Representations and warranties in mergers and acquisitions and effects of breach
What is a Representations and Warranties Clause?
Significance
A representation and warranty is a representation and warranty by a party to a contract to the other party that certain facts are true and accurate at a particular time. Representation and warranty clauses are often found in stock transfer agreements in M&A transactions. They are also commonly used in loan agreements.
Matters Covered by Representations and Warranties
In the case of a stock transfer or business transfer agreement, for example, representations and warranties can be broadly classified into the following categories: seller-related matters, target company-related matters, and buyer-related matters, with the main items of each being as follows
(i) Matters concerning the seller
Organization and structure; execution, performance, and enforceability of contracts; absence of violations of articles of incorporation, laws and regulations, etc.; absence of bankruptcy proceedings, etc.; antisocial forces, etc.
(ii) Matters concerning the subject company
Organization and composition, shares, subsidiaries and affiliates, financial statements, real estate and movable property, intellectual property rights, inventory, claims, contracts, insurance, permits and licenses, legal compliance, personnel and labor issues, pensions, taxes and public dues, environment, lawsuits and disputes, anti-social forces, absence of bankruptcy proceedings, accuracy of information disclosure, etc.
(iii) Matters related to the buyer
Organization and composition, contract execution, performance, enforceability, absence of violations of articles of incorporation, laws, etc., absence of bankruptcy proceedings, antisocial forces, financing, etc.
Legal nature
A representation and warranty is generally considered to be a damage security agreement subordinate to the main contract and an agreement to the effect that, in the event of certain consequences, a right to claim performance of monetary compensation will arise in accordance with the contents of the contract. Although it can also be considered as default liability (contractual incompatibility liability under the revised Civil Code of 2020), liability based on breach of a representation and warranty is based on the act of making the representation and warranty itself, and does not assume the existence of further obligations under the contract, their non-performance, or elements such as willful misconduct or negligence, and is therefore difficult to equate with default liability. In this sense, it can be said that as long as there is a breach of warranty representations, it is a no-fault or strict liability, where the party is liable regardless of whether or not it is negligent. In addition to the warranty representations, covenants may also be included in the stock transfer agreement. Covenants are promises made by the seller to the buyer, and are therefore different from representations of warranty, which are obligations and are subject to strict no-fault liability. Covenants include, for example, clauses such as “will not become insolvent” and “will not engage in competing business activities.
Functions of Representations and Warranties Clauses
Complementary function to due diligence
For example, in the case of a business or stock transfer, the seller of the target company is usually familiar with information about the target company, while the buyer does not have sufficient information about the target company, and there is information asymmetry between the seller and buyer. There is also a limit to the information that can be obtained through due diligence conducted by the buyer on the target company in an M&A transaction. In this regard, if a representation and warranty clause is provided, the seller is liable for breach of the representation and warranty clause if there is any fact that violates the clause. If the seller finds any violations, the seller may exclude the violations from the representations and warranties by listing the violations in an annex to the contract (Disclosure Schedule). Such voluntary disclosure by the seller will enable the buyer to become aware of any breaches of representations and warranties relating to the transferee company. In addition, the seller may propose modifications or deletions to the wording of the representations and warranties proposed by the buyer that may pose risks to the seller, and this may enable the buyer to have an idea of the risks posed by the subject company. From these points of view, it is advantageous from a due diligence perspective for the buyer to propose a draft contract that includes as many representations and warranties as possible.
Risk-sharing function
By stipulating a representation and warranty clause, the contracting party that made the representation and warranty is liable for the facts for which it made the representation and warranty but not for other facts, thereby clarifying the extent to which each party to the contract bears responsibility and risk (This function clarifies the extent to which each party to the contract bears responsibility and risk (risk-sharing function). This makes it easier for the buyer, who is inferior in terms of the amount of information, to enter into a contractual relationship with the seller. The seller may argue that since due diligence has been conducted, the buyer should know the content of the risk and that a warranty statement is unnecessary. Such an assertion from the seller is not a correct description of the distribution of risk.
Other functions
Furthermore, the absence of the seller’s breach of representations and warranties is a prerequisite for the buyer’s performance of its obligations (obligation to pay the price), and if such a breach of representations and warranties is found, the buyer is generally granted the right to cancel the contract. Therefore, if there is a risk of breach of representations and warranties by the target company, the buyer can avoid the contract. On the other hand, the seller also has the advantage that by making a representation and warranty, the seller can guarantee the value of the subject matter of the sale to the buyer, and the seller can transfer the subject matter to the buyer on better terms.
Requirements for Pursuing Liability for Breach of Representations and Warranties
Objective requirements
(i) Fact of breach of representations and warranties
(a) If the legal nature of a representation and warranty is a contract to secure damages as described above, the fact of breach of the representation and warranty clause is the central requirement for pursuing liability. In this regard, there are many cases in which the existence of a breach of representations and warranties is disputed in court, partly because the terms of the representations and warranties are abstract and their interpretation is not always unambiguous. However, it should be noted that a representation and warranty clause is not always formally interpreted in a court of law as it is written.
(b) Interpretation of representations and warranties clauses
For example, there was a case in which the existence of a breach of representations and warranties by the seller was an issue in an M&A transaction based on a stock transfer agreement (Tokyo District Court, July 26, 2007, HANREI TIMES 1268, No. 19). (Tokyo District Court, July 26, 2007, HANREI TIMES No. 1268, p. 192). In this case, the seller represented and warranted that all of the disclosed materials contained true and accurate information and that no material matters were omitted. In this regard, the court held that “it is unrealistic to expect that every conceivable matter should be the subject of disclosure or a warranty of accuracy, and that the subject matter should be limited to itself. The court then concluded that the representations and warranties provision of the Agreement should be interpreted as “a warranty that there are no material discrepancies or errors with respect to matters that would affect a decision as to whether to accept a business acquisition or how to determine the amount of consideration for it.” The court examined whether there were material discrepancies or errors in the information provided by the seller. In this case, the court determined whether there was a breach of representations and warranties by limiting the representations and warranties as a whole by materiality, even for representations and warranties clauses that do not necessarily carry a materiality limitation. It is pointed out that the court’s decision was based on the understanding that it is the buyer’s responsibility to gather necessary information in an M&A transaction, and that the representations and warranties provision was abstract in nature. Therefore, as a countermeasure, when setting forth a representation and warranty provision, it is considered that efforts should be made to make the provision as specific as possible so that there will be no latitude in interpretation of the provision.
(ii) Time of Representation and Warranty
In many cases, the time points at which the representations and warranties are made are defined in the contract as the time of the conclusion of the contract and the time of the closing.
Subjective requirements
(i) Seller’s subjective requirements
If the seller’s subjective requirements are not stated in the representations and warranties clause, then the seller’s subjective requirements are not considered in determining whether there has been a breach of the representations and warranties. On the other hand, there are cases in which the representations and warranties include a subjective limitation on the seller’s knowledge, such as “to the best of the seller’s knowledge”. In such cases, the question of when the seller can be said to have knowledge may become an issue in court. For example, if the person who made the representations and warranties is found to have been involved in the management of the subject company, such as by dispatching an officer to the company that was the subject of the representations and warranties, the court may find that the person who made the representations and warranties knew of the breach of representations and warranties without determining how the person who made the representations and warranties came to specifically recognize the fact of the breach. The Tokyo District Court held that the person who made the representations and warranties “knew” the fact of breach of representations and warranties without recognizing how the person who made the representations and warranties came to specifically recognize the fact of breach of representations and warranties (Tokyo District Court, November 19, 2013).
(ii) Subjective requirements of the buyer
(a) Limitation based on the buyer’s knowledge of breach of representations and warranties In cases where the buyer knew or was grossly negligent in not knowing about the fact of breach of representations and warranties (bad faith or gross negligence), the court made the following decision regarding whether the seller is exempt from liability for representations and warranties. If the plaintiff’s (buyer’s) good-faith belief that the defendants (sellers) were in breach of their representations and warranties is based on the plaintiff’s gross negligence, then from the standpoint of fairness, there should be room to conclude that this is the same as bad-faith and that the defendants are exempt from liability for the representations and warranties. (January 17, 2006, HANREI TIMES No. 123, p. 206). (Jan. 17, 2006, HANREI TIMES No. 123, p. 206).
(b) Sandbagging Clause
In this regard, it may be possible to respond by explicitly providing a provision (a sandbagging clause) to the effect that the fact that the buyer was aware of or had knowledge of the seller’s breach of representations and warranties does not affect the buyer’s claim for compensation, etc. against the seller.
Effect of Breach of Representations and Warranties Clause
Failure to satisfy preconditions
Since the absence of a breach of representations and warranties is usually a condition for the performance of counterparty obligations, if such a breach is found, the buyer will not be in breach of contract even if it withholds performance of the counterparty obligation (e.g., obligation to pay the price).
Loss of benefit of term
For example, in a loan contract, it is common that the borrower loses the benefit of time if the borrower’s breach of representations and warranties is found after the loan is made. In such a case, the borrower must immediately repay the entire amount of the obligation.
Claim for compensation
In the event of a breach of representations and warranties, the contracting party may make a claim for compensation against the breaching party for damages that have a reasonable causal relationship to the breach. In this regard, as mentioned above, the legal nature of a representation and warranty is considered to be a contract to secure damages based on a covenant, and therefore, if an indemnity clause is not stipulated in the contract, a claim for indemnity or damages is not allowed only because there was a breach of representation and warranty. However, if the breach of representation and warranty also satisfies the requirements for liability for default under the Civil Code (liability for nonconformance with contract), there is room for a claim for damages under the Civil Code.
Termination
In the event of breach of representations and warranties, there may be a clause allowing for termination of the contract. However, especially in large-scale M&A transactions, there are many cases in which termination of the contract after closing is restricted. If the contract does not contain a clause allowing for termination of the contract, as in the case of the above-mentioned claim for compensation, termination will not be allowed only because of the breach of representations and warranties, unless the requirements for termination under the Civil Code are fulfilled.
