In every M&A transaction, the primary agreement contains representations and warranties (often referred to as “reps and warranties” or simply “reps”) from each party to the other. These statements cover past, present, and sometimes future facts regarding the business, assets, liabilities, properties, condition, operations, and prospects of the party making the statements, the target company, or relevant assets and liabilities. Reps and warranties can be extensive, often encompassing 15 to 30 pages of a transaction agreement, including text incorporated by reference from the Definitions section.

WHY ARE REPRESENTATIONS AND WARRANTIES SO IMPORTANT?

1. Disclosure

Reps and warranties provide crucial disclosures from one party to the other, particularly where there is an informational advantage. These disclosures extend the due diligence process and help mitigate informational asymmetries. Often, drafting these reps and warranties leads to significant discoveries that can alter the deal’s value proposition.

2. Walk Rights

Representations and warranties can form the basis of a party’s right to terminate the deal before closing. If there is a gap period between signing and closing, the principal transaction agreement will include conditions precedent that must be satisfied or waived before consummation. If reps and warranties are not true at closing, the non-breaching party typically has the right to terminate the transaction.

3. Risk-Shifting

Reps and warranties, along with indemnification rights, serve as a mechanism for shifting risk. Inaccuracies in reps and warranties may entitle the other party to monetary compensation for associated losses. This risk-shifting function is especially important in private M&A deals, providing buyers with comfort and certainty, enabling more accurate deal pricing and post-closing planning.

4. Discipline

The possibility of termination or compensation for breaches incentivizes parties to ensure their reps are true. This means parties will work diligently to comply with representations about good standing, authorization, and absence of conflicts, leading to a more solid and reliable transaction foundation.

COMMON SUBJECTS OF REPRESENTATIONS AND WARRANTIES

Reps and warranties can cover a broad range of topics, including:

• Organization and good standing
• Authority and enforceability
• Capitalization and ownership
• Financial statements
• Absence of undisclosed liabilities
• Assets and real property
• Intellectual property
• Material contracts
• Tax matters
• Employment and labor
• Compliance with laws
• Legal proceedings
• Insurance
• Brokers and finders fees

BUYER REPRESENTATIONS AND WARRANTIES

Buyer representations and warranties often mirror those of the seller if the purchase price includes stock. Otherwise, for cash transactions, they are limited and typically cover:

• Organization and good standing
• Authority and enforceability
• Absence of conflicts
• Governmental consents
• Legal proceedings
• Investment intent
• Financing
• Brokers and finders fees

FACTORS INFLUENCING REPRESENTATIONS AND WARRANTIES

The configuration of reps and warranties depends on several factors, including:

• Transaction structure (stock vs. asset purchase)
• Public vs. private deal status
• Scope of due diligence
• Specific issues identified during diligence
• Industry of the target company
• Current market practices
• Parties' past practices and preferences
• Allocation of post-closing risk
• Availability of representations and warranties insurance
• Buyer’s need for deal optionality
• Relative bargaining power
• Definitions of pervasive qualifiers (e.g., “knowledge,” “material”)
• Complexity and cost considerations
• Whether the buyer’s or seller’s lawyer drafts the initial agreement

CONCLUSION

Representations and warranties are a critical component of M&A transactions, serving multiple functions from disclosure to risk management. Understanding their importance and the factors influencing their content helps both buyers and sellers navigate the transaction process more effectively, ensuring a smoother path to closing and beyond.

Disclaimer: This blog post is for informational purposes only and does not constitute legal advice. Consult with us for specific guidance.