Coming to Terms: Important Issues and Considerations in Drafting M&A Agreements — Part II: Representations, Warranties, and Disclosure Schedules

Earlier this month, I posted a brief overview blog regarding the drafting and negotiating of the purchase and sale agreement in an M&A deal.  Then I began a series detailing three of the most important sections of the purchase and sale agreement: (1) the economics, (2) representations, warranties, and disclosure schedules, and (3) indemnification.  This blog on the representations, warranties, and disclosure schedules in the agreement will dive deeper into a complex part of the agreement.

Representations, Warranties, and Disclosure schedules

The definitive agreement will usually contain an extensive set of statements, made by the seller, about various aspects of the seller’s business and assets, including issues such as customers, vendors, contracts, intellectual property, legal compliance, and many other areas.  The representations and warranties complement the due diligence process by forcing the seller to make binding statements about the materials it supplied in due diligence. The representations and warranties in the definitive agreement will be the basis for whether the acquirer is later justified in walking away from the deal or suing the seller after the deal has closed.  The target’s goal will be to include as few representations and warranties as possible, and to limit their scope as much as possible, while the acquirer will be motivated to make them as far reaching as possible.

For example, there may be a representation that the seller owns all intellectual property related to its business and that the seller is not infringing on anyone else’s intellectual property.  The lawyer should try to soften that language by limiting that representation to only cover intellectual property that is material to the business and infringement of which you actually know.

Representations and warranties serve many purposes.  First, they further the due diligence process by (hopefully) ferreting out problems or issues with the seller’s business or assets so they can be addressed before an agreement is signed or taken into account in arriving at a purchase price; if they are sufficiently grave, the parties may abandon the deal.

Second, in the case of a deal in which the purchase agreement is signed and the closing is scheduled for a later date (as opposed to simultaneous signing and closing), the representations serve as a basis for allowing the buyer to walk away from the deal without closing (“walk rights”) if the buyer learns that the representations are not accurate at closing.

Third, they serve as a basis for allowing the buyer to recover some of its purchase price (through indemnification) after closing if the seller’s representations are inaccurate and the buyer incurs damages (this latter function is referred to as “risk shifting” in industry jargon because each party is attempting to negotiate the language of the representations to shit the risk of post-closing events to the other party).

An important part of this aspect of the agreement is the Disclosure Schedule which will set out various lists of supporting documentation for and exceptions to the representations and warranties.  This will essentially shift the risk of the matters disclosed in the disclosure schedule back to the acquirer.

The representations and warranties serve four primary purposes: (1) disclosure, (2) walk rights, (3) risk-shifting, and (4) discipline.

1. Disclosure

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 circumstances in which a portion of the purchase prices is paid in buyer stock, most of this information relates to the target company or assets and flows from the seller to the buyer.

Representations and warranties may thus be thought of as an extension of the due diligence process – they ameliorate information asymmetries between the parties.  Frequently, parties will make meaningful discoveries through the process of drafting representations and warranties (and associated disclosure schedules) that may materially alter the deal’s value proposition.

2. Walk Rights

Second, representations and warranties may form the basis of a party’s right to terminate the deal prior to closing, as most do.  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 nonbreaching party will usually have the right to terminate the agreement and walk from the deal.  Thus, representations and warranties effectively enable a arty 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.

3. Risk-shifting

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 is not true,” “we cannot confirm this,” or words to that effect, to which a well-trained M&A lawyer may quickly retort, “so what? My client should not bear this risk.”  After all, the reasoning goes, representations 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.

4. Discipline

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).  For 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 representations often has salutary effects on the underlying substances of the deal.

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 difference in representations (i.e. 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 representations and warranties it will demand from the other side,
• Specific issues identified during due diligence – if problems re discovered during due diligence, such as a third party intellectual proper 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 (i.e. technology deals are IP-centric and chemicals transactions require more environmental coverage),
• Current market price – 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, earn-outs, 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 representations and warranties,
• 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 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.

Conclusion

Although there is consideration negotiating and posturing in relation to representations and warranties in M&A agreements, the practicalities relating to the use of representations and warranties are probably more important than enforcing the breach of these provisions.  The disclosure that accompanies the representations and warranties, and due diligence by the buyer is probably most important to the purchaser’s “purchase or pass” decision.  Once the purchaser has assessed the risk relating to each matter covered by the representations and warranties and reviews the business and legal due diligence, the aggregate risk can be reviewed and the decision whether to purchase cane be made based on a significant body of information.  Make sure to check out the last blog on this series, detailing indemnification provisions.