Representations & Warranties: What Is the Seller Really Promising?

By the time a buyer signs an SPA, it may have spent weeks reviewing financial statements, contracts, corporate records, tax matters, litigation, employment arrangements and intellectual property. Yet even the most extensive due diligence cannot establish every fact about a business with absolute certainty.

This is where representations and warranties become central to the transaction.

Through them, the seller makes contractual statements about the company and the shares being sold: that it owns the shares, that the financial statements have been properly prepared, that material contracts have been disclosed, that there is no undisclosed litigation, that taxes have been dealt with appropriately, and so on.

These provisions are sometimes described simply as a list of assurances from the seller. Their real function is more important. They help determine which risks remain with the seller and which risks the buyer accepts when it acquires the company.

That makes the warranty package one of the principal mechanisms through which due diligence findings are translated into contractual risk allocation.

Due diligence and warranties perform different functions

A common misconception is that extensive due diligence should reduce the need for warranties.

The two mechanisms are complementary, not interchangeable.

Due diligence allows the buyer to investigate the business before completing the acquisition. It helps identify known issues, test assumptions and determine whether the valuation and transaction structure remain appropriate.

Warranties deal with the residual uncertainty that remains after that investigation.

A buyer may review hundreds of customer contracts but still require a warranty that the material contracts disclosed are valid and that the target is not in material breach of them. It may review the litigation schedule but still require confirmation that there are no other material proceedings pending or threatened.

Due diligence asks: what can the buyer discover?

Warranties ask: what is the seller prepared to stand behind contractually?

The distinction is fundamental because no diligence process can realistically verify every aspect of a company. An acquisition ultimately requires the buyer to rely on a combination of information, contractual protection and commercial judgment.

Not all warranties are equal

The warranty package normally covers a broad range of matters, but different statements carry different significance.

Certain warranties concern the seller’s ability to enter into the transaction itself. These typically include ownership of the shares, authority to sell them and capacity to enter into the SPA. They are often referred to as fundamental warranties because they go to the legal basis of the acquisition.

Other warranties relate to the target’s underlying business. These may cover financial statements, taxation, material contracts, employment, intellectual property, compliance, litigation, assets, insurance, data protection and regulatory matters.

The distinction matters because the SPA may treat different categories differently.

A claim concerning ownership of the shares may be subject to a higher liability cap and a longer limitation period than a claim relating to an ordinary operational matter. The parties are effectively recognising that some contractual promises are more fundamental to the transaction than others.

The appropriate warranty package should therefore reflect the business being acquired rather than simply reproduce a standard precedent.

A software company will require extensive attention to intellectual property and data. A regulated financial business will raise different compliance questions. A manufacturing company may require greater emphasis on environmental matters, product liability, real estate and machinery.

The warranties should follow the risks of the business.

The negotiation is often about qualification, not the headline statement

Many warranty negotiations are not really about whether a statement should appear in the SPA. They are about how absolute that statement should be.

Consider a warranty stating that:

> The Company is not involved in any litigation.

The seller may reasonably object that it cannot give an unlimited statement if the group has hundreds of employees, customers and commercial relationships.

The provision might therefore become:

> So far as the Seller is aware, the Company is not involved in any material litigation.

Two relatively small qualifications have now changed the allocation of risk.

The first is materiality. Minor claims no longer fall within the warranty.

The second is knowledge. The seller is no longer guaranteeing the objective absence of litigation; it is effectively warranting that it is not aware of it.

These qualifications are common, but their drafting matters considerably.

What does "so far as the seller is aware" actually mean?

Knowledge qualifiers can appear deceptively simple.

If an SPA states that a particular warranty is given "so far as the Seller is aware", the next question should be: whose knowledge counts, and what steps must they have taken to acquire it?

In a company with thousands of employees, it may be unreasonable to treat every piece of information known anywhere within the organisation as knowledge of the seller.

The parties may therefore define knowledge by reference to specific individuals — for example the CEO, CFO, general counsel or heads of particular business functions.

They may also negotiate whether the relevant individuals are deemed to know only what they actually know, or what they would have discovered after making reasonable enquiries.

That distinction can materially affect a claim.

The drafting therefore needs to match the practical reality of the business. An overly broad knowledge standard may make a warranty impossible for the seller to give responsibly. An overly narrow one may deprive the buyer of meaningful protection.

Materiality can appear in several places

Materiality qualifiers create a similar issue.

A warranty may state that the target has complied "in all material respects" with applicable laws, or that no "material" contract has been breached.

This is intended to prevent immaterial matters from creating contractual claims.

But materiality can also operate elsewhere in the SPA through thresholds governing whether a claim can actually be brought. If materiality appears both inside the warranty and again in the claims regime, the buyer may argue that the seller is receiving the benefit twice.

This is why sophisticated negotiations sometimes address whether materiality qualifiers should be disregarded for certain purposes when determining whether a breach has occurred or calculating loss.

The broader point is that apparently modest drafting words — material, reasonable, aware, substantial — can change the economic allocation of risk just as much as the headline warranty itself.

The disclosure process changes the meaning of the warranties

Warranties cannot be properly understood without considering disclosure.

Suppose the SPA contains a warranty that the company is not involved in litigation, but the seller has expressly disclosed an ongoing proceeding in the disclosure letter.

The warranty is no longer read in isolation.

The seller is effectively saying: the statement is true except for the matters that have been disclosed to you in accordance with the agreed disclosure standard.

This interaction between warranties and disclosure is one of the most important elements of private M&A.

The seller uses disclosure to qualify the warranties. The buyer reviews those disclosures to determine whether they reveal risks that should affect the price, require a specific indemnity or change the decision to proceed.

For that reason, the disclosure letter — the subject of the next article in this series — is not a peripheral attachment to the SPA. It is part of the mechanism through which the warranties actually operate.

Known risks often belong somewhere else

Not every identified problem should be dealt with through a warranty.

Suppose due diligence reveals an ongoing tax investigation with a reasonably identifiable potential exposure.

It makes little sense for the buyer simply to rely on a broad tax warranty and wait to see whether it is breached. The issue is already known.

The parties may instead negotiate a specific indemnity, adjust the purchase price, require the matter to be resolved before closing or retain part of the consideration in escrow.

This highlights an important distinction between unknown and known risks.

Warranties are particularly useful for allocating risks relating to facts that the buyer cannot completely verify.

Once a specific exposure has been identified, the transaction advisers should ask whether a more targeted solution is appropriate.

A warranty should not become a substitute for addressing a known problem directly.

Warranties can also affect the period before closing

Where signing and closing occur on different dates, the warranty package may operate at more than one point in time.

The seller may give warranties at signing and be required to repeat — or bring down — some or all of them at closing.

That creates an important question: what happens if a warranty was accurate at signing but becomes inaccurate before completion?

The answer may depend on the seriousness of the change, the relevant closing conditions and the termination provisions of the SPA.

This is another example of how the various sections of the agreement interact. A warranty is not simply a post-closing compensation mechanism. In certain circumstances, its accuracy may influence whether the buyer is required to close at all.

The seller is not normally offering unlimited insurance

A warranty breach does not usually expose the seller to unlimited liability for every problem that might subsequently emerge.

The SPA will typically contain an extensive claims regime regulating matters such as financial caps, minimum claim thresholds, aggregate baskets, time limits and procedures for bringing claims.

Certain warranties may receive different treatment, particularly fundamental warranties or matters involving fraud.

In some transactions, Warranty & Indemnity insurance may transfer a significant part of the warranty risk to an insurer, allowing the seller to achieve a cleaner exit while still providing the buyer with recourse if covered warranties prove inaccurate.

These mechanisms will be considered more closely when we examine indemnification and seller liability later in the series.

For present purposes, the important point is that warranties form part of a wider contractual architecture. Their practical value depends not only on what the seller says, but also on the remedies available if what it says turns out to be wrong.

The advisory perspective: warranties are a map of transaction risk

A warranty schedule can sometimes appear like a long legal checklist.

Viewed properly, it is something more useful: a map of where the parties believe risk may exist in the business.

If negotiations become particularly intense around intellectual property ownership, that often says something about the transaction.

If the buyer insists on detailed environmental warranties, it may reflect concerns identified during diligence.

If the seller repeatedly seeks knowledge and materiality qualifications in a particular area, that may indicate that absolute certainty cannot realistically be provided.

The drafting process therefore generates information of its own.

For transaction advisers, this is important because warranty negotiations should not be disconnected from valuation and due diligence. If a seller cannot provide a warranty that the buyer considers fundamental, the answer may not simply be to continue negotiating the words.

The issue may require further diligence, a price adjustment, an indemnity, insurance or a different transaction structure.

The legal negotiation is sometimes revealing a commercial problem.

What is the seller really promising?

Representations and warranties do not guarantee that the acquired business will perform as expected.

They do not promise future revenues, successful integration or an attractive investment return.

Their purpose is narrower and more precise.

They establish a contractual picture of the company at the relevant point in time and allocate the consequences if important elements of that picture prove inaccurate.

For the buyer, they provide protection against information risk that due diligence cannot entirely eliminate. For the seller, their scope, qualifications and disclosure determine how much post-closing exposure remains after the shares have been sold.

That is why the most important question is not simply whether the SPA contains "standard warranties".

There is rarely anything truly standard about risk allocation.

The real question is:

which facts about this particular company is the seller prepared to stand behind, and what happens if those facts are wrong?