Reps and Warranties: Purchase Agreement Part 2

Representations and Warranties are a critical part of a business purchase agreement. This is a summary of these statements of fact that are inserted into the agreement, as well as “qualifiers” that can strengthen or water down the agreement.

This is a multi-part blog post that describes the various sections of a typical business purchase agreement.

1. Introduction
2. Price and structure of the acquisition / purchase
3. Representations and warranties of the buyer and seller
4. Covenants of the buyer and seller
5. Conditions to closing
6. Indemnification
7. Termination clauses and remedies
8. Miscellaneous
9. Representations and warranties of the buyer and seller

Reps and Warranties are statements of fact that a seller makes to a buyer (and vice versa) about all aspects of the company, and pledges that they are true. Even the most diligent of a buyer’s due diligence will not uncover and mitigate all of the risk that a buyer takes when buying a company.  Thus, through the Reps and Warranties, the buyer is asking the seller to disclose in writing (and memorialize in the formal agreement) every aspect of the company from taxes, contract, ownership, finances, legal issues, intellectual property, etc.

Disclosing everything in the reps and warranties is critical, as an omission of a liability or significant fact can give an unhappy buyer a cause of legal action for breach of contract.  It is well worth the effort to go through the list carefully and spend some quality time thinking about each item.  In fact, a good deal attorney will force the seller to sit through a final walkthrough of all the reps and warranties, trying to uncover every little thing that could be out there and get them into the agreement.

Lawyerese becomes critical in reps and warranties, and a good deal attorney is important to have.  For example, the buyer’s attorney will typically draft the reps and warranties, and one warranty may state that “all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” The seller’s counsel may add a “knowledge qualifier” so that it now states “To the best of the Seller’s Knowledge, all contracts have been performed in all respects and conforms with all federal, state and local laws, regulations, etc.” They may also add a “materiality qualifier” so that it becomes: “To the best of the Seller’s Knowledge, all contracts have been performed in all material respects and conforms with all federal, state and local laws, regulations, etc.”

By adding these qualifiers, a buyer would have a much tougher time coming after the seller later.  For example, they would have to prove not only that a contract wasn’t performed, but that the seller had knowledge of that fact.  Proving that the seller had prior knowledge is extremely difficult to accomplish, so by adding that clause it completely changes the legal exposure of both the buyer and the seller.

Deal attorneys can (and will) spend a great deal of time negotiating the reps and warranties, and then the qualifiers on them. 

An example of Reps and Warranties

We were getting ready to close and the final documents had been prepared.  Our sellside attorney did the final reps and warranties check with the seller and I was a little bored while listening in on the conference call.  One of the most basic representations is basic ownership.  Does the seller (or group of shareholders) actually own the company he is selling?  The attorney was asking questions around this area and asked the seller about the ownership of the patents he was selling with the business.

All of the sudden the call got a lot more interesting when the seller exclaimed: “Oh my gosh, I forgot that I don’t actually own the patents!”.  A scientist that worked for the company was the inventor and the owner of the patents.  The scientist still worked for the company and would continue after the close, so the seller knew he could work something out, but he just forgot to do it.   Whoops. Kind of a big thing to work out at the last minute, but he was able to work out in a matter of days a time-limited royalty arrangement for purchase of the patents.

During that process he also realized that the scientist was working with some of his own equipment in the laboratory, and we were about to sell that equipment out from under him.  I’m sure the buyer would have worked something out in this case because it wasn’t a lot of equipment, but much better to specifically exclude that equipment in the purchase agreement than to work it out later.