Traditionally representation and warranties are referred to as a single grouped concept wherein most tend to view them as synonymous terms. However, the two terms are separate and distinct from each other having different characteristics and hence different remedies under law. Understanding the differences between them and using them appropriately is essential to ensure that the right remedies are attached to the right terms in an agreement. And also to ensure that non-lawyers who are involved in the negotiation and implementation of the agreement have a clear understanding of the repercussions of these provisions.
Representations are statements of past or present fact or circumstance. Essentially a fact or circumstance that the party inducing the other states is presently true, and/or has been true in the past, which statement is the premise on which a contract has been entered into. Hence, representations are considered sanctimonious to the agreement and a breach thereof provides the non-breaching party with multiple contractual or legal remedies including seeking that the agreement be held void or invoking indemnification rights for the losses incurred pursuant to such misrepresentation etc.
Section 18 of the Indian Contract Act, 1872 (“Act”) defines the term misrepresentation. “Misrepresentation” means and includes—”
(1) the positive assertion, in a manner not warranted by the information of the person making it, of that which is not true, though he believes it to be true;
(2) any breach of duty which, without an intent to deceive, gains an advantage of the person committing it, or any one claiming under him, by misleading another to his prejudice, or to the prejudice of any one claiming under him;
(3) causing, however innocently, a party to an agreement, to make a mistake as to the substance of the thing which is the subject of the agreement.
Further, the Act provides for consequences in case of misrepresentation. Section 19 of the Act states that in the event an agreement has been entered into by coercion, fraud or misrepresentation, the aggrieved party has the following remedies:
- The contract shall be voidable at the option of the aggrieved party.
- The aggrieved party may require specific performance and seek restitution for unjust enrichment by the other party.
However, it must be noted that the power to avoid a contract is not an unfettered right and section 19 of the Act provides for an exception to the general rule, i.e., that if misrepresentation or fraudulent silence is capable of being discovered by ordinary diligence by the aggrieved party, then the contract cannot be avoided by the aggrieved party.
Warranties are statements of current and future condition. It’s a contractual stipulation that a condition (quality) is, and/or will be, true for a period of time (often the term of the agreement). An example of a warranty is “the software licensed hereunder conforms in all material respect to its documentation.” This is a statement of current and future condition. The statement may be true at the time the warranty is made, but may be breached during the course of the agreement (e.g., if a maintenance release breaks something). In the event of a breach of warranty, the non-breaching party may be entitled to damages resulting from the breach, and in many cases a contract will provide for specific remedies in connection with a breach of warranty (e.g., commercially reasonable efforts to repair). However, unlike a representation, a breach of warranty does not make the contract voidable at the option of the aggrieved party.
In the Indian context, the term “Warranty” is a stipulation, collateral to the main purpose of the contract and the breach of which gives rise to a claim for damages but not a right to reject the goods and treat the contract as repudiated as per the provision of Section – 12 of the Indian Sale of Goods Act, 1930 (“SGA”). The extent of coverage of warranty differs from case to case.
Warranties may be generally express in nature, but there are certain implied warranties under the SGA. For instance, that a buyer shall have a quiet possession of goods, goods are free from any charge or encumbrance, quality and fitness, merchantability of goods etc. Here the warranty should cover all the identified risks but the extent of liability and time limit for claiming losses should be set.
In order to enable a claim for damages a direct nexus between the claim and liability under the warranty clause should be established. Further, while it is necessary to show a breach of warranty and consequential loss to seek damages, but, as has been stated above, the contract cannot be repudiated on the aforementioned grounds.
REPRESENTATIONS AND WARRANTIES IN MERGERS AND ACQUISITIONS
While risks form an integral part of transacting any business, the nature and quantum of risks increase manifold while conducting a M&A transaction. Regardless of the deal structure, the basic transaction documents typically contain representations and warranties of the buyer and the seller to one another, which set forth the basic assurances of a party that certain facts are true and may be relied upon when entering into the transaction. The transaction agreement’s representations and warranties memorialize the condition of the business (typically, the target) and the instrument (shares, debentures etc) at the time of execution and hold the representing party accountable for the accuracy of those statements. Hence, representations and warranties are used as a contractual tool for allocation of risks in a M&A transaction.
The process of drafting the terms of the representations and warranties in a M&A transaction involves several rounds of negotiations from the side of the buyers and the sellers. The buyers seek as many representations and warranties as they deem necessary to minimize their risks, while the sellers seek a seamless exit with as less liability as possible. When negotiating such transaction agreements, typically the target company wants representations and warranties “narrowly drawn” — that is, limited to just a few specific issues. Conversely, the buyer company requires the representations and warranties to be “broad and flat”— that is, general language that’s designed to cover as many potential issues as possible.
Inaccurate representation / warranty stipulation may not necessarily lead to consequences under Section 19 as detailed above even if such inaccuracy follows the three tests / ingredients laid out in Section 18 to cause a misrepresentation or is patent breach of warranty. Hence, contractual protection in this regard is necessary and is often sketched out in great detail through indemnities, liquidated damages and right to terminate the contract. This would of course depend on the negotiating power of the parties. In a contract pertaining to telecom companies, the breach of a representation / warranty pertaining to the license to do telecom business may require the seller to provide liquidated damages to the entire extent of the consideration being paid by the buyer, as such a warranty is fundamental to the acquisition. However, no specific remedies may be provided in relation to breaches pertaining to non-payment of stamp duty / expiry of certain lease agreements as these may not be essential to the core business.
What to expect to cover under R&W
R&W fundamentally cover statements pertaining to the past, present and future relating to the financial and operational aspects of the target and also its promoters. R&W act as a protective shield by giving the aggrieved party a right to terminate the contract prior to its closure in the event such R&W is found to be untrue at a later time. In most cases where such discovery may be made post-closure of the transaction, it would ordinarily provide a ground for the aggrieved party to make claims of indemnification. In some cases, the buyer /investor may withhold a portion of the consideration or require a pledge of the promoter’s shares to secure such indemnification obligation as well.
Qualifications to a Representation / Warranty Stipulation
Representations and warranties are often qualified in whole or in part by materiality, and actual or imputed knowledge standards.
The materiality qualifier is significant from the seller’s point of view. The seller includes the “materiality” qualifier which allows for potential changes to a statement if such a change does not significantly affect the business or the assets of the company. This qualifier prevents the buyer from walking away from the deal before closing or from indemnity claims post-closing on the grounds of an inaccurate or untrue statement. There are many ways of stating the materiality qualifier. One such way is to include it in disclosure schedule with the qualifier that “all material contracts are listed in the schedule”. Another application is during the submission of the documents for due diligence to the buyer where only insignificant contracts with having no impact on value are not included. The question regarding such qualifiers is the way in which “materiality” is defined. This would be relevant where the work involved for the target in ensuring that the representation as provided is correct and where carve out of those items that are minimally relevant can in fact be made. For ex: Contracts.
Another materiality threshold is expressed in terms of the value of the object regarding which representations are being made. For eg: “Litigation against the company which involves a claim of over Rs. X”
There are different approaches deployed by the buyers and the sellers when negotiating an agreement for mergers and acquisitions. One such is by qualifying the representations and warranties to the best of its “knowledge”. This shall allow the target company to limit the burden of the requirement of doing a diligence process to ensure that the representations / warranties being provided are in fact accurate. On the other hand, the seller company will desire to limit the extent of such qualifiers to ensure that as many issues as possible shall be covered.
Subsequently, the negotiations in the mergers and acquisitions process will be fixed on defining the scope and the extent of the seller’s knowledge. The knowledge in the case of buyers can include “specific knowledge” or constructive” knowledge. It may also be essential for the parties, and especially the buyer to determine the scope of the “knowledge group” to be construed in context. ‘Knowledge group’ includes the people who are involved or whose knowledge it is essential to determine the knowledge that the parties have. It is often prudent to include all shareholders in the knowledge group in case of small, closely held corporations. However, when the seller is a large company with multiple operational functions, specific individuals might be included as to areas—e.g., including the seller’s human resources director as to the employment and HR representations only, the risk management director with respect to insurance, etc.
While representations and warranties are customarily stated in broad, general terms, the disclosure schedules annexed to the agreement identifies exceptions to the representations and warranties made. Thus, a party may represent that there are no pending litigations for the entity save as disclosed in the disclosure schedule. Hence, the representation made pertaining to the pending litigation shall be subject to the specific disclosure made under the disclosure schedule. An incorrect or incomplete disclosure schedule could result in a breach of the transaction document and potentially significant liability to the selling company or its shareholders. A well-drafted disclosure schedule will provide substantial protection against post-closing allegations that the selling company breached its representations and warranties.
Representations and warranties are protective clauses intended to shield a party to the contract from any misgivings in relation to such transaction. Representations and warranties act as contractual tools for diluting the risk factor in a transaction besides allocating the risks in the transaction. Generally, it is in the interest of a buyer to include various representations and warranties in the contract, however, the strength of such clauses is dependent upon the bargaining power of the parties. These clauses come into the forefront when the transaction falls apart since the rights of each party against the other arises out of the representations and warranties and the remedies are dependent on the indemnity provisions. Hence, it is crucial to carefully analyse the factual aspects of the contract while drafting these clauses and / or the disclosure schedules.
Each transaction, depending on the sector of the target would come with its attendant issues / challenges in relation to identifying adequate representations / warranty stipulations on the part of the investor or buyer. Translation of due diligence findings into the transactional documents along with a deep understanding of the relevant sector and its functions assumes great importance in this context. Further tying up the consequences of breach of the material representations and warranties also assumes importance while drafting transactional documents.