Digging deeper into representations and warranties
Energy and Resources M&A Transaction Guide
Digging deeper into representations and warranties
ABOUT THE GUIDE
- This is the second volume of McCullough Robertson’s Energy and Resources M&A Transaction Guide developed for the resources sector.
ABOUT EDITION 4
- In Edition 4, we look more closely at representations and warranties in M&A transactions.
- We’ll wrap up this second volume of the Guide with a Masterclass in Brisbane and Sydney in 2018 where you can ask our expert panel any questions related to undertaking an M&A transaction. Dates will be announced in 2018, but you can register your interest for Brisbane here and Sydney here.
Negotiations around risk allocation form an integral part of any M&A transaction, with sellers seeking (to the greatest extent possible) to secure a clean exit and buyers seeking to hold sellers to account for their pre-contractual representations as to the state of the business or project. Often this results in a heavily negotiated set of representations and warranties in the transaction document, which the seller is obliged to stand behind or, in some cases, is supported by insurance.
In this article we take a closer look at typical representations and warranties in M&A transactions.
Key areas of warranty protection
Warranties typically fall into two categories, those relating to the seller and those relating to the business or assets for sale. Most M&A transactions will include the following key warranty areas:
|Seller||That the seller has the ability to enter into and perform the transaction document.|
|Title to the assets||That the seller has title to the assets and is able to transfer those assets free of encumbrances.|
|Accounts||That the accounts are a true and accurate record of the business accounts.|
|Records||That current and full records (including financial records) exist and have been maintained in accordance with applicable laws.|
|Plant and Equipment||That the plant and equipment being acquired are in good repair and are all the assets required to operate the business.|
|Tax||That all tax liabilities have been disclosed, all taxes in relation to pre-completion liabilities have been or will be paid and all taxation laws complied with.|
|Environment||That all environmental laws have been complied with and that there is no liability under any laws or in relation to any environmental approvals.|
|Employees||That all relevant employment laws have been complied with and all employees and their entitlements have been disclosed.|
|Trading Arrangements||That all material contracts have been disclosed, there are no existing breaches of the contracts and the contracts cannot be terminated as a result of the completion of the transaction.|
|Intellectual Property||That all IP is lawfully used by the company.|
|Accuracy of Information||That all material information has been disclosed.|
While this list sets out the types of warranties you would expect to see in an M&A transaction, sellers will naturally seek to limit their post-completion risk exposure as much as possible. A way in which to do this is for a seller to qualify the warranties given. For example, warranties can be given ‘to the best of the Seller’s knowledge’ or ‘so far as the Sellers are aware’. These limitations have been further considered in Edition 2 of this Guide.
Seller’s pre-contractual disclosures
During negotiations, a seller is likely to make various statements regarding the affairs of the company and the state of the business, for example in relation to the production capacity or profitability of the business. Such information can constitute a representation made by the seller to the buyer, which if untrue, can be the basis of a claim against the seller. This means that, in addition to seeking to limit warranties to the knowledge of the seller, a seller will also seek to ensure the agreement of the parties only includes those representations and warranties expressly contained in the transaction document. For sellers, care must be taken to ensure these clauses expressly exclude any statements not set out in the transaction document and for buyers, care needs to be taken to ensure all statements being relied upon are set out in the transaction document.
Indemnities for breach of warranty
Another matter to be aware of when negotiating your transaction document is that the jurisdiction of your transaction may impact on whether an indemnity will be given in respect of breaches of warranties under the sale agreement. An indemnity is essentially an agreement to cover loss and damage suffered by another and provides a separate right of action in addition to a buyer’s contractual rights in the event of a breach of a warranty. An indemnity claim is generally considered to be an easier right of action for a buyer to pursue.
Generally speaking, what we are seeing is that indemnification in respect of warranty claims in:
- US based contracts, is standard
- Australian based contracts, has become relatively commonplace, and
- UK based contracts, is uncommon.
A potential explanation for the above trends may lay in the approach taken by the judicial systems of the respective jurisdictions on the question of costs following litigation. In the US, the courts are bound by what is known as the ‘American Rule’, the basic premise of which is that legal fees are not ordinarily recoverable by the successful litigant in federal litigation in the absence of a statutory provision to the contrary. This means that an express indemnity by the seller covering the legal costs of a successful warranty claim by the buyer is highly desirable in a US based sale and purchase agreement.
Courts in the UK (and Australia) are bound by what is known as the ‘English Rule’, which in contrast to the American Rule, provides that costs follow the event (i.e. the unsuccessful litigant is required to pay the successful litigant’s costs). Therefore the inclusion of an express indemnity is not required to the same extent as it is in the US.
Remedies for breach of warranty
Under general law, the remedy available to a buyer for a breach of warranty by a seller is typically damages (unless the warranty is considered a condition of the contract). Importantly, a buyer does not have a general law right to terminate the contract as a result of a breach of warranty by a seller (again, unless the warranty is a condition of the contract). Therefore, if the parties agree that termination of the contract is a remedy that is available to the buyer following breach of warranty by a seller, the contract must expressly state that the buyer may terminate the contract for breach of warranty.
Warranty and indemnity insurance
Warranty and indemnity insurance (W&I Insurance) is a means by which the seller can facilitate a clean exit from the business. W&I Insurance is also useful from a buyer’s perspective, as it provides a certain level of security knowing that if a claim arises post-completion in relation to a warranty, the buyer can turn to the W&I Insurance to compensate it for its losses. W&I Insurance is particularly useful:
- for sellers, to circumvent the need for an escrow or a holdback arrangement under the transaction document, and
- for buyers, to provide greater protection by potentially providing a higher liability cap and extended periods of warranties than a seller may be willing to offer, and also greater certainty that any claims can be paid, particularly where the seller is in financial difficulty or leaving the jurisdiction following completion of the transaction.
W&I Insurance can be either:
- a buyer-side policy, under which the buyer is the insured party and makes a claim directly against the insurance policy (not against the seller) in the event of a breach of warranty, or
- a seller-side policy, under which the seller is the insured party and makes a claim against the insurance policy in the event of a successful claim by the buyer.
A hybrid version of the above, known as ‘seller-initiated buyer-side’ policy is also becoming more common, under which the seller arranges W&I Insurance prior to or at the time of signing the transaction document and hands the process (along with the premium) over to the buyer once the transaction has sufficiently progressed. The recourse under this arrangement is the same as the buyer side policy (i.e. the buyer is the insured party and makes a claim directly against the insurance policy).
In Australia the premium for W&I Insurance is typically around 1- 1.5% of the consideration of the transaction and can take up to one month to implement. As premiums vary across jurisdictions, consideration should be given to the jurisdiction in which the W&I Insurance is purchased.
Once the parties have agreed to take out W&I Insurance, the parties will need to consider whether W&I Insurance will cover the entire amount of any liability arising from a breach of a seller warranty or whether the seller will be responsible for a given amount of the liability before W&I Insurance responds. Careful consideration also needs to be given to any exclusions from the W&I Insurance and whether those are acceptable.
Representations and warranties are highly negotiated parts of transaction documents. Care needs to be taken to ensure that the transactions documents reflect the agreed position and that once representations and warranties are agreed, the parties to the transaction understand their continuing rights and obligations following completion.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.