Understanding Representations and Warranties in Acquisition Agreements

By Peter King

In an acquisition contract there are a series of statements “representations and warranties” which typically confirm the seller has no liabilities (other than those set forth in a disclosure schedule to the acquisition agreement), the seller’s financial statements are accurate, the assets are in good condition, etc.  These items are essential as they form the basis to determine the proper purchase price.  While the seller and buyer may want to close quickly, these terms will likely be very important to each party in the future and thus require extensive negotiation. 

There is a tension between the parties’ sale goals.  The selling company wants the sale to be an “as is” sale where after closing they have no liability.  In contrast, the buyer wants the representations and warranties to survive the closing.  The buyer will argue for indemnification from the first dollar while the seller will argue for deductibles and a ceiling in total damages.  Additionally, the buyer seeks to assume responsibility for only those liabilities that are in the ordinary course of the business, while leaving behind unknown and contingent liabilities.  Seller wants buyer to assume responsibility for all of seller’s liabilities, known and unknown, liquidated or unliquidated, fixed and contingent.  Seller’s counsel will argue for terms such as “material” and “knowledge of liabilities” to limit future liability, while the buyer’s counsel will seek terms like “liabilities known and unknown.”  

Key representations and warranties for the buyer include items not appearing on the balance sheet, for example, indemnification for environmental/pollution violations, employment discrimination claims, pension underfunding, antitrust violations, and OSHA violations.  A tax issue of particular complexity is whether buyer or seller should bear the cost of tax deficiency where the IRS disallows tax deductions for pre-acquisition tax years.  Generally, the acquisition agreement is drafted to make the seller liable for all preacquisition taxes and interest.  Seller may seek to draft the agreement to be liable for only the interest on the deficiency and the excess of the tax over the discounted present value of the future deduction.  Skilled drafting of representations and warranties in acquisition agreements is essential to protect the interests of both buyer’s and seller’s future.