Standard Clauses providing general representations and warranties for a commercial sale of goods or services transaction under Ohio law. This resource also includes a disclaimer of other representations and warranties and acknowledgment of non-reliance sub-section. These Standard Clauses have integrated notes with important explanations and drafting tips.
Representations and warranties are two principal components of most commercial contracts. Technically, they have different meanings:
A warranty:
In addition to inducing the recipient to enter into the contract, representations and warranties are used to:
In most commercial contracts, each party represents and warrants to any given statement of fact concurrently and interchangeably. So, each statement of
fact serves as both a representation and a warranty. Many agreements expressly limit the recipient’s remedies for inaccuracy or breach of representations and warranties to either:
Therefore, despite their technical differences, in practice, any functional distinction between representations and warranties is, in most cases, irrelevant However, the distinction between representation and warranties may have significance in specialized areas of the law (for example, insurance law) (see Care Risk Retention Group v. Martin, 947 N.E.2d 1214, ¶ 62 (Ohio 2d Dist. 2010)).
These Standard Clauses are general representations and warranties commonly used in a variety of commercial contracts. To allow for greater drafting flexibility, they include separate sub-clauses for the seller or service provider and for the buyer or service recipient, even though many standard representations and warranties are given mutually by the parties.
These clauses can be revised if the drafter prefers to make some of the representations and warranties mutual instead of including separate sub-sections for each party. When revising these clauses to create a mutual provision, if the contracting parties are different types of legal entities (for example, if one is a corporation and the other is a limited liability company (LLC)), the drafter should generalize each of the entity-specific references.
These Standard Clauses are not drafted in favor of either party. Counsel should customize these provisions to reflect: The facts and circumstances of the particular transaction.
Each party’s relative bargaining position and risk tolerance, including the effect on the representations and warranties of any indemnification or other provisions in the agreement (for example, counsel may negotiate and provide certain warranties if they do not survive the closing or are subject to favorable liability caps and baskets).
In most commercial contracts, the parties make:
In a commercial contract, transaction- specific representations and warranties typically relate to the nature, type, quality, and condition of the goods, assets, or services central to the subject matter of the agreement. For example, a party may
warrant that a purchased good (for example, a machine) is free from defects in material and workmanship, under normal use and service, for a specified period of time (see,
for example, Caterpillar Fin. Servs. Corp. v. Harold Tatman & Son’s Ents., Inc., 50 N.E.3d 955, ¶ 15 (Ohio 4th Dist. 2015)). Sellers and service providers, who often have most of the performance obligations, typically make more transaction-specific representations and warranties than buyers and service recipients.
These Standard Clauses include standard representations and warranties and some optional transaction-specific representations and warranties that may be appropriate for certain types of commercial agreements. They do not include product and service warranties, which are specialized contractual provisions that combine the concept of a warranty and a covenant (see Representations and Warranties or Covenants?). For information on product warranties under the Uniform Commercial Code (UCC), see Practice Note, UCC Article 2 Express Warranties (OH): Express Warranties Under UCC Article 2 (w-001-7823).
For examples of product and service warranty provisions, see Standard Documents: General Purchase Order Terms and Conditions (Pro-Buyer): Section 15 (3-504-2036). Product Reseller Agreement (Pro- Supplier): Section 17.02 (4-517-9793). Professional Services Agreement: Section 10.2 (9-500-2928).
These Standard Clauses also do not include the numerous and detailed representations and warranties contained in M&A and finance agreements. For examples of representations and warranties included in acquisition agreements, see Standard Document, Asset Purchase Agreement (Pro-Buyer Long Form): Articles IV (6-384-1736) and Article V (6-384-1736), and Standard Clauses, IP Representations: Stock Purchase (Pro-Buyer) (0-517-0657). For examples of representations and warranties included in loan agreements, see Standard Clauses, Loan Agreement: Representations and Warranties (0-383-3169).
Representations and warranties are made on or “as of” a specific date, often the date on which the agreement is executed by the parties. They typically relate to either: The present. Periods or points in time that occurred in the past. For example, an Ohio court found that representations at issue in the case were made as of the signing date and, again, as of the closing date of the transaction (see Carnahan v. SCI Ohio Funeral Services, Inc., 2001 WL 242555, at *9 (Ohio App. 10 Dist.)).
In some agreements, however, the parties include language stating that the facts of the representations and warranties will be true in the future. These statements are actually disguised covenants. The maker is effectively promising to act or refrain from acting in a manner that will result in the future accuracy of the presently made statement. Examples of representations and warranties that are (in whole or in part) disguised covenants include statements that:
This technical distinction can have practical consequences. Legal, equitable, and express contractual remedies may be different for inaccuracies or breaches of representations and warranties than they are for breaches of covenants. For example, a breach of representations may give a party the right to void a contract or rescission damages, while a breach of covenants may give rise to injunctive relief or specific performance. Parties to a commercial agreement should consider the practical implications of including disguised covenants within the representations and warranties section of the agreement (see Practice Note, Relationship between Representations, Warranties, Covenants, Rights, and Conditions: Representation and Warranty or Covenant? (7-519-8870)). These Standard Clauses are limited to true representations and warranties and assume that all covenants are included in other sections of the contract.
When drafting or reviewing a commercial contract, counsel should consider each representation and warranty and whether it is appropriate to include a corresponding covenant. For example, representations and warranties that often support adding corresponding covenants include:
In addition to discrete provisions for product and service warranties, related clauses include:
Indemnification. This is a remedial clause that creates an express obligation for one party to reimburse the other party or pay directly for certain costs and other expenses typically arising from the indemnifying party’s inaccuracy of representations, breach of warranties, and breach of
some or all covenants (see Practice Note, Indemnification Clauses in Commercial Contracts (OH) (w-006-3791) and Standard Clauses, General Contract Clauses: Indemnification (OH) (w-000-1141)).
The seller or service provider makes:
Transaction-specific representations and warranties included in a particular agreement depend on:
Usually the maker qualifies individual representations and warranties. In some contracts, the maker qualifies all of its representations and warranties by including a general qualification in the lead-in language (for example, “Seller represents and warrants, to the best of its knowledge, ...”). The recipient should resist a blanket qualification and instead address appropriate limitations within individual representations and warranties.
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Working With Contracts: What Law School Doesn't Teach You, 2nd Edition (PLI's Corporate and Securities Law Library) 2nd Editionby Charles M. Fox (Author) :
Representations and warranties1 are statements of fact made in the contract by one party to the other party as of a particular point in time. Their purpose is to create a "snapshot" of facts that are important to the recipient’s business decision to enter into the transaction. The failure of a party’s representations to be true will result in the other party having rights and remedies under the contract.
Let’s look at a contract for the sale of the assets of a business, consisting of a plant that processes and dyes fabric. The buyer will want to know whether there are any environmental problems at the plant, because it may become liable for them under environmental laws. The buyer may have done an environmental examination providing a moderate degree of comfort that there are no environmental issues. However, it’s possible there had been a hazardous waste spill that was not discovered in the environmental review. If, after the sale, that waste leaches onto an adjoining property, the neighbor may have a claim against the new owner for damages. This risk would be addressed by requiring the seller to make a representation in the purchase agreement regarding the absence of hazardous waste spills. If the buyer discovers before the closing that the representation is untrue, it would typically have the right to terminate the contract and walk away from the deal. Alternatively, if the spill is discovered after the sale closes, the buyer will have a claim against the seller for breach of representation. Typically, the buyer will also have an indemnity or damage claim based on the breach.
Going back to our example, the buyer will ask the seller to make the following representation:
Except as disclosed on Schedule C, Hazardous Materials have not at any time been released on or from any real property constituting part of the Purchased Assets.
When the seller receives the draft purchase agreement containing this representation, it has several choices:
Give the representation after disclosing on Schedule C any responsive facts of which it is aware.
A party being asked to make a representation will want to make complete disclosure in order to avoid liability. The disclosures may give rise to additional demands on the representing party, however: the buyer in the example may insist on an undertaking from the seller to remediate the disclosed environmental conditions, or on a reduction to the purchase price to compensate the buyer for having to pay for the remediation itself. Or, the buyer may walk away from the deal.
Representations allocate risk between parties to a contract. The party making a representation assumes the risk that if the representation is untrue, the other party will have a claim against it or some other remedy under the contract. The party being asked to make the representation may not have any better information on the subject matter of the representation than the party requesting it. But it may be forced to make the representation anyway, based on the principle that the representation recipient is entitled to some remedy if the fact being represented turns out to be false. In the example of a previous environmental spill, neither party may be aware of its existence, but from the buyer’s standpoint the risk of there being such a problem should be borne by the seller. Having the seller make the appropriate representation is the method by which this risk is allocated. If it turns out that there is a spill that results in damages to the buyer, the existence of the representation gives it the ability to assert a claim against the seller.
Representations fall into three basic categories. The first category includes representations that relate to the contract itself. The purpose of these representations (referred to here as "enforceability representations") is to provide assurance that the party making them has the contractual capacity and authority to enter into the agreement, and that the contract is legally enforceable and doesn’t result in a violation of law. The party asking for enforceability representations wants to ensure that the other party doesn’t have any technical defenses available to it if the contract ever becomes the subject of litigation. These are standard representations and are rarely negotiated to any significant extent. Enforceability representations are discussed in greater detail in section 9:2.
The second category of representations is those that relate to the subject matter of the contract. These representations are made to ensure that a party is getting what it bargained for, and are tailored to the specific context of the contract in which they are contained. Here are some examples:
Many contracts require the parties to make representations about themselves that go beyond the enforceability representations and subject matter-related representations discussed above. These are required where particular facts about a party are relevant to its ability to perform its contractual obligations. The most frequent of these are representations that relate to the financial condition of the party. These are required where a party’s credit—that is, its ability to perform financial obligations—is being relied upon. These representations are described in greater detail in section 9:3.1. Other examples of this type of representation are the following:
As representations are negotiated, information that is inconsistent with the statements made in the representations will emerge. This information must be disclosed in the contract in order to make the representations true. This may be done by excluding, or carving out, the inconsistent facts in the text of the representation. The following is an example:
It is important to note that schedules cannot be updated once the conract is signed, unless there is language in the contract that specifically permits it.
Representations are statements of fact as of a particular point in time; that point in time can be the date that the contract is entered into, the date that the closing of the transactions under the contract occurs, or any other date provided for in the contract. Representations that are made again on a later date are referred to as being "brought down."
The bring-down of representations is usually required at times when a significant event occurs under the contract. For example, an acquisition agreement may provide for the transfer of a portion of the assets at a future date, after a necessary consent is obtained. The purchaser will want the seller to bring down its representations at the time of the delayed transfer; this ensures that there has been no change in facts since the date that the representations were originally made.
A common occurrence of the bring-down of representations is in connection with contracts that are signed before closing. The representations are made at signing to induce the parties to enter into the contract. They are brought down at closing, to induce the parties to close by assuring them that the facts covered by the representations haven’t changed since the signing date.
Another common occurrence of representation bring-downs is in revolving credit agreements, which provide for multiple borrowings. The borrower is required to bring down its representations to the lender as a condition precedent to each loan. If an agreement like this requires bring-downs at future dates, be aware that changing facts may make the bring-down impossible. Consider a representation in a credit agreement that all the borrower’s subsidiaries are listed in a schedule. If new subsidiaries are created or acquired after the closing date, the representation can’t be brought down, because the schedule doesn’t list the new subsidiaries. As a result, additional borrowings can’t be obtained.
If the lender wants to prevent the existence of new subsidiaries, this would be the correct result. If, however, the creation or acquisition of subsidiaries is contemplated, the potential bring-down problem must be addressed. This can be done in a number of ways. First (and most common) is to limit the representation to facts in existence on a specific date:
All of the Company’s subsidiaries are described in Schedule A, as such Schedule may be updated from time to time [with the Lender’s consent (such consent not to be unreasonably withheld)].
Although these concepts are often confused, there is a difference between a provision stating that representations "survive the closing" and a provision stating that the representations are brought down at some future time. A survival clause means that the recipient of a representation continues to have the benefit of that representation after the closing. In other words, if a month after the closing date a recipient of a representation discovers that the representation was false at the time when it was made, the recipient will have a remedy under the contract. Some people incorrectly assume that a survival clause means that the representations are made or brought down on a continuing basis. This is inconsistent with the concept of representations as a snapshot and would have the effect of converting representations into covenants.
The alternative to a survival clause is a provision that the representations merge, or terminate, at closing. This type of provision is typical in residential real estate contracts. In these contracts, the representations made by the seller must be true at closing as a condition to the buyer’s performance, but once title passes, cease to have any effect. The net result of such a merger provision is that the buyer acquires the real estate "as is–where is"—it assumes the risk of problems that are discovered after closing, even those that were the subject of a representation by the seller.
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What is a warranty?
A warranty is a promise that a particular statement made is true at the date of the contract. A breach of warranty gives rise to a claim for breach of contract – the main remedy being an award of damages. To give an example, in a contract for the sale of goods, a warranty may be given about the condition, age or history of the goods being sold. In a software supply agreement, a warranty is usually given that the software will be free from material defects at the time it is delivered.
What is a representation?
A representation, like a warranty, is a statement of fact but is one which is made during contractual negotiations in order to induce another party to enter into a contract. While representations are usually made prior to the contract they are often repeated and therefore form the basis of a contract.
So, what is the difference between representations and warranties?
The key difference between a representation and a warranty is the remedy available to the innocent party when there is a breach. If a warranty is found to be untrue, the innocent party will be entitled to damages. A breach of warranty does not allow the innocent party to rescind the contract, which would effectively set it aside and put the parties back in the position they were in before the contract was made. As a warranty is a term of the contract, normal breach of contract considerations apply. A breach of warranty will therefore only give rise to damages if the innocent party can prove that the breach resulted in a loss and that the loss was not too remote i.e. the loss was in the reasonable contemplation of the parties at the time the relevant contract was entered into. If damages are available, they will be assessed to put the innocent party back in the position they would have been in had the breach of warranty never occurred.
In contrast, if a representation is found to be untrue the innocent party will be entitled to bring a claim for misrepresentation, which if successful would allow the innocent party to rescind the contract. The right to rescind may be lost, though, if the innocent party affirms the contract, if a significant amount of time has passed, or if third-party rights would be infringed.
A breach of representation may also entitle the innocent party to damages, which in principle are wider in scope than the damages available under a breach of warranty. With a breach of representation, the innocent party will not have to prove that their losses were in the reasonable contemplation of the parties at the time the relevant contract was entered into. Instead, the losses must be “reasonably foreseeable”, which has been held by the courts to be a less onerous test than the test associated with a breach of warranty claim. The manner in which damages are calculated also differs for a breach of representation claim versus a claim for breach of warranty. Under a claim for breach of warranty, damages are usually assessed at the time of the breach. Under a claim for breach of representation, damages are assessed from the date the misrepresentation was made. This is usually an earlier date and so may give rise to a higher level of damages.
Given the potential to rescind the contract and the wider scope for damages, it is generally more advantageous for a party to be given representations rather than warranties. However, whether or not a party can insist on this will depend on the bargaining strength of both parties and the type of contract on the table.
Can warranties also be representations?
If you are familiar with contracts, you may have seen wording such as “the seller represents and warrants…”. Where the wording is clear cut, it is likely that the court will view the statement as both a representation and a warranty. However, where the wording does not expressly provide that a warranty is to take effect as a representation, an innocent party will struggle to argue that the warranty is also actionable in misrepresentation. Take the case of Sycamore Bidco Ltd v Breslin in 2012 as an example. In this case, the court held that various warranties in the share purchase agreement, which were not expressed to be representations, could not be representations.
The case of Idemitsu Kosan Co Ltd v Sumitomo Co Corp in 2016 further reiterated this point. Here, the court concluded that it was not enough that the subject matter of the warranty was capable of being a representation; there was no representation because there was no express provision to that effect. The fact that the agreement contained an entire agreement clause also made it clear that any pre-contractual understandings, communications or representations had not been relied upon or had been withdrawn before completion.
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Warranties, not representations and warranties. The word warranties is very often coupled with representations, in that the parties do not merely warrant, they would represent and warrant. Using both words, however, a superfluous search for certainty. If a distinction can be made at all, it is probably best acknowledged under English law. Under English common law, a representation is a statement of fact made by one party to induce the other party to enter into the contract. As in many other legal systems, a ‘breach’ of a representation would lead to the conclusion that such other party entered into the contracts on undue grounds. Accordingly the default remedy should be (and as codified for English law in the Misrepresentation Act 1967 indeed is) that the induced or misled other party may rescind the contract in case of (significant) misreprentation. An immediate consequence would then also be that such other party would make a claim ‘in tort’ rather than a (contractually qualified and contractually limited) claim under the contract. Although one may reflect the representations in the contract, by its very nature (as an inducement to enter into the contract) such written reflection is not necessary: whether the remedy (rescission of the contract) is justified will be determined regardless of whether the representation was in writing.
The term warranty has a different meaning: it reflects the promise made by one party to the other as regards the object of the contract, and what such other party might expect from performance of the contract. In case a warranty appears to be incorrect, the remedy under common law is damages (and not rescission). Whilst representations refer to the particular facts as they are (or would be) at the time of contracting, a warranty is more likely to address a future fact, benefit or circumstance measured as of the moment such a warranty is made. On similar grounds, warranties imply a risk allocation mechanism, whilst this is less evident in case of a representation. Having pointed out these notions of warranties vs. representations, it must be admitted that many English or other common law lawyers are unaware of the distinction.
A warranty is incorrect (or ‘untrue‘), but not breached. Like recitals, warranties are statements of fact. Someone can ‘breach’ a contractual obligation or covenant, but not a statement of fact. A properly drafted warranty is either true (or correct) or not. There should be no room for something in-between. Of course, a warranty can be partially incorrect, but this implies that also the warranty in its entirety is incorrect. In the English language, it is also appropriate to stipulate that a warranty is ‘accurate’ (or ‘inaccurate’).
Smoking out the facts. The process of asking and negotiating warranties should trigger the disclosure of facts and events that might not otherwise become known. In this respect, warranties spur the seller on to discharge its ‘duty to inform’, whilst at the same time the purchaser effectively conducts its ‘duty to investigate’. Asking and negotiating the warranties is therefore a natural outflow of the due diligence investigation. (Ideally, a purchaser’s due diligence questionnaire will match the set of model warranties, which a purchaser would require if it had full bargaining power. At the same time, since such a set is likely ‘complete’, a seller would organise its data room consistent with such model warranties.)
For example, a purchaser will ask the seller of a company to make the following warranty:
Except as disclosed in Schedule 11, there have not at any time been any Spills or Contaminations on or from the Production Site.
When the seller receives this warranty as part of the first draft set of warranties, it has several options:
Allocation of risk. Warranties allocate risks amongst the parties. The party making a warranty assumes the risk that if the warranty is incorrect, the other party will have a claim against it or another appropriate remedy under the agreement.
In the example of environmental spills (see previous paragraph), neither party may be aware of its existence, but from the purchaser’s standpoint the risk of there being such contaminations should be borne by the seller. Having the seller make the warranty is in fact an allocation of risk. If there appears to have been spills, the existence of the warranty gives the purchaser recourse against the seller.
In line with this principle of allocating risks, some people consider that it is appropriate for a seller of a company to make warranties of which it already knows that they are incorrect, without making (or even attempting to make) disclosures against such warranties. Such behaviour may be questionable in the event that such incorrect warranty substantially impacts the purchaser’s ability to recover damages under any other warranties, because of the agreed limitations on liability claims (i.e. the ‘cap’). It is inappropriate if a seller does not to answer questions during a due diligence, anticipating a subsequent first draft of warranties in which the subject matter will most likely be addressed (and also anticipating that it will be able to stay away from making such warranties during the negotiations). Conversely, a seller may expect that if a data room is not as such a disclosure against warranties and it contains important information that clearly and materially contradicts a warranty, such information is addressed during the negotiations rather than that the purchaser raises it as a warranty claim immediately after the closing of the transaction.
Fitness for purpose and merchantability. In day-to-day business contracts, warranties related to fitness for a particular purpose and ascertaining the merchantability of the products are very common. Also the opposite, that such warranties are specifically disclaimed, is common practice.
What do these disclaimer formulae mean? Most legal systems will require that a sold product must generally be fit for the ordinary purpose for which such products are to be used (whatever that may be). If not, the seller would be selling crap and would rely on a disclaimer allowing it to be in material breach without any remedy or penalty. People call that deceit. A disclaimer that a product may not be deemed to be “fit for any purpose” is therefore ineffective if it allows the seller to deliver total crap (unless the purchaser actually assumed the risk that the seller’s performance could potentially lead to no-result at all). The trick is in the specificity of the purpose and in the extent to which the product should meet the purchaser’s personal intentions (i.e. particular purposes on top of what may generally be expected). A warranty requiring that a product meets the ‘Specifications’ may trigger the purchaser to clarify for which purpose it will use that product. Because this can be very subjective (and probably also subject to changes) it is risky for a seller to make warranties that the product is fit for the particular purpose for which the purchaser will use it.
Disclaiming the merchantability of a product refers to the freedom of the purchaser to sell the product to third parties (and such parties’ freedom to use it). In most cases, this is not problematic at all. When the product is subject to a limited license or if the use of the product independently or in combination with another product infringes the (intellectual property) rights of a third party, however, the product is not merchantable. The same applies if the product is subject to encumbrances or if it cannot be delivered because of any litigation, seizure or embargo. A first response would be that this is obviously something that a seller should warrant. The problem is that the seller is not always able to know which intellectual property rights its competitors own (or in which jurisdiction they apply). Furthermore, it disregards another aspect of merchantability: the seller does not necessarily know how its product will be processed and probably the product is subject to additional regulatory requirements under any local law (e.g. export or import restrictions, registration requirements or specific permits or authorisations). In the US Uniform Commercial Code (§ 2-314(2)), ‘merchantability’ is equivalent to fitness for ordinary purpose.
To ‘bring down‘ warranties. Warranties are made as of a particular moment in time. That moment in time can be the signing date of the contract, the closing date of the transaction or any other date provided for in the contract. Warranties that are deemed to be repeated on a later date are referred to as being brought down.
Bringing down warranties is usually required at times when a significant event occurs under an agreement. For example, a share purchase agreement may provide for completion of the transfer only after the required approvals are obtained; the purchaser will require the seller to bring down its warranties at the closing. This bring-down implies an extra incentive for the seller to make sure that the quality of the transferred business remains as it was at the signing date by leaving any deterioration for the risk and account of the seller.
Warranty bring-downs are also found in other types of agreement. In master sale agreements with deliveries of product pursuant to subsequent (future) purchase orders, the purchaser needs the warranties to be made as of each delivery date. A borrower is required to bring down its warranties to the lender each time it draws under a loan or credit agreement. If a warranty in a credit agreement provides that all the borrower’s subsidiaries are listed in a schedule, the bring-down of that warranty may become impossible (and rightfully so). When new subsidiaries were created or acquired, the risk profile of the borrower has likely changed and additional loans cannot be made without violating the warranty, unless a specific waiver is obtained or an appropriate amendment made to the schedule. Obviously, such waiver or amendment will trigger the lender to scrutinise the creditworthiness of the borrower after creating or acquiring the subsidiaries.
Survival of warranties. Other than the bring-down of warranties at some future moment in time, there is also the concept of warranties ‘surviving the closing of a transaction’. Survival of the warranties in fact refers to the right of the purchaser to claim under those warranties. Normally, the seller will limit this right by stipulating that all claims related to a warranty being incorrect must be made (or made known) within a certain period of time. In such case, it is appropriate to distinguish between the various types of warranties. Accordingly, short periods would apply to running business and tangible assets, whilst warranties related to real estate and environmental contamination would probably be subjected to longer periods. Warranties related to taxation are often subject to the statutory period during which tax authorities may continue to impose taxes related to the period before closing of the transaction.
Triggering disclosure and clarification. In M&A agreements, credit agreements and other major transactions, warranties serve to smoke out the facts. The process of asking and negotiating warranties should trigger the disclosure of facts and events that might not otherwise become known. In this respect, warranties spur the seller on to discharge its ‘duty to inform’, whilst at the same time the purchaser effectively conducts its ‘duty to investigate’. Asking and negotiating the warranties is therefore a natural outflow of the due diligence investigation. (Ideally, a purchaser’s due diligence questionnaire will match the set of model warranties which a purchaser would require if it had full bargaining power. At the same time, since such a set is likely to be ‘complete’, a seller would organise its data room consistent with such model warranties.)
Table of contents
In this paragraph, we will address a few other particularities of warranties and limitation of liability as they are used in the context of major transactions (e.g.M&A or financing transactions).
Sandbagging. Negotiating for contractual provisions that create burdens to actually receiving compensation is referred to as ‘sand-bagging’. Sand bags are used to protect against invasions and may indeed imply the impossibilities associated with battles taking place in the trenches. Sand-bagging behaviour obviously insinuates that a seller is creating contractual burdens and is overly complicating a purchaser’s ability to recover damages. As Dutchmen, however, we should emphasise that sand-bagging is also a modest alternative to a dike and yet is a proper means to prevent a flood.
Making incorrect warranties. In line with the principle of allocating risk, some people consider that it is appropriate for a seller of a company to make warranties about information which it already knows to be incorrect, without making (or even attempting to make) disclosures against such warranties. Such behaviour may be questionable in the event that such incorrect warranty substantially impacts the purchaser’s ability to recover damages under any other warranties, because of the agreed limitations on liability claims (i.e.the ‘cap’). It is inappropriate if a seller does not answer questions during a due diligence exercise, anticipating a subsequent first draft of warranties in which the subject matter will most likely be addressed (and also anticipating that it will be able to stay away from making such warranties during the negotiations). Conversely, a seller may expect that if a data room is not as such a disclosure against warranties and it contains important information that clearly and materially contradicts a warranty, such information should be addressed during the negotiations rather than that the purchaser raises it as a warranty claim immediately after the closing of the transaction.
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n golf, a “sandbagger” is a person who pretends to be a worse player than he or she really is in order to take advantage of and lie to other players in order to gain additional handicap strokes and increase his or her chances of winning. The term “sandbagging” is believed to have originated with 19th century street gangs who would fill socks with sand (hence, the term “sandbags”) and use them as weapons. The term “sandbagging” is commonly used in merger and acquisition transactions to refer to a practice employed by buyers to claim a breach of a representation or warranty in the transaction agreement and seek indemnification from the seller in spite of the buyer having known of the breach or the fact that a particular representation or warranty was not true at the time the governing agreement was signed or the transaction closed. Sandbagging claims can arise irrespective of the transaction structure—whether a stock purchase, an asset purchase or a merger, provided the seller’s representations and warranties survive the closing.
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Many contracts contain representations relating to facts that could affect the enforceability of the contract (referred to here as "enforceability representations"). Whether or not these representations are made is usually a matter of custom and negotiating leverage. In addition, where performance is only required from one party, usually only that party will make these (or any other) representations.
It is also important to understand the specific purpose of a subset of the enforceability representations: the representations regarding organization, power and authority and corporate or other action (sections 9:2.1 through 9:2.3 below). These representations go to the capacity of an entity (as opposed to a natural person) to enter into the contract. A corporation, limited liability company, limited partnership or other entity has not validly executed and delivered an agreement unless (a) it validly exists as an artificial legal person, (b) it has the legal power and authority to enter into the agreement and (c) all necessary organizational action has been taken to authorize the entity’s entering into the agreement. Not only are these representations usually required of contracting entities, they are often the subject of legal opinions and closing conditions as well.
The Company is a duly organized and validly existing corporation in good standing under the laws of the jurisdiction of its organization and is duly qualified and authorized to do business and is in good standing in all jurisdictions where it is required to be so qualified and where the failure to be so qualified would reasonably be expected to have a Material Adverse Effect.
This representation goes to whether the party making the representation has been properly organized, is validly existing as an entity and is in good standing.1 Due diligence for this representation would include ordering a certified certificate of incorporation (or analogous filing for a limited partnership or limited liability company) and a good standing certificate from the state where the entity is organized. This representation is requested to avoid the risk that an entity does not legally exist as an artificial person.
This provision often also covers the entity’s good standing in its state of organization and qualification to do business in states other than its state of organization. Failure to be so qualified in a state doesn’t affect the entity’s capacity to enter in the contract, but may impair its ability to appear in the courts of that state to enforce the contract. Often this portion of the representation is subject to a materiality qualification, as in the above example.
The Company has the corporate power and authority to (a) own its property and assets and to transact the business in which it is engaged and presently proposes to engage and (b) execute, deliver and perform this Agreement.
An entity’s ability to enter into and perform different kinds of contracts may be limited by its organizational documents or, in the case of regulated entities, by statute or regulation. This representation is a statement that there are no such restrictions on the party’s ability to conduct its business or to execute, deliver and perform the contract. Enforcement of an agreement against an entity that lacks the legal right or power to enter into the agreement may be subject to an ultra vires defense. The due diligence required to ensure that this representation is made correctly is a review of the organizational documents and, if the party is a regulated entity, of all applicable statutes and regulations.
The Company has taken all necessary action to authorize the execution, delivery and performance of this Agreement.
This is another representation that applies only to entities. It states that all actions required by its organizational documents and by applicable law in connection with the execution, delivery and performance of the contract by the entity have been properly taken. In the case of a corporation, this representation would be correct if the corporation’s board of directors had duly adopted a resolution authorizing it to enter into the agreement. In the case of a limited or general partnership, a general partner must execute and deliver the agreement. The partnership agreement must be reviewed to determine whether other actions or consents may be required. If the general partner is itself an entity, there must be appropriate action taken by such entity. For example, if the general partner is a corporation, its board of directors must adopt a resolution authorizing its execution and delivery of the contract on behalf of the partnership, in its capacity as general partner.
Limited liability company statutes provide a great amount of latitude to the organizers of an LLC as to how acts of the LLC may be authorized. The limited liability company agreement may grant this power to each member, a single member, a board of members, or one or more managers.
The Company has duly executed and delivered this Agreement.
This representation states, first, that the agreement has been properly executed by or on behalf of the party making the representation. In the case of an entity, it means that the agreement was signed by an officer or representative who was properly authorized to do so. To ensure that this representation is true, the lawyers should (a) review the organizational documents to ascertain whether there are any specific requirements relating to execution and delivery of contracts (for example, a requirement that certain kinds of contracts be signed by specific officers), (b) determine whether the officer or representative signing on behalf of the entity is authorized to do so, by inspecting the organizational documents and any authorizing resolutions, and (c) obtain evidence that the signer’s signature is genuine, usually in the form of an incumbency certificate, in which the secretary (or other officer) of the entity certifies the authenticity of the signatures of the individual signers. See section 3:5.1[A].
The representation also covers due delivery of the agreement. An executed contract is not enforceable until it has been delivered by each of the parties. Deal-specific delivery requirements may exist. For example, in the case of an agreement signed by the parties and placed in escrow subject to the satisfaction of stated conditions, valid delivery of the contract would not occur until the conditions to delivery of the agreement out of escrow were satisfied.
The execution, delivery and performance by the Company of this Agreement do not (i) contravene any applicable provision of any law, statute, rule or regulation, or any order, writ, injunction or decree of any court or governmental instrumentality, (ii) conflict with or result in any breach of any agreement to which the Company is a party or (iii) violate any provision of the Company’s Certificate of Incorporation or By-Laws.
This is a representation that the execution, delivery and performance of the contract does not violate or conflict with other legal restrictions or arrangements to which the representing party is subject. It cannot be made if there are any provisions in the entity’s organizational documents or other agreements that would prohibit, or impose conditions that have not been satisfied on, the execution, delivery or performance of the agreement. The representation also cannot be made if there are restrictions on the party’s ability to execute, deliver or perform2 the agreement under statutes, rules, regulations, judgments or orders. To ensure that this representation is correct requires a careful analysis of organizational documents, contracts and applicable laws, rules, regulations, judgments and orders. It should be obvious why this is a standard representation: the party receiving the representation wants to be certain that entering into the contract is not going to give rise to a conflict which could be the basis for litigation or worse.3
No authorization or approval or other action by, and no notice to or filing with, any governmental authority or regulatory body is required for the due execution, delivery and performance by the Company of this Agreement, other than those that have been duly obtained or made and are in full force and effect.
This representation covers governmental approvals required in connection with the party’s entering into the contract or performing under it. The representing party must determine whether any such approvals are required and, if so, obtain them. Examples of governmental approvals that may be required in connection with particular transactions include the following: Federal Communications Commission approval of a contract to sell a radio station; the passage of the necessary waiting period under the Hart-Scott-Rodino Antitrust Improvements Act in connection with certain mergers and acquisitions; and the receipt of a necessary zoning variance in connection with an agreement to purchase and develop real property.
The provision contains an exclusion for approvals "that have been duly obtained or made and are in full force and effect." Without this language, the representation would be untrue if necessary approvals had already been obtained. Of course, this representation may require exceptions on the date that an agreement is signed if approvals are required for performance (as opposed to execution and delivery). In this case, obtaining the approvals would be added as a condition precedent.
This Agreement constitutes the legal, valid and binding obligation of the Company enforceable against the Company in accordance with its terms, except to the extent that the enforceability thereof may be limited by applicable bankruptcy, insolvency, reorganization, moratorium or similar laws affecting creditors’ rights generally and by equitable principles (regardless of whether enforcement is sought in equity or at law).
This representation states a legal conclusion that in part depends on each of the other representations discussed above. In other words, the enforceability of a contract may be impaired if a party doesn’t exist; if it doesn’t have the necessary power and authority; if it hasn’t taken the necessary organizational actions to enter into the contract; if the contract hasn’t been duly executed and delivered; if the contract conflicts with other contracts to which it is a party or with its organizational documents or other legal requirements; or if the contract requires governmental consents that aren’t obtained. Additionally, the enforceability representation constitutes a conclusion that the necessary legal elements of a valid contract formation—consideration, mutuality, offer and acceptance and the like—are present, and that no other defenses to enforcement exist.
The qualifications at the end are known as the bankruptcy and equitable principles exceptions. The bankruptcy exceptions recognize that a contract may be wholly or partly unenforceable if the promisor is the subject of a bankruptcy proceeding, notwithstanding that all enforceability requirements have been satisfied. Bankruptcy law provides, among other things, for the application of the automatic stay, which prevents enforcement of contract claims against the bankruptcy debtor except through specific procedures provided for under the Bankruptcy Code. The equitable principles exception is needed because it is often impossible to get a court to specifically enforce contract obligaitons.
The representations discussed in this section are often the subject of legal opinions required as a condition precedent to the effectiveness or closing of the agreement in which they are contained. Since the subject matter of these representations consists primarily of legal conclusions, it is appropriate for these legal opinions to be requested. Whether or not these opinions are given is usually a matter of custom. For example, opinions are almost always provided by borrower’s counsel in connection with a loan agreement, but are not usually required in connection with an employment agreement.
Specific representations, covenants and remedial provisions have evolved to protect a party to a contract against the credit risk of its counterparty. Credit risk, the risk that the obligor will become financially unable to perform its payment obligations when required under the contract, is present any time a party has an ongoing contractual obligation to make payments to another party.
An understanding of the fundamental principles of bankruptcy law is necessary to understand credit risk. In a bankruptcy liquidation, the value of assets subject to liens goes first to satisfy the claims secured by those liens. Any excess value attributable to such assets plus the value of all unencumbered assets is shared ratably by all unsecured creditors. In a bankruptcy reorganization, where the debtor in possession keeps its assets, the value that each creditor is entitled to receive under the reorganization plan is based in part on the value that such creditor would have received in a liquidation. So, it is easy to see why a creditor with a contractual claim against a debtor has an ongoing interest in the credit or financial health of the debtor. A financial failure by the debtor could result in its bankruptcy and the creditor’s inability to recover all or a portion of its claim, depending on the existence and amount of other secured and unsecured claims and the value of the debtor’s assets.
The magnitude of credit risk is a function of the amount that is at stake at any one time. Take a supply contract that requires the purchaser to pay for each shipment within 15 days of delivery. The contract further provides that the seller is not obligated to make any shipments if payment for any previous shipment is in arrears. If the purchaser fails to pay for a shipment, the seller can limit its credit risk to the amount of that payment by not making any additional deliveries until the delinquent account has been settled. By allowing the seller to limit the credit risk, this type of arrangement is likely to result in the seller requiring fewer provisions in the contract relating to the purchaser’s financial condition.
On the opposite end of the spectrum is a term loan agreement under which a loan is made at closing, which the borrower promises to repay in installments, with interest, over a stated term. Once the term loan is made, the money is gone—typically, having been spent by the borrower on capital assets or acquisitions. Before making the loan, the lender will have reached a conclusion that the borrower’s financial condition over the term of the loan should enable it to meet its principal and interest obligations. However, the lender will add provisions to the contract that protect it against the borrower’s financial deterioration. These may include provisions that (a) require the borrower to provide regular financial information, (b) restrict the borrower’s ability to act in a manner that would make it less creditworthy, and (c) give the lender certain legal rights in the event that the borrower gets into financial (or other) trouble.
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A party entering into a contractual relationship involving credit risk will normally undertake financial due diligence before entering into the contract. This would include reviewing the debtor’s business plan, financial statements and projections, reviewing the debtor’s key contracts, analyzing the collection history of its accounts receivable and so forth. This due diligence is usually buttressed by credit-related representations which, taken together, provide a snapshot of the debtor’s financial condition. Some of these credit-related representations are discussed below.
The audited consolidated balance sheet of the Debtor for the fiscal year ended December 31, 2007, the unaudited consolidated balance sheet of the Debtor for the fiscal period ended March 31, 2008, and the related consolidated statements of operations and cash flows of the Debtor for the fiscal periods ended as of said dates (which annual financial statements have been examined by Big Accounting Firm LLP, certified public accountants), present fairly in all material respects the financial position of the Debtor on a consolidated basis at the date of such financial statements and the results for the periods covered thereby. All such financial statements have been prepared in accordance with GAAP, consistently applied and subject, in the case of the March 31, 2008 financial statements, to normal year-end audit adjustments.
The purpose of this representation is to have the debtor stand behind the accuracy of its historical financial statements. Since financial statements are probably relied on by a creditor more than any other due diligence item in making a credit decision, this representation is extremely important. It will always cover the debtor’s most recent annual financial statements, as well as the most recent quarterly (and, if available, monthly) financial statements. Because consistency of presentation is fundamental to the reliability of financial statements, the representation usually includes a statement that the financial statements have been prepared in accordance with generally accepted accounting principles (GAAP), consistently applied. The key statement is that the financial statements "fairly present the financial condition and results of operations" of the debtor. This statement is not true if the financial statements are incorrect.
Note the distinction between audited and unaudited financial statements. Typically, a company’s annual financial statements are audited by certified public accountants who issue an auditor’s report that states that the financial statements fairly present the company’s financial position and results of operations in accordance with GAAP. Interim financial statements—those prepared on a quarterly, and sometimes monthly, basis—are usually not audited and are therefore, as the last sentence of the representation indicates, subject to being retroactively adjusted as a part of the year-end audit process.
The financial projections attached hereto as Exhibit P have been prepared on a basis consistent with the Debtor’s financial statements and are based on good faith estimates and assumptions made by the Debtor. On the date hereof the Debtor believes that the projections are reasonable and attainable, provided, however, that projections as to future events are not to be viewed as facts and the actual results during the periods covered may differ from the projected results.
This representation addresses projected financial information, as opposed to historical financial statements. Projections are predictions as to a party’s financial condition and results of operations in the future, and therefore cannot be the subject of a representation that is expressed with the same level of certainty as a representation regarding historical financial results. The representation above is typical: the debtor states that it believes in the projections, and that the assumptions that went into the development of the projections were reasonable. The creditor could allege a breach of this representation by asserting that the debtor didn’t actually believe, at the time the representation was made, that the projections were attainable; however, the mere fact that the results set forth in the projections are not achieved would not by itself constitute a breach.
Since December 31, 2007, there has been no material adverse change to the business, assets, liabilities, financial condition or prospects of the Debtor and its subsidiaries, taken as a whole.
This is an extremely important representation from a credit standpoint. It is premised on the creditor’s reliance on the debtor’s financial statements, and constitutes assurance by the debtor to the creditor that nothing significant has happened to it or its financial position since the date of the financial statements. The date in this provision will typically be the date of a set of financial statements reviewed by the creditor. There may be a discussion as to whether the date should be the most recent audited statements, or available subsequent unaudited statements. The creditor will usually prefer the date of the audited statements, since the accountants’ audit provides it with a more certain baseline. The debtor may advocate the use of more recent audited statements, particularly if the trend of the business between the date of the unaudited and subsequent unaudited financial statements was negative. A material adverse change test is always easier to meet if the starting point is lower.
There are no actions, suits or proceedings pending or, to the knowledge of the Debtor threatened, against the Debtor or any of its subsidiaries that (a) relate to this Agreement or any of the transactions contemplated hereby, or (b) are reasonably likely to be determined adversely to the Debtor or such subsidiary, and, if so adversely determined, could reasonably be expected to have a material adverse effect.
Why should the existence of litigation be part of a credit decision? Because a judgment resulting from litigation becomes a financial claim that might interfere with the debtor’s ability to satisfy its other financial obligations. In addition, a judgment can be converted into a lien on the debtor’s assets. In an extreme case, a large judgment might trigger a bankruptcy filing by the debtor.
The second part of the representation relates to all other litigation (i.e., litigation not relating to the transaction). The above language limits the representation to litigation that satisfies two criteria. The first is that the litigation is reasonably likely to be adversely determined. Thus, if the debtor has been sued on a claim that it believes to be spurious, it may conclude that such claim is not reasonably likely to be adversely determined and therefore not covered by the representation. The second criterion is that the litigation is reasonably likely to have a material adverse effect if adversely determined. Even if the debtor believes it will lose the case, the litigation will not be picked up by the representation if the claim is for an amount of damages that is not material. This approach allows the debtor to make subjective determinations regarding the merits and materiality of the litigation. The other approach is to require the representation to be made "flat"—that is, draft the representation to cover all litigation. The benefit of this approach to the creditor is that there is no subjective element and therefore no possibility of a surprise. The problem is that it will result in the debtor having to disclose all litigation, and the creditor will then have to perform its own examination and draw its own conclusions as to the materiality of each disclosed item of litigation.
Note also that the representation as to threatened litigation is subject to a knowledge qualification. This is one of the few instances where such a qualification is generally accepted, on the basis that it would be unfair to hold a party accountable for a breach of this representation due to third party threats that aren’t known to the debtor.
The Debtor and each of its subsidiaries are in compliance with all applicable statutes, rules, regulations, orders and decrees, except where the failure to be in compliance could not reasonably be expected to have a Material Adverse Effect.
This representation is designed to elicit disclosure of any violations of law or judicial orders or decrees. The material adverse effect qualifier is usually the only part of this representation that is negotiated. It may be resisted by the creditor on the basis that there shouldn’t be any violations of law, material or otherwise. The debtor’s counterargument is that the materiality standard does not deprive the recipient of the protection that it wants against violations of law that could result in some material reduction to the debtor’s creditworthiness. Without a materiality qualifier the representation could be untrue as a result of some insignificant infraction. (See section 5:2.1.)
The Debtor and its subsidiaries have paid all material taxes, assessments and governmental charges or levies imposed upon them or their income or profits, or upon any properties owned by them, prior to the date on which penalties attach thereto, except for any such tax, assessment, charge or levy being diligently contested in good faith and with respect to which reserves have been established in accordance with GAAP.
This reflects the creditor’s general concern about the existence of claims against the debtor. Tax claims are a particular issue, because taxing authorities may obtain liens securing their claims that in certain circumstances may take priority over the creditor’s.
There are two customary qualifiers in the above language. First, the limitation of the covenant to material taxes allows the debtor to make the representation despite a delinquency in the payment of an immaterial amount of taxes. Second, the provision allows the debtor to make the representation even if it has not paid taxes, so long as the debtor is contesting the validity of the tax and has entered on its books any reserve required by GAAP. Without this carveout, the debtor would be required to pay even wrongfully asserted taxes.
All factual information (taken as a whole) delivered in writing by or on behalf of the Debtor to the Creditor for purposes of or in connection with this Agreement or the transactions contemplated hereby is true and accurate in all material respects and does not omit any material fact necessary to prevent such information (taken as a whole) from being misleading in any material respect.
This representation is designed to counteract the principle of caveat emptor, that a contracting party is under no obligation to volunteer information not otherwise required to be disclosed by the agreement. It reflects the reality that even an exhaustive set of representations may not be effective to uncover some adverse fact that may be relevant to the creditor’s credit decision. It is a difficult representation to object to, because doing so creates the impression that there is something to hide. This representation is often referred to as a "10b-5 representation" because it is modeled on the disclosure standard set forth in Rule 10b-5 under the Securities Exchange Act of 1934.
There are numerous other more specialized credit-related representations that regularly appear in credit-related documentation. These representations cover subjects such as environmental, ERISA and intellectual property matters. In addition, individual transactions often give rise to representations that are specially tailored to address specific risks and circumstances.
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The representations made by a seller in an acquisition agreement consist of a series of statements about the target19 intended to create an accurate picture of the target on which the buyer can rely in making its investment decision. The representations serve three basic functions. First, negotiation of the representations uncovers issues that may give rise to additional price negotiations or requests by the buyer for additional protections (such as promises by the seller to remedy a problem that is disclosed by the representations). Second, if a representation is untrue, it may give the buyer the right to terminate the transaction. Third, if the buyer discovers after closing that a representation of the seller was untrue when made, it may have an indemnification claim or a claim for breach of contract against the seller.20
The scope of the representations in an acquisition agreement is typically much broader than in credit documentation, because a buyer’s need to understand all aspects of the business being acquired is much more extensive than a creditor’s need to know facts that may affect its credit decision. The primary business term in any acquisition is price, which may be affected significantly by any issues or problems relating to the target. The buyer will also have operational and management considerations that require a close understanding of the business that it intends to acquire.
A buyer’s first step in determining the necessary facts to make its investment decision and inform its pricing analysis is the completion of its own due diligence. Many representations made in the acquisition agreement force the seller to stand behind the information provided to the buyer in the due diligence process. They also tend to smoke out facts that may not have surfaced during due diligence.
The way that the negotiation of representations results in disclosure is as follows. The acquisition agreement, which is normally drafted by counsel to the buyer, will contain, for example, a representation that the target is not the subject of any litigation which could reasonably be expected to have a material adverse effect on the target. (Sometimes the material adverse effect qualifier will not be included in the first draft but will be added as a result of negotiation.) If the target does have such potentially material litigation, it cannot make this representation truthfully unless the litigation is carved out of the representation. This is typically done in the disclosure schedules that are attached to the acquisition agreement. By disclosing facts that are inconsistent with the representations in the disclosure schedules, the seller eliminates the buyer’s ability to walk away from the transaction or to bring claims for breach or indemnification on the basis of the fact that is disclosed. The risk of the disclosed information is thus shifted from the seller to the buyer by virtue of disclosure. The buyer, on the other hand, receives information that allows it to make a fully-informed investment decision and to price the deal accordingly.
Representations are often made at the time that the acquisition agreement is signed, and again at the closing. In cases where there is a long gap between these two points in time, the facts represented to by the seller may change. Accordingly, there should be a mechanism allowing the seller to update its representations so as to be true at closing. The buyer, despite its interest in knowing all the relevant facts, will not want to be forced to close after the seller has disclosed unfavorable facts between signing and closing. This is usually addressed by allowing the seller to terminate prior to closing if additional facts are disclosed by the seller; often this right is conditioned on the additional disclosure being material or resulting in a material adverse effect on the target.
The scope of a representation will dictate the amount and detail of disclosure that must be made by the seller in order to make the representation true. Consider the following two variations of the same representation made in an agreement to acquire a large chemical company:
This hypothetical target and its subsidiaries regularly run afoul of environmental requirements. Sometimes the noncompliance is immaterial—the target cures the problem by performing routine and inexpensive remediation. Sometimes the issue is material, involving potentially significant fines and remediation costs. Under the first variation of the environmental compliance representation, the seller is required to disclose all violations, material or otherwise. Although preparing such a long schedule may be more work, the seller will be off the hook for all matters that are disclosed. The buyer, on the other hand, will have gotten more information than may be useful to it. In order to understand the potential exposure resulting from these environmental issues, it must understand and analyze every item disclosed on this long schedule.
On the other hand, if the second representation is used a burden is placed on the seller to differentiate between material and immaterial events of noncompliance. The result of this is twofold. First, failure by the seller to include any material violations will result in the representation being breached. Second, the buyer’s review and analysis will be better focused, and the risk of the target’s noncompliance with environmental requirements will be shifted to the seller only with respect to those matters that are disclosed.
In addition to materiality qualifiers, the other main device used by sellers to soften their representations is the qualification that a representation is made "to the best of the seller’s knowledge." An example of this is the following:
To the best knowledge of the Seller, the Target has good, valid and marketable title to the property it purports to own, free and clear of all encumbrances.
After the closing the buyer learns of an existing easement in favor of a state agency running through the center of the target’s main operating facility, and the state’s plans to exercise its rights under the easement in connection with a road-building project. The buyer will have recourse against the seller only to the extent that it can show that the seller knew about the easement.
The use of a knowledge standard may have a negative impact on the value of the seller’s representations, and therefore is usually vigorously resisted by buyers. The issue for the buyer as to most representations is not whether adverse facts are known by the seller, but rather which party should bear the risk they represent. The use of a knowledge standard effectively shifts the risk of unknown problems from the seller to the buyer.
In a stock acquisition or a merger, the buyer will want to know that the acquired companies have all the necessary attributes of corporate existence. The language of this representation is as follows:
Each of the Target and its subsidiaries (i) is a corporation duly organized, validly existing and in good standing under the laws of its state of incorporation; (ii) has full corporate power and authority to carry on its business as it is now being conducted and to own the properties and assets it now owns; and (iii) is duly qualified or licensed to do business as a foreign corporation in good standing in every jurisdiction in which such qualification is required.
The only part of this that is likely to be negotiated is clause (iii). The impact of failing to be qualified in a particular state may be small; accordingly, this representation is often subject to a materiality qualification. Additionally, if the entity being acquired is some form of entity other than a corporation, the representation must be modified accordingly.
Note that the representation covers not only the target but also the target’s subsidiaries, as the acquisition of a target with subsidiaries results in the acquisition of the subsidiaries as well. Consider an acquisition of a holding company, the only assets of which are the equity interests in a number of operating subsidiaries. An acquisition agreement that provides for representations only as to the entity that is being directly acquired (the parent holding company) will fail to provide the buyer with comfort as to the real guts of the business. Therefore, the buyer will always want representations that cover both the target and the target’s subsidiaries.
If an acquisition results in the target’s violation of a legal or contractual requirement, the buyer may be purchasing a headache. For example, if the target has an important lease with a change of control provision that isn’t discovered by the buyer until after the closing, the buyer may find itself with a landlord that has the right to terminate or renegotiate the lease. Or, the target could be in violation of a law or order because of the transaction and as a result be facing criminal sanctions or penalties. Obviously, no buyer wants to walk unknowingly into a situation like this, and therefore the following representation is standard.
The consummation of the transactions contemplated hereby will not (i) conflict with or result in the breach of any provision of the certificate of incorporation, by-laws or similar organizational documents of the Target or any of its subsidiaries, (ii) require any filing with, or permit, authorization, consent or approval of, any Governmental Entity or other Person (including consents from parties to agreements to which the Target or any of its subsidiaries is a party), (iii) require any consent, approval or notice under, or result in a violation or breach of, or constitute (with or without notice or the passage of time or both) a default (or give rise to any right of termination, amendment, cancellation or acceleration) under, any agreement to which the Target or any of its subsidiaries is a party, or (iv) violate any order, writ, injunction, decree, statute, rule or regulation applicable to the Target, any of its subsidiaries or any of their properties or assets.
The buyer will probably require, as a condition to closing, that the seller obtain any consents that are necessary to make this representation true. Sometimes a materiality qualifier is negotiated with respect to conflicts with agreements. For example, a target that is a retailer with 500 leased locations may have a handful of leases that contain change-of-control provisions that aren’t waived. A materiality qualifier would prevent this situation from blowing up the deal.
This is an extremely important representation: the financial statements of the target are probably the single most crucial document to a buyer in making its investment decision. The representation will be similar in form and substance to that discussed above in connection with credit agreements (see section 9:3.1[A]). This representation may need to be significantly modified in the context of an asset sale or the sale of a subsidiary. If the acquisition involves all of the assets of a business that has its own financial statements, there is no issue: the seller will make the normal representations with regard to these financial statements. If, however, the assets being sold are the assets of a division or a subsidiary of a larger business, it is likely that separate financial statements with respect to the business represented by these assets will not exist. In this case, the representation will have to be tailored to cover the financial information that was actually delivered to the buyer in its due diligence. So, for example, if such financial information was not audited by accountants, no representation can be requested as to the existence of an audit.
The buyer protects itself against target problems or financial deterioration after the date of the financial statements by getting a representation that there has been no material adverse change after the statement date. Thus, if the target’s sales had fallen significantly since the period covered by the financial statements delivered to the buyer, the seller fails to disclose this as a material adverse change at its own risk.
In many cases, the effectiveness of the buyer’s due diligence will depend on the soundness of the target’s books and records (including accounting records, minute books and stock transfer records). Therefore, the seller will be expected to make the following representation:
The books of account, minute books, stock record books and other records of the Target and its subsidiaries are complete and correct in all material respects and have been maintained in accordance with sound business practices, including the maintenance of an adequate system of internal controls. The minute books of the Target contain accurate and complete records of all meetings of, and corporate action taken by, the shareholders of the Target and its board of directors and all committees thereof.
The Target and each of its subsidiaries has good, valid and marketable title to all the properties and assets that they purport to own (tangible and intangible) free and clear of all Encumbrances.
This representation will be worded differently depending on whether the transaction is an asset purchase or a stock purchase. In an asset deal, the seller will make this representation as to the assets that are being sold to the buyer. In a stock deal or a merger, the representation will be made with respect to the assets that are owned by the target and each of its subsidiaries.
A buyer is trying to mitigate two important risks by asking for this representation: first the buyer’s plans to operate the acquired assets may be impaired by a claim or encumbrance. For example, trademarks might be subject to a long-term license agreement that would prevent their use by the buyer, or an encumbrance may represent an economic cost that should be factored into the purchase price. The second risk addressed by this representation is a financial one. If, for instance, as a result of disclosure under this representation the buyer learns that a plant of the target is subject to a $1 million mechanics’ lien, the buyer will probably require either a corresponding reduction to the purchase price or satisfaction of the lien by the seller as a condition to closing.
This representation will be required in stock acquisition and merger transactions. Since in each of these transactions the buyer is acquiring the target by acquiring the target’s shares directly (or indirectly, in the case of certain mergers), it is important for the buyer to fully understand the characteristics of these shares.
The authorized capital stock of the Target consists of ______ Shares of common stock (of which ______ shares are issued and outstanding) and _____ shares of preferred stock, par value $___ per share (of which ____ shares are issued and outstanding). All the outstanding shares of the Target’s capital stock have been duly authorized and validly issued and are fully paid and non-assessable. Except as set forth above, (i) there are no shares of capital stock of the Target authorized, issued or outstanding; (ii) there are no existing options, warrants, calls, preemptive rights, subscriptions or other rights, agreements, arrangements or commitments of any character, relating to the issued or unissued capital stock of the Target, obligating the Target to issue, transfer or sell or cause to be issued, transferred or sold any shares of capital stock, or other equity interest in, the Target or securities convertible into or exchangeable for such shares or equity interests, or obligating the Target to grant, extend or enter into any such option, warrant, call, preemptive right, subscription or other right, agreement, arrangement or commitment; and (iii) there are no outstanding contractual obligations of the Target to repurchase, redeem or otherwise acquire any capital stock of the Target.
The buyer’s overriding concern is to ensure that it is acquiring 100% of the voting and economic interests in the target. This goal could be defeated if there are shares owned by someone other than the seller, if there are options, conversion rights or preemptive rights pursuant to which third parties may be able to obtain shares or if there are voting agreements relating to such shares. The existence of present or future minority shareholders may affect buyer’s view as to the appropriate value of the transaction or whether the potential nuisance of dealing with other shareholders makes the deal undesirable. The buyer will also want to know the details of any preferred or other non-voting stock, because such securities raise a potential economic (as opposed to control) issue. If the buyer expects to have the target pay dividends or make distributions to it, the existence of other classes of capital stock that would be required to share therein will be significant. Outstanding preferred stock may have dividend requirements that have to be satisfied before common dividends may be paid. The provisions of the preferred stock may give the holders thereof veto power over specified transactions or contain other contract-like provisions that may be adverse to the buyer’s interests.
Acquisition agreements contain a number of representations that are similar to, and serve the same purpose as, certain of the representations discussed above in the context of credit agreements. These include representations regarding litigation (section 9:3.1[D]), compliance with law (section 9:3.1[E]), and full disclosure (section 9:3.1[G]).
The typical acquisition agreement will also contain a number of additional representations regarding specific aspects of the target’s business. They will often be tailored to the specific transaction. These representations may cover, among other matters, the following:
In the case of efforts covenants, the court noted that qualifiers like “best efforts”, “reasonable best efforts”, “commercially reasonable efforts” and shades in between are used to define “how hard the parties have to try” to satisfy a commitment in the agreement such as obtaining regulatory approvals. VC Laster cited an ABA publication that purports to set a hierarchy among these clauses, with each prescribing a slightly different level of required efforts. However, he pointed to a string of recent cases, including the decision in Williams v. ETE, which view these standards — even when they appear in the same agreement — as largely interchangeable despite clearly seeming to suggest the parties intended a difference. In the Williams case, the court found that the “commercially reasonable efforts” and “reasonable best efforts” standards both “impose[d] obligations to take all reasonable steps to solve problems and consummate the transaction”. In another case (Alliance Data), the Delaware court said that even a flat “best efforts”, typically considered the most demanding standard, “is implicitly qualified by a reasonableness test”. A recent New York decision (Holland Loader) suggests that New York law will similarly imply a reasonableness standard regardless of which modifier is used.
A “materiality scrape” is a buyer-friendly provision often contained in an M&A purchase agreement (such as a stock purchase agreement, merger agreement, or asset purchase agreement) that effectively eliminates or disregards (i.e., “scrapes”), for specified purposes, materiality qualifiers that are present in a representation and warranty. See examples of materiality scrapes below.
Nonetheless, because the warranty to act in good faith inheres in every contract, "the relationship between ‘best efforts’ and ‘good faith,’ ‘fair dealing,’ and ‘reasonable care’ " remains unclear. Ashokan Water Servs. , 807 N.Y.S.2d at 553 ; see Travellers Int'l A.G. , 41 F.3d at 1572, 1576 ("Under New York law, the implied covenant of good faith and fair dealing inheres in every contract." (citing Van Valkenburgh, Nooger & Neville, Inc. v. Hayden Publ'g Co. , 30 N.Y.2d 34, 45, 330 N.Y.S.2d 329, 281 N.E.2d 142 (1972) ) ); 511 West 232nd Owners Corp. v. Jennifer Realty Co. , 98 N.Y.2d 144, 153, 746 N.Y.S.2d 131, 773 N.E.2d 496 (2002) ("In New York, all contracts imply a covenant of good faith and fair dealing in the course of performance.").
What is also unclear is the precise relationship between a party's obligation to act in good faith and the obligation imposed by a "commercially reasonable efforts" clause. While much case law has been dedicated to interpreting, albeit without much clarity, "best efforts" and "reasonable efforts" provisions under New York law, the opposite is true with respect to "commercially reasonable efforts" obligations. The few cases addressing "commercially reasonable efforts" clauses under New York law, however, have held that such a clause is to be analyzed objectively, not subjectively. See, e.g. , Sekisui Am. Corp. v. Hart , 15 F.Supp.3d 359, 381 (S.D.N.Y. 2014) (describing the standard for evaluating a "commercially reasonable efforts" requirement as an objective one); MBIA I , 842 F.Supp.2d at 704 ("The requirement that [the defendant] use ‘commercially reasonable efforts’ in a timely manner provided an objective standard of reasonableness rather than [the defendant's] mere subjective believe about what efforts [it] should take" to satisfy its contractual obligations. (citing Christie's Inc. v. SWCA, Inc. , 22 Misc.3d 380, 867 N.Y.S.2d 650, 653–54 (Sup. Ct. 2008) ) ).
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Here, the IP Agreement does not specify the efforts that the parties agreed would satisfy Section 6.1(b). Therefore, because the IP Agreement does not define "commercially reasonable efforts," it fell upon Plaintiff to establish the objective standard by which Defendant's efforts are to be judged, which Plaintiff did by introducing the testimony of its expert, James Humphrey. Defendant's expert, Milan Sjaus, provided additional testimony regarding the industry standard that applies. Measured against the customs in the mining industry and its own conduct in promoting its other products, FLS's "efforts" to both promote the Holland Loader products and develop the Acquired Assets fell significantly short of commercial reasonableness.
Holland also argues that the district court erred in ignoring the long-standing New York rule that "[a] person violating his contract should not be permitted entirely to escape liability because the amount of the damage which he has caused is uncertain." Tractebel, 487 F.3d at 110. But, again, this rule applies only after the existence or fact — as opposed to the amount — of damages is determined to be reasonably certain. Id. Because the district court held that Holland failed to prove the fact of damage with reasonable certainty, it never reached the question of the amount of damages. Thus, it did not err in not invoking the wrongdoer rule.
Finally, Holland argues that the district court improperly applied New York's new business rule in concluding that Holland's evidence was insufficient to establish the fact of damages. The new business rule provides that "evidence of lost profits from a new business venture receives greater scrutiny because there is no track record upon which to base an estimate." Schonfeld v. Hilliard, 218 F.3d 164, 172 (2d Cir. 2000). It "is not a per se rule forbidding the award of lost profits damages to new businesses, but rather an evidentiary rule that creates a higher `level of proof needed to achieve reasonable certainty as to the amount of damages.'" Int'l Telepassport Corp. v. USFI, Inc., 89 F.3d 82, 86 (2d Cir. 1996) (quoting Travellers Int'l, A.G. v. Trans World Airlines, 41 F.3d 1570, 1579 (2d Cir. 1994)). Holland notes that the new business rule applies only to consequential lost profit damages and that, therefore, its use here was error. FLS cites to Inficon, Inc. v. Verionix, Inc., for the proposition that the new business rule applies equally to cases involving general lost profit damages. 182 F. Supp. 3d 32, 37 (S.D.N.Y. 2016).
We need not wade into this unsettled area of New York law. To the extent the district relied on this rule, rather than merely citing to it generally, there is no error. Regardless of the application of the new business rule, the district court was entitled to make credibility determinations, and it was entitled to find that certain evidence was less probative of the fact of lost profits because the evidence was speculative, unreliable, or not factually comparable. The district court thoroughly analyzed the evidence of damages and determined that much of Holland's evidence of damage was unreliable and speculative. "If the district court's account of the evidence is plausible in light of the record viewed in its entirety, the court of appeals may not reverse it even though convinced that had it been sitting as the trier of fact, it would have weighed the evidence differently. Where there are two permissible views of the evidence, the factfinder's choice between them cannot be clearly erroneous." Anderson v. City of Bessemer City, 470 U.S. 564, 573-74 (1985). As discussed above, the district court's findings were not clearly erroneous.