What is the “Representations and Warranties” Section of a Purchase Agreement for, and Why is it Important?
When buying or selling a business, an accurate representations and warranties section of a purchase agreement is critical for ensuring a smooth transition. Any size entity, whether a small family business or larger corporation, is bound to the facts stated in the agreement in order to close the transaction.
Because there are so many legal details that could result in indemnification (compensation for loss and harm) for either party if not accurate, it’s always best to have a trustworthy attorney by your side who can explain what everything means during all contract negotiations.
What Are Representations and Warranties?
Representations and warranties are contractually binding statements assuring both parties of a sale that the business is what the buyer believes it to be. They give both parties legal recourse if the transaction does not go through as expected. Both the buyer and seller make representations and warranties, but the majority of them are made by the seller.
A representation is an assertion that everything in a contract is true as stated. Especially in M&A transactions, sellers must include information about the target company or business and the stock or assets and liabilities being transferred.
A warranty can result in indemnification, or compensation, if the assertion is false. The seller will warrant information given to the buyer during the diligence process, such as that:
- The business is in compliance with all relevant government regulations.
- All financial statements are true and accurate.
- All property—whether tangible or intangible—is free of any encumbrances.
The buyer will need to make warranties as well, such as that:
- They have enough money on hand to pay the purchase price.
- They are a duly formed corporation with the power to execute the contemplated transaction.
Representations and warranties are drafted as general statements in most M&A transactions. The seller must disclose exceptions to those statements in a disclosure schedule attached to the purchase agreement. As long as the exception is properly disclosed, the buyer has been given official notice of the fact. If a seller fails to make a disclosure, it may result in a claim of fraud against the seller.
For example: Except as set forth in Section 1.1 of the Disclosure Schedule, the Company has no current litigation. Disclosure: A claim for XXX was filed in the Superior Court for Perry County on March 3, 2020, under Case No. 1234.
Remedies and Enforcement
The indemnification obligations of the parties, provided in the purchase agreement, is what enforces the representations and warranties. Indemnification language typically states that for a limited time after closing, the parties can indemnify each other for breach of or inaccuracy in the representations and warranties provided by that party.
For example, if a deal closes and the buyer discovers that the seller’s financial statements are inaccurate, the buyer can seek indemnification for losses incurred.
Because of the repercussions that can happen if any inaccuracies occur, it’s extremely important to have a lawyer help craft the deal at an early stage. A simple mistake made here can actually have larger ramifications on if the deal goes through, or whether a seller can get paid if it doesn’t.
Representation and Warranties Insurance
Insurance to protect both parties of an M&A transaction has become fairly common, although it is more often requested by the seller as protection from post-closing indemnity claims. Because the policies pay out claims that arise from breaches in the representations and warranties, those covered by insurance tend to be less concerned about deal friction and closing issues.
The insurance issuer is involved in due diligence and negotiation of the representations and warranties. Every policy has different exclusions and conditions under which the policy will not cover indemnification claims. Exclusions are determined based on the insurance company’s due diligence review, and usually include issues the parties knew of prior to closing and other extraordinary risk issues.
What Information is Included in Representations and Warranties?
In general, the seller and target of the M&A will include the following information in this section of the purchase agreement.
This ensures that financial statements delivered to the purchaser:
- Are true and complete.
- Were prepared from the financial records of the target.
- Were prepared with sound accounting principles.
- Reflect actual transactions and have been maintained in accordance with sound business practices.
This states that there is no debt or liabilities other than:
- Those disclosed in or reserved against in the aforementioned financial statements.
- Those incurred in the ordinary course of business since a particular date.
This clarifies all information about taxes, stating that:
- The target has filed all required tax returns.
- All tax returns are true, complete and correct in all material respects.
- All taxes have been paid in full and there are no liens or contests.
This states that the target and each seller party has:
- The full legal right and authority to execute the purchase agreement.
- Authorizations, consents and approvals required by law.
This states that the target and each seller party has the power and authority to:
- Own, lease, operate and use its assets and properties.
- Perform all its obligations under its contracts.
Ownership of Target Company; No Subsidiaries
This states that the seller owns the issued equity interests of the target and that:
- They are free and clear of all liens, encumbrances and rights of third parties.
- There are no subsidiaries of the target.
- All issued equity securities of the target were issued in compliance with federal and state laws.
Title and Sufficiency of Purchased Assets
This states that each seller party owns the goods sold, and that:
- At closing, the seller will transfer and deliver to the buyer all purchased assets.
- All goods and assets will be free and clear of liens and rights of third parties.
- Purchased assets constitute all of the material assets, properties and rights necessary.
- The tangible personal property is in good operating condition and repair, except for with the exception of normal wear and tear.
- All items of tangible personal property are located at the target’s premises.
Legal and Authorized Transactions
The purchase agreement constitutes the legal, valid and binding obligation of the target and each seller party.
Compliance with Laws
There are no violations by the target of any law relating to the target, its equity, assets or the transaction.
Licenses and Permits
The target has all required licenses and permits.
There are no claims, lawsuits, investigations or judgments relating to the target.
The target and each seller party is in good standing under the laws of its jurisdiction of organization.
This explains that the purchase agreement does not contain any untrue statement or omit any information that would make the statements false or misleading.
This states that except what is included in the disclosure schedule, the target is not bound by any contract or other agreement. The contracts set forth on the applicable disclosure schedule:
- Are a legal, valid and binding obligation of the target and the other parties.
- In full force and effect in accordance with its terms.
- May be assigned to the purchaser and will continue after closing.
The representations and warranties section may also include information regarding:
- Product Warranties to Customers.
- Customer Credits.
- Intellectual Property and Confidential Information.
- Employee and Labor Matters.
- Environmental, Health and Safety Matters.
- Real Estate.
- Insurance Matters.
A Knowledgeable M&A Attorney Should Be Involved in All Parts of a Purchase Agreement
Regardless of why you are buying or selling a business, it is best to have an M&A lawyer at the earliest stages of the deal. They should be the ones obtaining a valuation and crafting the agreement, along with ensuring the representations and warranties are complete and accurate. Instead of waiting until a deal is on the table and contracts are already drafted, contact Swiecicki & Muskett, LLC to help you navigate your merger or acquisition.
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