This is the sixth article in our series on selling the family business. If you need to catch up, please read our previous articles on advance planning, preliminary diligence, marketing, letters of intent, and indemnification provisions.

What Are the Representations and Warranties?

The representations and warranties section of a purchase and sale agreement is one of the most important and heavily negotiated sections. At their core, representations and warranties are contractually binding statements of fact that give both parties assurance that the transaction is in fact what they believe it to be and to give them legal recourse if it is not. Both the buyer and seller make representations and warranties, but often the majority of them are made by the seller.

The bulk of the representations and warranties made by the seller concern the state and inner workings of the seller's business. The content of the seller's representations and warranties will closely track the information they provided to the buyer during the diligence process.1 For example, the seller will likely have to warrant that all their financial statements are true and accurate, that all property they own—whether tangible or intangible—is free of any encumbrances, and that they are in compliance with all relevant government regulations and things of that nature.

While the focus in negotiations will usually be on the seller's representations and warranties, the buyer must make some as well. For instance, the buyer will usually warrant that they have enough money on hand to pay the purchase price and that they are a duly formed corporation with the power to execute the contemplated transaction. In addition, if the consideration for the deal includes equity in the buyer, then the seller will request that the buyer makes representations and warranties on par with those that the seller themselves makes.

In most M&A transactions, the representations and warranties will be drafted as general statements, and the seller is responsible for disclosing any exceptions to those statements. These exceptions are disclosed in a schedule attached to the purchase agreement called the disclosure schedule. If an exception is properly disclosed, the buyer is deemed to have notice of the fact. Failure to disclose material exceptions can give rise to a fraud claim against the seller.

Example: Except as set forth in Section 1.1 of the Disclosure Schedule, the Company has no current litigation. Disclosure: A claim for employment discrimination was filed in the Superior Court for King County on January 1, 2021, under Case No. 123456.

Remedies and Enforcement

Enforcement of the representations and warranties comes through the indemnification obligations of the parties provided for in the purchase agreement. Typically, the indemnification language will provide something to the effect that for a limited period of time after closing, the parties will indemnify each other for any breach of or inaccuracy in the representations and warranties provided by that party.

As such, by way of an example, in the event the deal closes and the buyer finds out that the seller's financial statements are inaccurate and the assets of the target company are less valuable than what was represented, the buyer would seek indemnification for any losses incurred as a result of the inaccuracy.

In recent years, representations and warranties insurance has become more common in M&A transactions. These insurance policies protect parties by paying out claims that arise from breaches in the representations and warranties.

Both buyers and sellers can purchase such policies, but they are typically requested by the seller in order to protect itself from post-closing indemnity claims. Parties covered by insurance tend to be less concerned with the scope of their representations and warranties, which in turn can reduce deal friction and increase the likelihood of closing.

However, the insurance issuer will also be involved in due diligence and negotiation of the representations and warranties. Each insurance policy will have different exclusions and conditions under which the policy will not cover indemnification claims. These exclusions will be determined based on the insurance company's due diligence review and most often include material adverse issues that the parties knew of prior to closing and other extraordinary risk issues.

To avoid exposing themselves to liability, buyers and sellers alike should carefully review their policies to make sure they cover what they think should be covered.