Seller representations and warranties in a business sale

In virtually every business sale, the purchase agreement contains a section in which the seller makes certain “representations and warranties” (R&Ws) regarding the state of their company. Some R&W provisions are boilerplate, while others are negotiated and carefully tailored to the deal, the nature of the company, its operations and financial condition, and how the seller has described them.

In reducing the seller’s R&Ws to writing, both parties seek to establish the buyer’s recourse and remedies in the event that information provided by the seller undermines the company’s value after the closing.

“The representations and warranties section of the purchase agreement is very important,” said Gary Papay, an M&A advisor and managing partner in the Pennsylvania office of IBG Business. “The R&W provisions confirm what the seller has told the buyer about the company, and they define the allocation of risk between the seller and buyer.

“Looking out for the seller’s interests in hammering out those provisions is a critical role for the seller’s attorney and M&A professional.”

Papay notes that R&W provisions typically have an expiration date, ranging from short-term (e.g., six months) to long-term, perhaps as long as four years.

In addition, negotiating the content and shelf life of the provisions often results in a holdback by the buyer, frequently in the range of 5% to 10% of the purchase price, to cover the buyer’s risk.

This article provides an overview of six common categories of seller representations and warranties:

• undisclosed liabilities;
• legal compliance;
• full disclosure;
• “no other representations” and “non-reliance” clauses;
• accuracy of representations; and
• indemnification.

No Undisclosed Liabilities. This representation is very common. In its survey, “2021 M&A Deal Terms Study,” SRS Acquion, Inc., found that 98% of surveyed deals contained representations by the seller that there were “no undisclosed liabilities,” with the appropriate acronym NUL.

A NUL warranty is important to both parties. A Bloomberg Law article notes that it “can significantly impact the relative risk allocation as between the parties for undisclosed – or otherwise unknown – liabilities of the [company].”

In a typical NUL representation, the seller certifies that there are no liabilities that aren’t disclosed elsewhere in the purchase agreement. The wording will reflect a negotiated compromise between two conflicting objectives: The buyer will want an “unqualified” NUL statement, with few exceptions and a maximum scope, while the seller will want to limit the scope of liabilities and try to work in as many exceptions and allowances as possible.

Compliance with Laws. This type of representation is nearly as common as an NUL provision, with 93% of deals in the aforementioned survey including representations regarding past and present legal compliance.

While the provision might be as simple as this – “To the Seller’s knowledge, the Business has been and is being conducted in compliance with all applicable laws” – the seller’s advocates will frequently seek to include various limitations intended to narrow the scope of the compliance representation.

Full Disclosure. It is common for the buyer to ask the seller to affirm in writing that it did not make any false statements or omit material facts regarding the company.

The widely accepted standard for full disclosure is contained in Rule 10b-5 of the Securities Exchange Act of 1934. Thus, sellers should not be surprised when a mention of a “10-b5 representation” enters the conversation.

Because “full disclosure” can have a broad scope, and reining it in can be elusive, many deals feature a buy-side “representations and warranties insurance” (RWI) policy to protect the buyer against losses stemming from less-than-full disclosure.

This type of insurance was discussed in the report of Harvard Law School’s 2017 Forum on Corporate Governance:

“Under a buy-side [RWI] policy, the buyer … recovers directly from an insurer for losses arising from certain breaches of the seller’s representations and warranties in the acquisition agreement. By shifting the risk of such losses from the seller to an insurer, the buyer and seller can limit or even eliminate the seller’s liability for certain rep breaches, all without materially diminishing the buyer’s coverage.”

“RWI policies are becoming more commonplace today,” notes M&A advisor John Zayac, the managing partner in IBG Business’s Colorado office. “As compared to the demands and economics of escrows, insurance stands as a viable alternative.”

Whether and how the policy premium will be split between buyer and seller is a matter for negotiation.

“No Other Representations” and “Non-Reliance” Clauses. These two types of provisions are sufficiently related that they can be discussed in tandem.

A no other representations or warranties clause might look like this: “Buyer acknowledges that Seller has not made and is not making any representations or warranties regarding the subject matter of this Agreement, except as provided in …”

This provision is good for the seller, as it provides an acknowledgement by the buyer that the seller’s representations and warranties are specified in, and limited by, the purchase agreement.

Similarly, a non-reliance clause – e.g., “Buyer is not relying and has not relied on any representations or warranties regarding the subject matter of this Agreement, except for the representations and warranties provided in …” – prevents both the buyer and the seller from relying on any representations that are not spelled out in the purchase agreement.

As with 10b-5 full-disclosure representations, the purchase of a buy-side RWI policy can offer comfort to the buyer and help them accept the above clauses.

Accuracy. The purchase agreement will likely express the parties’ understanding regarding the (a) effective date and (b) standard for accuracy of the representations and warranties.

In our experience, four out of five purchase agreements state that all representations are accurate at both the signing date and the closing date.

Also, the agreement will likely specify a standard of accuracy for the representations. Only if a representation is shown to fall short of the selected standard would it give rise to an actionable breach.

Again in our experience, roughly half of our deals have specified the “material adverse effect” (MAE) standard, which is the most forgiving of the three most common standards. A close second, and more stringent, is the requirement that a representation be accurate “in all material respects.” The third and most draconian standard, applicable in perhaps one in 20 deals, requires a representation to be accurate “in all respects.”

Indemnification. Your purchase agreement might include an indemnification clause, which calls for one party to make the other party “financially whole” in case the indemnified party experiences an economic loss due to specified acts on the part of the indemnifying party.

In most cases, an indemnification clause is party-neutral, as either the buyer or the seller might anticipate events that could cause them to seek indemnification by the other party.

Conclusion. In contrast to the relatively surprising eleventh-hour issues that we describe in our article on settlement adjustments, representations and warranties are predictable: Either they evolve from the due diligence process (see article) and are negotiated against the backdrop of the overall deal, or they are on someone’s radar screen from the outset.

Nevertheless, the wording of representations and warranties is very important, and ensuring that one party does not make promises on which they cannot deliver is, as we noted at the beginning of this article, a vital responsibility of the parties’ attorneys and, for the seller, their M&A advisor.

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