Representations and Warranties – Part 2

4               Effects and Functions of Representations and Warranties

4.1           Terminating the M&A transaction and claims for damages

When a Representation was inaccurate, and/or a Warranty had been clearly breached:
(i) The breaching party is deemed not to have fulfilled its pre-contractual representation, and the aggrieved party has the right to terminate the M&A transaction, or
(ii) If the aggrieved party does not wish to terminate the transaction but if the valuation of the Target Company were to be lower, the aggrieved party may claim indemnity against the breaching party.

Usually, the seller’s Representations and Warranties are considered to be more important, but occasionally the buyer will make Representations and Warranties for instance as to their ability to obtain financing and the date they are able to make the payment. In this circumstance, it protects the seller from the buyer’s credit risks.

4.2           Encourage Disclosure

Representations and Warranties could motivate the Seller to carefully scrutinise and attempt to grasp all the material information of the Target Company, and then to disclose as much information as possible to the buyer. On the other hand, it is advantageous to the buyer as they will be able to reduce their burden to some degree in conducting DD.  

4.3           Effective Date of Representations and Warranties　

As much as the buyer would want the Effective Date to be as late as possible, the seller would not want the Effective Date to be the Closing Date which is far in the future from the Signing Date. By having the Signing Date as the Effective Date, the seller would not have to Represent and Warrant the issues that may arise on the Closing Date such as the uncertainty of factual matters and rights accrued. To compromise, the parties sometimes agree that the Effective Date will be both the Signing Date and the Closing Date but, the seller will not be liable to pay damages for any inaccuracies or breaches which occur at the Closing Date.

4.4           Scope of Representations and Warranties

It is normal for sellers to want the scope of Representations and Warranties to be as narrow as possible. For example, sellers may limit the scope of Representations and Warranties only to certain material and important aspects, such that it will be “The Seller represents that the Relevant Financial Statements, in respect of XXX, are accurate in all material aspects”. The seller could also limit the scope to be such that “to the extent of the Seller’s knowledge” or “to the extent the Seller reasonably ought to know”, which are relatively subjective.
Further, if a particular aspect is known by a seller and they disclose it to the buyer through DD and the buyer is also aware of that aspect, it is common for both parties to exclude that aspect from Representations and Warranties by including that in a Disclosure Letter/Disclosure Schedule which is then annexed to the contract. If the Disclosure Schedule were to mention that all information disclosed during DD will be excluded from the seller’s representation, then it would be advantageous to the seller as their scope of exclusion will be very wide.

4.5           Representations and Warranties Insurance

Representations and Warranties Insurance (“RWI”) can be used to prepare for breaches of Representations and Warranties. RWI is being more commonly used especially in large cross border deals above US$100 million.
The specific RWI policy differs to the buyer and the seller. As for the buyer’s side, in the event of breach of Representations and Warranties by the seller, the buyer may claim directly from the insurance company rather than to claim for damages from the Seller.  As a result, the buyer does not have to bear the seller’s credit risk.