plume of contaminants had leached underground onto the company’s property years before the transaction date. In this example, the question is not, “Did the seller lie?” Rather the question is, which party bore the risk of unknown contamination being present at the time of the transaction? In this example, the seller would bear the risk and potentially be responsible for the costs resulting from the discovery.

Some reps & warranties include  the phrase “To the seller’s knowledge,…” The insertion of “knowledge qualifiers” is heavily negotiated between the parties since the presence of a knowledge qualifier in a representation shifts the risk of an unknown problem from the seller to the buyer. For example, if the environmental rep in the preceding example was worded “To the seller’s knowledge, there are no hazardous materials on, in, under or affecting the facility or operations at or on the facility” then the seller would be off the hook and the costs of that unknown contamination would be borne by the buyer rather than the seller.

Reps & warranties are a fundamental part of every M&A purchase agreement. Mirus investment bankers work closely with our clients and our clients’ corporate lawyers in negotiating representations & warranties within the overall transaction negotiations, and we look forward to working with you.

 

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