Price & Prejudice - Representations and Warranties in Contracts
Why a well-negotiated representations and warranties section can save you time during due diligence and reduce the risk inherent in every transaction.
If you only had ten minutes to review a contract, and your life depends on the decision between signing it or not, I would recommend going straight to the Representations and Warranties section of the contract and that first. “Reps and Warranties” or “R&Ws”, as they are known, are basically assertions that the buyer and seller are making to each other with the knowledge that if these assertions are untrue, incorrect, or misleading, the contract is breached and the party that relied on that assertion can sue or withhold deposit money. So, naturally, this section is one of the most negotiated, drafted, edited, redrafted, and re-edited, reviewed – you get the point – sections of the contract.
(FYI: this is an excerpt from my 15-page e-guide, “Seven Ways to Better Deals”, which you can get for FREE when subscribing to my Weekly Newsletter.)
The R&Ws are the flip side of due diligence; these two concepts work together to give the transacting parties a better – and nearly full picture – of the deal. In fact, ideally, there should be no reason to conduct due diligence if all parties would agree to guarantee their promises and assertions of the facts on the ground. But, alas, few ever agree to give sufficient assurances to make the other party forgo inspection and review altogether.
Reps and Warranties introduce efficiency. It is quite expensive to sieve through bank records, corporate documents, contracts, and interview contractors who have dealt with the target business or asset being transacted. A simpler solution is to have the party who is closest to the information represent and warrant what this information means. By agreeing that something is true, the parties can then move on to other issues, and focus their finite time and resources investigating a smaller set of items. If the facts being represented to be true turns out to not to be true, the party relying on that fact being true can then seek relief either in court or as made available in the contract by, say, withholding the deposit, canceling the deal, or getting a credit at closing. The R&Ws are a great way to allocate risk for “known unknowns” and “unknown unknowns” if they are uncovered during due diligence.
Reps and Warranties are generally divided into two main categories: those that “survive” the closing, and those that don’t. What use is a promise if it can’t be referenced after the closing, some might say, but depending on market conditions, the seller of the business or asset may have leverage (say, other buyers knocking at its door), and then it doesn’t have to agree to the R&Ws surviving the closing. Insisting that the R&W survive the closing for, say, six to twelve months, may be a good way to call someone’s bluff if they refuse for no apparent reason (except, of course, the reason is that it’s untrue!).
However, it is good to remember that no business or asset has an unblemished existence. It would be a fool’s errand, at a huge opportunity cost, avoid transactions because of less than air-tight R&Ws. A good R&Ws provision is a combination of concessions on items you don’t really care about, negotiated and qualified language on items you can supplement with your own due diligence, and a few hard nonnegotiables.