Representations and Warranties

What are Representations and Warranties?

Representations and warranties are fundamental elements in most commercial contracts, serving as assertions and promises that parties make to one another. A "representation" is a statement of fact made by one party to induce another to enter into a contract. A "warranty" is a promise that a particular statement or condition is true or will remain true for a specified period. These legal tools help allocate risk and establish accountability.

The distinction between the two is often blurred because they frequently appear together in contract language, particularly in high-stakes agreements such as mergers and acquisitions (M&A) or startup funding deals. Representations provide the factual foundation of the transaction, while warranties offer a form of contractual assurance. Together, they build trust and safeguard the parties' expectations.

What is an Example of Representations and Warranties in a Contract?

In startup agreements, representations and warranties are especially critical. For instance, when a startup seeks investment from venture capital firms, the founders may be required to provide representations and warranties about the company’s financial condition, ownership of intellectual property, and compliance with applicable laws.

A common example might include: "The Company represents and warrants that it owns all rights, title, and interest in the intellectual property listed in Schedule A, and that such ownership is free and clear of any liens or encumbrances." This statement gives the investor confidence that the startup legitimately owns the assets it claims and that there are no hidden legal claims that could jeopardize the business.

What are Representations and Warranties in M&A?

In M&A transactions, representations and warranties help buyers confirm the accuracy of the seller’s disclosures and protect against undisclosed liabilities. These provisions often cover a broad range of topics, including:

Financial Statements: The seller represents that financial statements are accurate and comply with generally accepted accounting principles (GAAP).
Litigation: The company is not involved in any undisclosed litigation.
Tax Matters: All tax filings are current, and there are no pending tax audits.
Material Contracts: All material contracts are valid and enforceable.

The buyer typically relies on these assurances to assess the risk of the transaction. If any representation or warranty turns out to be false, the buyer may be entitled to remedies, including indemnification or termination of the deal.

What is the Difference Between Warranty and Representation Damages?

The legal remedies for breach of a warranty versus breach of a representation can vary considerably.

Representation Damages: If a representation turns out to be false and the other party relied on it to their detriment, it could be considered a form of misrepresentation. The damaged party may be entitled to rescission of the contract or compensation based on tort principles, such as fraud or negligent misstatement.
Warranty Damages: Breach of warranty, on the other hand, typically results in a claim for breach of contract. Damages are calculated based on the loss caused by the failure of the warranted fact to be true, without requiring proof of reliance or intent.

Understanding this distinction is important for contract drafting and risk management. It determines not only what kind of evidence is needed to support a claim but also the type and scope of compensation that may be awarded.

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Why Are Representations and Warranties Important in Due Diligence?

Representations and warranties play a key role in the due diligence process. When a buyer evaluates a target company, they rely on these provisions to verify the company’s condition and legal standing. Accurate representations can make or break a deal.

During due diligence, buyers review every representation and warranty to ensure there are no material omissions or misstatements. The process can uncover issues that may require renegotiation of the purchase price or additional protections, such as escrow arrangements or holdbacks.

How Are Representations and Warranties Negotiated?

The negotiation of representations and warranties is a delicate balancing act. Sellers aim to limit their liability by narrowing the scope or duration of warranties, while buyers seek broad and lasting protections.

Key negotiation points include:

Knowledge Qualifiers: Statements may be limited to the seller's "knowledge," reducing their liability for unknown issues.
Materiality Thresholds: Representations may apply only to matters deemed "material," focusing on issues that would impact the buyer’s decision.
Survival Periods: Parties agree on how long representations and warranties remain enforceable after the closing date.

These negotiations are essential for aligning expectations and reducing the potential for post-closing disputes.

What is a Disclosure Schedule?

A disclosure schedule is an attachment to the main agreement that qualifies or explains certain representations and warranties. It allows the seller to make exceptions or clarifications without breaching the core contract.

For example, if the seller represents that "there is no pending litigation," the disclosure schedule might list a pending lawsuit and thus carve out that case from the representation. These schedules provide transparency and protect the seller from liability for disclosed issues.

How Does Insurance Cover Representation and Warranty Risk?

In some large-scale transactions, parties use Representation and Warranty (R&W) insurance to manage risk. This insurance provides coverage for losses arising from breaches of representations and warranties, typically protecting either the buyer or the seller.

Buyer-Side R&W Insurance: Compensates the buyer directly for losses caused by breaches.
Seller-Side R&W Insurance: Reimburses the seller for indemnification obligations.

R&W insurance helps close deals faster by reducing the need for escrow funds and allowing sellers to walk away with more certainty.