Representation and Warranty

When entering the world of business transactions, particularly in mergers and acquisitions, one will frequently encounter the terms representation and warranty. These terms are fundamental components of agreements and contracts, serving as assurances from one party to another about various aspects of the business.

Representations are factual statements made by one party to another within a contract. These statements assert the current condition of the business and are used to convey information that can help the other party assess the transaction. For example, a seller might represent that their company has no outstanding legal issues.

Warranties, on the other hand, are promises that certain facts are true at the time of the contract and will remain true for a specified period following the transaction. If a warranty proves to be false, the aggrieved party may have a claim for breach of contract. For instance, a warranty might guarantee that the financial statements provided are accurate and complete.

Let's break down the concepts further:

Scope and Function:

• Representations are typically broad and cover a wide range of information about the past and present state of the business.
• Warranties are narrower and assure the condition of specific aspects of the business.

Due Diligence:

• Representations play a crucial role in the due diligence process, as they provide the basis for the buyer to investigate the business.
• Warranties supplement this by ensuring that the buyer has legal recourse if post-transaction issues arise that were not disclosed or were inaccurately represented.

Legal Implications:

• If a representation is found to be false, it can lead to a claim for misrepresentation, potentially resulting in the rescission of the contract or compensation for losses.
• A breach of warranty allows the injured party to claim damages, reflecting the difference between the value of the business as warranted and its actual value.

Negotiation and Risk Allocation:

• During negotiations, representations and warranties are heavily scrutinized and often subject to much back-and-forth between the parties.
• They serve as a mechanism for allocating risk. The seller aims to limit their scope to avoid future liability, while the buyer seeks comprehensive assurances to minimize their risk.

Disclosure Schedules:

• These are often attached to contracts to disclose exceptions to representations and warranties, providing transparency and limiting the seller's liability.

In summary, representations and warranties are not mere formalities but are critical tools for risk management in business transactions. They provide a framework within which the buyer can conduct due diligence and offer a means of recourse should the business not be as it was presented.

While representation and warranty are assurances given at the time of a business transaction, indemnity is a contractual obligation to compensate for some form of loss or damage that might occur.

Here's how they differ:

1. Purpose:
   • Representations and warranties are made to assert the truthfulness of certain facts about the business at the time of sale.
   • Indemnity is a promise to reimburse the other party for certain types of losses or damages that might occur in the future.
2. Timing:
   • Representations and warranties are concerned with the state of affairs up to and at the moment of the transaction.
   • Indemnity deals with potential future events and the associated financial implications.
3. Scope of Protection:
   • Representations and warranties provide a basis for claims if the business is not as stated at the time of the transaction.
   • Indemnity provides a safety net against future liabilities, such as lawsuits or unforeseen expenses related to the business.
4. Negotiation:
   • The negotiation of representations and warranties involves defining the scope of what is being assured and any exceptions.
   • Indemnity negotiations focus on the types of losses covered, caps on liability, and the duration of the indemnity obligations.
5. Claims Process:
   • Claims arising from misrepresentations or breaches of warranty typically involve proving that the statements were false and caused harm.
   • Indemnity claims require the indemnified party to show that they have suffered a loss covered by the indemnity provision.

In essence, representations and warranties are about the accuracy of information at the time of the deal, while indemnity is about protection from future liabilities. Both are crucial in managing risk, but they address different types of risks.

Representations and warranties are vital in business transactions for several reasons. They provide a foundation for trust between parties and ensure that the buyer has a clear understanding of what they are purchasing. Here are some key reasons why they are important:

1. Risk Allocation: They help allocate risks between the seller and the buyer. The seller discloses the business's current state, and the buyer can decide whether to proceed with the transaction.
2. Due Diligence: They are essential for the due diligence process, allowing the buyer to verify the information provided by the seller.
3. Legal Recourse: If representations and warranties are breached, they give the aggrieved party a basis for legal recourse, which can include compensation for losses incurred.
4. Negotiation Leverage: During negotiations, they can be used as leverage. A seller with strong representations and warranties may command a higher price, while a buyer might negotiate for more favorable terms based on the risks involved.
5. Confidence in Transaction: They instill confidence in the transaction, as both parties have a clearer understanding of the terms and the state of the business.
6. Preventive Measure: They act as a preventive measure against misrepresentation and fraud, encouraging honesty and transparency in the transaction.
7. Market Practice: In many industries, they are standard market practice, and not including them could be a red flag to potential buyers.
8. Insurance: In some cases, representations and warranties can be insured, which can further allocate risk and potentially smooth the transaction process.

By ensuring that all relevant information is disclosed and that promises about the business's state are kept, representations and warranties protect both parties and contribute to the overall success of the transaction.

Imagine you're trading your favorite baseball card with a friend. You tell your friend that the card is in perfect condition and that it's a rare edition. In this scenario, you're making a representation (it's in perfect condition) and a warranty (it's a rare edition). If your friend finds out the card is neither in perfect condition nor a rare edition, they'd be pretty upset, right? That's similar to how representations and warranties work in business deals.

In simple terms, representations and warranties are like promises made when a business is being sold or merged. The seller tells the buyer all about the business—things like how much money it makes, if there are any legal issues, or if all the equipment works. If any of these promises turn out to be untrue, the buyer can ask for money back or even cancel the deal.

They're super important because they make sure everyone is honest and that the buyer knows exactly what they're getting. It's like having a rulebook for the trade to make sure no one is cheating. This helps people trust each other and makes sure the deal is fair for everyone.

Shami, A. Z. A. (2021, October 13). Representations & warranties in contracts. https://www.linkedin.com/pulse/representations-warranties-contracts-aurang-zaib-ashraf-shami

Sarah. (2023, June 5). Warranties v Indemnities – considerations and differences - Clarkslegal LLP. Clarkslegal LLP. https://clarkslegal.com/insights/articles/warranties-v-indemnities-considerations-and-differences/#:~:text=An%20indemnity%20is%20a%20promise,are%20recoverable%20under%20an%20indemnity.

Pllc, H. +. G. (2024, February 7). The importance of representations and warranties. Holmquist + Gardiner. https://www.lawhg.net/news-and-insights/2019/10/8/the-importance-of-representations-and-warranties-in-contracts-and-negotiations