This article is written by Surya Rose Thomas who is pursuing a Diploma in M&A, Institutional Finance and Investment Laws (PE and VC transactions) from LawSikho.
Table of Contents
Introduction
Caveat Emptor is a popular legal maxim which means buyer beware. This principle applies to small scale business transactions to million-dollar transactions. The duty of the buyer to know facts regarding the transaction, as well as the seller, is of paramount importance. In this business world, a huge number of commercial transactions are made each day. Every day we hear new merger or an acquisition deal. hances of misrepresentations and fraud are very high in such deals, and measures to hinder such practices must be diligently and cautiously effectuated from the side of the buyer. However, it is pertinent to note that fraud and misrepresentation are possible even from the side of the buyer. Here comes the importance of the representation and warranties clause in a commercial transaction. In this article, we discuss how important it is to include this clause in a Merger and Acquisition transaction and what are the consequences if the parties breach any Representations and Warranties clause.
Meaning of representations and warranties
The name itself implies that representation is the presentation of something. This something is the facts associated with a company. In a Merger and Acquisition transaction, it is important to apprehend the details of the companies which are parties to the transaction. Though representation and warranties are clubbed together to form a single clause, warranty is different from representation. Warranty is a guarantee or a promise that the representations stated by the company, which are facts of the company, are true. An example of the representation and warranties clause is as follows:
“The company has been duly incorporated and organized and is validly existing, under the laws of India.”
Importance of representations and warranties clause in merger and acquisition
The importance of representations and warranties clause can be best analyzed from Ranbaxy Laboratories, a famous Indian pharmaceutical company, that was sued by Daiichi Sankyo, a Japanese Pharmaceutical company for concealing information related to wrongdoing from Daiichi Sankyo when it acquired Ranbaxy in 2008. Daiichi Sankyo acquired Ranbaxy for $4.6 Billion. An arbitration tribunal in Singapore decided in favor of Daiichi Sankyo and held that Ranbaxy had misrepresented certain facts to Daiichi Sankyo at the time of acquirement. The Delhi High Court upheld this foreign arbitral award and directed Ranbaxy to pay 3500 Crore to Daiichi Sankyo.
The main objective of the representation and warranty clause is to minimize risks in investment. Understanding the business of both the seller and the buyer as well as their financial capacity is relevant in a Merger and Acquisition because such transactions are characterized by huge financial investments. Both the parties disclose facts associated with their companies so as to avoid future disputes and provide an indemnity clause to support their disclosures. Such indemnity clauses which are compensatory in nature guarantee payment at the occurrence of a breach of representations and warranties clause. Hence, both the parties very diligently draft their representations and warranties clause.
The importance of the representations and warranties clause can be summarized as follows:
- It minimizes the risk in investment
- To ensure safety and to support their due diligence.
- To have better knowledge about the business of the other company.
- To eliminate any subsequent problems arising due to facts associated with the company. For example, if Company A has a legal suit pending against it which claims crores of money from Company A. Company A hides this fact from Company B which is going to acquire Company A. Absence of Representations and warranties clause on the agreement between Company A and B will make things in favor of Company A. Later Company B will have to burden that liability. If there was a Representations and Warranties clause, A would be liable for such an act.
What are important breaches?
Technically, the term breach refers to any violation of the terms of the contract by a party to the contract. Therefore, negotiations and drafting by experts are important components of any business transaction especially merger and acquisition. All the terms of a contract even the minute terms must be treated with accuracy. A small mistake may lead to huge losses. Some of the important breaches associated with a business transaction are:
- BREACH OF REPRESENTATIONS AND WARRANTIES CLAUSE
Ever thought of the effect of a merger and acquisition without a representation and warranty clause? Companies may have liabilities, tax dues, claims, legal suits pending, etc. Therefore, it is indispensable that in huge transactions like merger and acquisition, both parties disclose every single detail of the company which is relevant to the point. To avoid catastrophic damages in the future it is important to know the relevant facts. There are chances that companies hide relevant information regarding them in order to make a deal. To avoid such situations, parties must include an indemnification clause along with a representation and warranties clause. An indemnification clause contains the promise by the declaring company that it will compensate the other company in an event of a breach of any facts given under the representations and warranty clause.
Therefore, lawyers or other representatives of both the companies negotiate thoroughly in this regard. An indemnification clause is as important as a representations and warranties clause. Usually, the seller negotiates for a narrow indemnification clause whereas the buyer negotiates for a broader one. The definition of the word ‘loss’ is also highly negotiated. The seller usually insists on a narrow meaning which includes only direct loss and excludes consequential loss. On the other hand, the buyer or the investor wants a broader one that covers all aspects of loss. Often, the length of the representations and warranties clause directs to the quantum of negotiations done. Companies insist on negotiating representations and warranties especially, to walk free after a transaction.
Sometimes, to secure the indemnification obligation of the seller, the buyer may retain some portion of the consideration or ask for a pledge of the promoter’s shares.
Both parties must give true facts. Misrepresentation can make the contract void according to Section 19 of the Indian Contract Act, 1872.
- BREACH OF COVENANTS
At its most basic level, Covenants are dos and don’ts agreed between two parties through an agreement. Usually, Covenants are issued by creditors to debtors to safeguard their money. If the debtor breaches any of the terms specified in a covenant, it amounts to the Breach of Covenants.
Consequences of Breach of Covenant include termination of the agreement or compensation or both. In the case of Bank Covenants, a breach of the covenant may lead to the curtailment of further credits to the debtor. Sometimes the interest rates may increase as a consequence of the breach.
- BREACH OF ANY OTHER OBLIGATION
The terms of any contract are so vital. Even violation of a single term will amount to a breach and financial loss. For example, it was agreed that the goods will be supplied to the market within 40 business days. But the supplier fails to deliver goods on time. This indeed will amount to breach and the supplier will be obliged to compensate the other party.
- BREACH OF PAYMENT
Without a second thought, even a layman can say that this breach results in financial loss and, compensation must be provided. For example, Company A ordered certain products from Company B. Company B shipped the products to Company A. But Company A rejected the delivery of goods and denied payment without any genuine reason. This creates a financial loss to Company B. Company A has committed a Breach of Payment.
What should the representations and warranties clause cover?
Parties negotiate while drafting the Representations and Warranties clause in order to reduce risk. Each contract is different, so is the Representations and Warranties clause. To eliminate future obligations, parties contract their respective representations and warranties clause. Hence, the lawyers or legal representatives involved must ensure sufficient representations and warranties are given by other parties. Mainly, the Representations and Warranties clause covers the following points:
- Status of the Company.
- Financial Condition of the Company.
- Ownerships
- The Company is validly existing following the applicable laws.
- No orders have been passed for winding up the company.
- There are no legal cases pending against the Company.
- All documents and information given to the other party are true and genuine.
- The Company has secured all the necessary approvals for entering into agreements.
- Regarding environmental matters if any.
- Regarding Intellectual Property if any.
- Ability to contract
Conclusion
To recapitulate, we are now well aware of the importance of including the Representations and Warranties clause in any contract and how far this will help us in eliminating future disputes. The role played by lawyers here is very crucial to draft documents indisputably. A deep understanding of the consequences of the Breach of Representations and Warranties clause should be an essential component in lawyers’ minds while drafting. The quantum of risk involved in Merger and Acquisition transactions makes this clause a mandatory one in the M&A documentation. Earlier, indemnity was backed up with the creation of escrow in which some portion of the proceeds were reserved. But now Representations and Warranties insurance is often used. Such insurances are very expensive.
References
- indiacorplaw.in
- www.mondaq.com
- agamalaw.in
- corporatefinanceinstitute.com
- www.forbes.com
- blog.ipleaders.in
- theonebrief.com
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