Warranties & Representations: The International Perspective

Transcript

Introduction – Denis Philippe – Interleges President

I am very happy to introduce this seminar. Interleges is an exceptional network of highly competent lawyers, and it is important to reinforce the links between all our members. It is also important to exchange ideas on topics we practise almost every day, such as warranties and representations. The approach to warranties and representations differs significantly from one country to another, which is exactly why a group of members from all over the world can contribute to a better understanding of these concepts.

A number of people will speak today from all over the world, and we will begin with the mother country of law itself: English law. I will give the floor to John North.

Warranties and indemnities in M&A transactions: the English law perspective

John North – RWK Goodman

Welcome, everybody, to the webinar. I have not been described as coming from the mother country before, but I suppose it is some sort of compliment. Certainly, England is the origin of the common law. My presentation, as you will see, is titled Warranties and Indemnities in M&A Transactions. That is what I do, and I will speak from a common law perspective, particularly an English law one. There are other common law lawyers on the call today, including from Ireland, India and the United States, and they will offer their own perspectives, because things differ between jurisdictions.

You will notice I have not mentioned representations in the title, and that is deliberate. Although warranties and representations are often rolled together colloquially, under English law they are quite different things, and it would be too large a topic to cover today. Representations have both a common law and a statutory basis under English law, giving rise to different remedies depending on whether the misrepresentation is fraudulent, negligent or innocent, and a different way of calculating damages. That is a subject for another day.

Why warranties are needed

So why do we need warranties in a share purchase agreement or business acquisition agreement? The starting point under English law is caveat emptor, or “let the buyer beware”. There is very little statutory or underlying protection for a buyer of shares, so when a buyer acquires a company, it needs to know exactly what it is acquiring, including all of that company’s history, its liabilities, its existing contracts and its historic tax liabilities. To mitigate that risk, a buyer will first carry out due diligence, asking questions to find out about the company, and will then seek contractual protection in the form of warranties and indemnities in the acquisition agreement.

What warranties cover

Warranties, under English law, are contractual statements or assurances given by a seller concerning various matters relating to the target company or its business. In English practice they are usually contained in a separate, detailed schedule to the acquisition agreement, and in reality, they form the great bulk of the agreement. Warranties usually speak as at the date the acquisition agreement is entered into, unless there is a gap between signing and completion, typically because a condition such as merger control consent has to be satisfied first.

If the warranty terms prove incorrect or untrue, the buyer will have a claim for breach of contract, unless the facts giving rise to the breach were fairly disclosed (the threshold is usually sufficient detail to enable a buyer to make an informed assessment of the matter disclosed) by the seller. The main purpose of a warranty is therefore to provide the buyer with a remedy if the statements later prove incorrect, and also to serve as an information-gathering exercise: warranties often call for the seller to provide information so the buyer can build a full picture of the target company.

The warranty schedule covers common areas such as the due incorporation of the company, its constitution, its compliance with laws and regulations, its accounts and financial position, and its assets, including land, intellectual property, information technology and employees. The areas of focus shift over time: environmental warranties were once heavily emphasised and remain relevant, though with less prominence; anti-bribery compliance is well established; and we are currently seeing a trend towards warranties on ESG (environmental, social and governance) practice and, particularly on international acquisitions, human rights.

The disclosure letter

Alongside the warranty schedule, the seller will want to carry out its own disclosure exercise to protect itself from warranty claims and will prepare a disclosure letter. Despite its name, this is often the longest document in the whole suite of transaction documents, comprising the letter itself together with a bundle of supporting documents and information.

The disclosure letter is generally in two parts:

General disclosure covers matters in the public domain that the buyer should be aware of, for example information on the target company’s Companies House file.
Specific disclosures draw the buyer’s attention to particular issues that do not comply with the warranties given, for example an existing litigation claim where a warranty states there is none.

Where matters are fairly disclosed in the letter, the buyer will not be able to bring a claim in respect of those matters. A thornier issue under English law concerns buyer’s knowledge outside the disclosure letter, whether actual knowledge (things the buyer itself knows), constructive knowledge (things a buyer ought reasonably to have known) or imputed knowledge (things its advisers, such as lawyers or accountants carrying out due diligence, may know). Case law suggests a buyer who knows of a breach of warranty before entering into the agreement will not be able to claim in respect of it, but the position is not definitively settled and it will depend on the facts of each case and the wording in the share purchase agreement. Buyers will typically include a saving provision in the share purchase agreement to seek to preserve the buyer’s right to claim notwithstanding actual, constructive or imputed knowledge outside the disclosure letter.

I think there remains a real question mark over the actual knowledge element in particular. It would be difficult for a buyer to claim where it is effectively creating its own loss, and if a buyer becomes aware of something through formal disclosure or its own due diligence, it should seek protection through an indemnity (or even negotiating a purchase price reduction if the matter is sufficiently significant) instead.

Remedies and indemnities

The remedy for breach of warranty is damages on a contractual basis. The buyer will never recover pound for pound: damages are limited by remoteness, must flow naturally from the breach, and must have been within the parties’ contemplation when they entered into the contract. The aim is to put the buyer into the position it would have been in had there been no breach, so the quantum of damage is assessed by reference to the diminution in value of the target as a result of the breach. Where there is more than one seller, warranties are usually given on a joint and several basis, so the buyer can recover the whole loss from one seller or from all of the sellers together.

As an alternative to warranties, a buyer aware of a specific issue that could give rise to a claim should seek an indemnity in the share purchase agreement instead, allowing recovery on a pound-for-pound, or dollar-for-dollar, basis.

Limitations on liability

The share purchase agreement will also contain provisions limiting liability, such as:

time limits within which the buyer can bring a claim,
financial limits, which may cap the total claim at the purchase price, and we do see trends towards setting that cap lower,
and the exclusion of small claims that would not be commercially worthwhile to bring and would waste both parties’ time.

That is a very quick run-through of a very large subject. I will leave the comparison between UK and US practice to our colleagues from the United States, who can point out where their experience differs from mine.

I will now hand over to Elaine McGrath in Dublin, to give the Irish perspective.

Warranties and representations under Irish law

Elaine McGrath – Reddy Charlton

Thank you, Denis and John. From the Irish perspective, the position mirrors the UK in all material respects, so rather than repeat what John has covered, I want to highlight a few issues that have been litigated, as a warning about the risks of imprecise drafting. These cases inevitably turn on their own facts, but they show where things can be overlooked if you are not careful.

Valuation of warranty claims

The standard principle is that the loss of bargain is assessed by reference to the difference between the value of the shares as warranted, that is, on the basis that all the warranties were true, and the value of the shares as is, reflecting the breach that has come to light. The as-warranted price is generally taken to be the price paid, though that is not always the case.

In Cardeman and McAllister, the court heard that the parties had entered the SPA knowing the price did not represent the shares’ real market value, for reasons including the need to complete quickly and the use of cash consideration. The court held that the as-warranted price was in fact higher than the purchase price, meaning the buyers were entitled to recover in excess of what they had paid. The SPA did include a number of limitations, including a cap on recovery at the purchase price and a de minimis excluding the first £500,000 of any claim, but because the as-warranted price exceeded the purchase price, the buyers were still able to recover the full purchase price.

Warranties versus representations

As John said, representations are a whole separate area, but it is worth mentioning that they are often added on to try to bolster a claim for breach of warranty. The first draft of an SPA will often provide that the sellers “warrant and represent”, and the seller’s solicitor will typically seek to strike out the reference to representations. That does not stop a claimant trying to rely on it later. The courts have held that as long as warranties are clearly labelled as warranties, they will not be construed as representations, unless the parties have specifically provided that they are both warranties and representations.

It is therefore important to keep the wording clear, since a whole separate set of remedies becomes available if a statement is construed as a misrepresentation. It is also standard, and important, to exclude reliance on any pre-contractual representations, confirming the parties are relying on nothing outside what is expressly set out in the contract. The courts will uphold such provisions, keeping any claim within the four corners of the agreement.

Notification of claims

The formalities around notifying a claim have been heavily litigated, and it is important to review those provisions carefully and adhere to them strictly. In one case, a claim required notice “as soon as possible” and, in any event, no later than a long-stop date. Notice was given before the long-stop date but was not given promptly, and the claim failed for want of compliance with that formality. Notice provisions will also usually require reasonable detail of the circumstances giving rise to the claim; general language such as “we are looking into some irregularities” has been held insufficient where it does not set out what those irregularities actually are. A more recent case has said that such language should be interpreted in light of the commercial purpose of the provision, so it does not become divorced from the merits of the underlying claim.

Buyer’s knowledge

Finally, on the question of buyer’s knowledge that John raised, the courts have upheld the position that actual awareness of a breach will preclude a claim. Imputed awareness remains an open issue. It is always better to cover this off expressly in the contract, where possible.

What if a seller doesn’t disclose an obvious defect?

Stefano De Bosio: John mentioned that if a buyer is aware of a breach of warranty, it will not easily be indemnified under English law or by the English courts. My question is whether that also applies where the defect was not formally disclosed but would have been easy to detect: an obvious defect. Has that been addressed in case law?

Elaine McGrath: The case I am referring to involved a buyer with actual knowledge. As John said, imputed knowledge, on the basis that something is well known and therefore must have been known, is not so clear-cut. It is always better to deal with this expressly in the contract.

Stefano De Bosio: But what if the defect is rather obvious and evident, yet was not formally disclosed?

Elaine McGrath: I am not aware of a definitive decision in that type of scenario, so it remains unclear.

John North: I think the position is the same here. There is relatively little case law on this specific issue. Most matters settle without going to court, and where they do reach court, judges tend not to give a definitive ruling on this point, offering only informal comments that carry no binding weight. The important thing is that if a buyer is aware of something, it should seek an indemnity rather than rely on the warranty, since it is unlikely to be able to do so.

Warranties and representations under Italian law

Stefano De Bosio – Studio Legale de Bosio & Vecchione

Since most of those attending today were also at our Dubai AGM, I will not repeat what I said there, and will pick up from the point I raised earlier. Under civil law, and Italian law specifically, there is a significant difference depending on whether a breach or defect was obvious or difficult to detect: a hidden defect that was not, or could not easily have been, detected on sale, as against something that anyone with reasonable skill would have detected.

Obvious defects

Where a defect is obvious, either a mandatory provision excludes any warranty on it, so an attempt to warrant it would not be valid, or the parties could in theory address it by specific agreement, though in practice that makes little sense: a specific agreement about something obvious is unlikely to happen in reality. Where the defect is obvious, we have a mandatory rule that the buyer must notify it within eight days of the sale, or the right to claim is forfeited. That period can be extended by agreement, for example to thirty days, though the validity of a very long extension would be questionable.

Hidden defects and time limits

Where a defect is discovered later, civil law again imposes strict time limits: under Italian law, notification must be given within eight days of actual discovery. There is then a statute of limitations of one year from the sale, which is mandatory and overriding, and cannot be changed by agreement. It is therefore often questionable whether an express warranty can be enforced more than one year after the sale, absent a prior claim, since civil law takes the view that obligations should not last indefinitely.

This one-year limit should not, in principle, apply to a properly drafted indemnity. As John explained, an indemnity is a distinct, specific obligation on the seller, and our courts would not normally treat it as subject to the same time limit as a warranty. In practice, though, it is often unclear whether a particular provision is an indemnity or a warranty.

Convergence with the Anglo-Saxon approach

In summary, civil law gives a limited, implied protection to the buyer under the civil code, and specific drafting is generally unnecessary, except in relation to the eight-day notification period. Under Italian law, however, we have seen a development towards an Anglo-Saxon approach for the sale of company shares, because the implied legal warranty in a share sale extends only to the share itself: whether it exists, is valid, and represents a certain amount of equity, whether nominal or as a share of net asset value.

Beyond that, in a share sale as opposed to an asset sale, the system of implied warranties simply does not work, so practitioners began drafting contracts in a similar way to the Anglo-Saxon tradition. A buyer of an entire share capital wants far more than a warranty as to the existence and validity of the transfer; it wants warranties on the substance of the underlying assets, which becomes particularly complex for intellectual property, for example the validity of patents and trademarks. That development has certainly narrowed the distance between the civil law and Anglo-Saxon systems.

Warranties and representations under French law

Chiara Botta – MBG & Associés

In a few words, as we are running short on time: in France, the position is very similar to common law practice. Everything must be limited to what is stipulated in the contract, except in the case of fraud, so precision in drafting is essential.

I would say the main difference is the level of financial limits. In France, the seller’s liability is in most cases limited to thirty to forty per cent of the sale price, except in the event of fraud, and in any case the compensation will not exceed the sale price, which can be a problem where the price is symbolic or low. That is the main difference, and it is rather more flexible than the Italian position, for once.

Warranties and representations under Portuguese law

Luis Leitao – Antonio Leitão e Carlos Serafim

Thank you, Denis. The most common position among Portuguese legal writers is that the Anglo-Saxon structure of representations and warranties is radically different from what exists under Portuguese law, including the underlying concept of obligation in our civil law. If the fact assured by a warranty does not exist, or is not true, that non-conformity gives rise only to an obligation binding the party that gave the warranty. A warranty is not itself considered an obligation, but a specific statement about the existence or veracity of a fact, which has caused difficulty in applying these concepts where international contracts governed by Portuguese law include such clauses.

Where a representation in the contract is false, that constitutes an error as to the reason for the contract, on the basis that the parties agreed the reason was essential, and the contract may be annulled on that basis, under Article 252 of the Portuguese Civil Code. Where there is negligence or intent, the party may also be subject to pre-contractual liability under Article 227 of the Civil Code.

A breach of warranty, by contrast, does not entitle the other party to terminate the contract, only to compensation for losses and damages, since a warranty is not treated as an essential provision. The one exception concerns sales contracts: non-compliance with a warranty as to the quality of the thing sold is treated in Portuguese law as an undisclosed defect, which does entitle the buyer to annul the contract. However, the buyer must communicate discovery of the defect within thirty days of discovering it, and within six months of delivery, extending to one and five years respectively for certain categories of property. The only exception is fraud, in which case the contract can be annulled without any need to notify.

In short, the common view among Portuguese legal writers is that it is very difficult to reconcile English-language representations and warranties clauses, which are increasingly common in international share purchase agreements governed by Portuguese law, with a legal system based on obligations rather than statements or facts.

Warranties and representations under Belgian law

Denis Philippe – Interleges President

Thank you, Luis, that was very interesting, and there are clearly some similarities alongside the differences with English and Portuguese law. I will be brief and cover a small presentation of my own.

As mentioned, in English law a “warranty” is a limited obligation, collateral to the main purpose of the contract. In our law, warranty is often translated as “guarantee”, because the words are similar, but this is a false friend: a guarantee is in fact the highest level of obligation under our law, which is the opposite of what is intended. To avoid this, warranty is now increasingly translated instead as “attestation”, reflecting a lesser obligation. Even so, there was an important case (reportedly decided on 18 June, year to be confirmed) in which the court translated warranties directly as guarantee, so real care is needed here.

A representation, by contrast, is something outside the contract: a statement that can induce the other party into a false belief and induce them to enter into the contract. That might suggest representations carry a very limited obligation, with no contractual liability. But where a Belgian contract includes “warranties and representations”, the impression given is of a top-level obligation. That is quite different in substance, and it is important to understand, particularly coming from a civil law background, because these contracts originate in the common law world, and there is still real confusion between French civil law countries and common law countries on this point.

The last point is good faith, which is fundamental in our law. If a contract includes warranties and representations but the seller forgets to include a warranty on, say, the absence of litigation, and that litigation turns out to be significant, English law would say liability is limited to what is expressly warranted, and since litigation was not mentioned, there is no liability. Under our law, based on good faith, the seller could still be held liable for something significant, even though it was not expressly warranted. Loyalty, in English law, is confined to a very narrow set of contracts, but in civil law it is a much broader concept, and that difference can change everything. This is why real care is needed in the interaction between civil law and common law on this point.

Warranties and representations under Turkish law

Zeynep Yagmur – Ictem Legal

Thank you, Denis. John and Elaine wisely noted that reps and warranties are two distinct topics, and I fully agree, so given the limited time I will focus on three points.

Share deals and asset deals

The first is the distinction between a share deal and an asset deal, because it also affects the distinction between representations and warranties. In an asset deal, the defect provisions applicable to the sale of immovable property apply; in a share deal, only breach of contract and defects relating to the share certificates themselves are relevant. Under Turkish law, where the transaction is a full transfer of shares, or a transfer of shares conferring control over the company, it is treated as an asset deal for this purpose, and that same distinction carries through to how representations and warranties are treated.

Statute of limitations

There are two main legal differences between representations and warranties. The first is the statute of limitation. For representations, it is two years unless otherwise agreed, and as a matter of market practice, particularly when acting for a purchaser, we usually try to extend it, for example to a minimum of five years for tax representations, to keep the seller liable for a period covering the legal responsibility period before the transfer. For warranties, by contrast, the statute of limitation is ten years. This difference stems from the underlying legal basis: a representation is treated as relating to a movable asset, so the defect provisions and remedies apply, whereas a warranty falls under the general provisions on breach of contract, entitling the purchaser to compensation. For representations, the available remedies are given to the purchaser as alternatives, so which route is more advantageous depends on which side you are acting for.

Due diligence findings and seller liability

The last point concerns the relationship between due diligence findings and the seller’s responsibility. Since representations are treated under the defect provisions, we need to look at the link between defects already known to the purchaser through due diligence and the seller’s liability. The general rule, as most of today’s speakers have also said, is that if the purchaser conducted due diligence and became aware of defects before closing, the seller will not be liable for those known defects.

A further point, raised earlier by Stefano, is what happens where a defect could have been identified through reasonable inspection: in that case the seller is generally deemed not liable, unless the seller explicitly represented that no such defect existed, in which case the seller remains liable. I am not certain how English law treats reliance on actual or implicit knowledge in this context, but under Turkish law, and consistent with the good faith principle Denis mentioned, the majority of precedent holds that a seller is not liable for defects already known to the purchaser, even where the seller explicitly represented otherwise, although this remains a debated point under Turkish law.

Warranties and representations under Indian law

Riju Jamwal – JRD & Partners

Good evening, Denis, and hello to everybody. Much has already been said about common law that is relevant to India, given how closely connected we are to UK law. Our contract law is governed by the Indian Contract Act 1872. There is no statutory definition of warranties and representations as such, but a substantial body of case law has developed over time, and it plays an important role in contractual relationships, not only between companies but across the range of transactions that take place in India.

One principle that is very consistently followed concerns compensation where an indemnity is given: we apply a principle of unjust enrichment, meaning that compensation granted on a breach of warranty or representation is always limited to the extent of the actual loss, plus perhaps a measure of interest. A party cannot be enriched by seeking compensation, and that principle is very much followed in India.

The Contract Act does not define representation, but it does define misrepresentation, which plays a significant role in shaping contracts. Broadly, misrepresentation covers:

a positive assertion of a fact that is not warranted by the information available to the person making it, though that person believes it to be true;
a breach of duty by a party, without intent to deceive, that nonetheless gives that party an advantage by misleading the other party to its prejudice;
and, thirdly, innocently causing the other party to make a mistake as to the substance of the subject matter of the agreement.

There is a well-known example from an old case, decided by the Orissa High Court in around 1960, and followed in many high courts since, including by the Supreme Court. A forest contractor had marked certain trees for felling and, based on their external appearance, stated they were in good, saleable condition. When felled, the trees were found not to be saleable, having termite damage that was not visible externally. The court held there was no misrepresentation, because the contractor’s statement had been made after a reasonable external inspection, which amounted to his own due diligence, and that innocent misrepresentation does not void a contract unless made without reasonable grounds.

That principle, that misrepresentation requires an assertion or breach of duty made without intent to deceive, and that intent to deceive instead constitutes fraud, has been followed consistently since. The consequence is that the wronged party is compensated to the extent of its loss, or restored to the position it would have been in had the contract not been entered into.

In most cases in India, a representation is followed by a warranty, and if the warranty is breached, an indemnity automatically arises. Indemnity is defined categorically under Section 124 of the Contract Act, which sets out the entire framework for how, and to what extent, compensation is to be granted, and it is applied across India in cases involving breach of warranty.

Warranties and representations under United States law: an overview

Jay Taylor – Anderson Kill

Thank you very much, and thank you for the opportunity to speak to the group. We can debate whether the United States is the most important nation, but it is certainly one of the most complex. I will speak briefly, and my colleague Carrie will talk in more detail about Delaware law and insurance.

There are significant similarities in how reps and warranties are drafted and interpreted, but that is largely where the similarities end. The US legal framework relies heavily on the written contract and on detailed analysis of the underlying transaction. Part of what makes this jurisdiction unique is federalism: power is divided between federal and state law, and the two are sometimes in conflict, which makes for an interesting patchwork. Within the states, reps and warranties are further shaped by:

the common law,
by equitable remedies,
and, in some states, by statutory remedies.

That is why there is such heavy reliance on precise contract drafting, taking into account, even from an extraterritorial perspective, where the buyer and seller are located and which law applies.

Briefly, the key components of reps and warranties in the US are:

to encourage the buyer to gather information and learn as much as possible about the seller, supporting an informed decision by both parties;
to set out explicitly the framework for remedies and the course of action available;
and to protect the buyer, including by providing options to cancel or renegotiate the contract.

I will pass over to Carrie, who will speak about representations and warranties insurance and Delaware law.

Representations and warranties insurance, and Delaware law

Carrie Dicanio – Anderson Kill

Thank you, Jay, and thank you all for having us. As you know, we are both at Anderson Kill. I am a partner managing our Colorado office, so if you are ever out that way, please look me up. My specialty is representations and warranties insurance, which overlaps substantially with general M&A law, generally governed, as Jay mentioned, by Delaware law. I will highlight a few points I noticed are different between the US and some of the jurisdictions represented on the call today.

Sandbagging

John North mentioned that under English law, if the buyer has knowledge of an issue that is represented to be otherwise in the contract, that can prevent recovery. Delaware, by contrast, is what is known in the United States as a pro-sandbagging jurisdiction: even if the buyer knows of an issue that is represented to be otherwise, the seller is explicitly treated as assuming the risk of that representation being breached, even if the buyer knew about it. That is a point worth being aware of.

Calculation of damages

The other interesting point follows on from Elaine’s discussion of the measure of damages in Irish breach-of-contract disputes over reps and warranties. In the United States, the central issue is the calculation of damages following a breach of a representation, and this comes up frequently in insurance, because often the biggest dispute is how to calculate the buyer’s loss. Under Delaware law, the big dispute is really whether the loss should be calculated at a multiple.

Many US transactions are private equity deals, where the target is valued as a multiple of its EBITDA (earnings before interest, taxation, depreciation and amortisation). The dispute between buyers and sellers is whether, on a breach of representation, the impact should be calculated at that same multiple, which can produce a very large gap in the resulting figure. A one-off loss will not affect the company’s value into perpetuity, so it might simply be a one million dollar loss to the buyer. But where the breach concerns something like the company’s financial statements, and EBITDA was overstated by one million dollars, and the buyer used, say, a five-times multiple to set the purchase price, that overstatement should be multiplied by five to determine the actual loss, giving a five million dollar loss rather than a one million dollar one: a substantial gap.

Representations and warranties insurance

A couple of notes on insurance. Once a representations and warranties insurance policy is in place, it becomes the governing document for the buyer’s ability to recover for a breach of representation. The buyer is the insured party and policyholder, and pursues the insurer to recover for a breach; the insurer effectively steps into the seller’s shoes, making the arguments a seller would otherwise make as to why the loss is smaller, or why liability should not extend as far as claimed. The seller remains liable only where it committed fraud, and the insurer can only pursue, or subrogate against, the seller in cases of fraud.

This type of insurance, known in the UK as warranties and indemnities insurance, is very prominent in the United States. At least half, if not the majority, of transactions now use representations and warranties insurance, and sellers have come to expect it, since it limits their liability so substantially that buyers often need to offer it simply to remain competitive in a bidding situation. I love this topic, and I am happy to discuss it further with anyone afterwards, but I will stop there in the interest of time.