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Drafting contracts

(f) Allocation of risk

Allocation of risk. Warranties allocate risks amongst the parties. The party making a warranty assumes the risk that if the warranty is incorrect, the other party will have a claim against it or anoth­er appropriate remedy under the agreement.

In the example of environmental spills (see previous paragraph), neither party may be aware of its existence, but from the purchaser’s standpoint the risk of there being such contaminations should be borne by the seller. Having the seller make the warranty is in fact an allocation of risk. If there appears to have been spills, the exist­ence of the warranty gives the purchaser recourse against the seller.

In line with this principle of allocating risks, some people consider that it is appropriate for a seller of a company to make warranties of which it already knows that they are incorrect, without making (or even attempting to make) disclosures against such warranties. Such behaviour may be questionable in the event that such incorrect warranty substantially impacts the purchaser’s ability to recover damages under any other warranties, because of the agreed limitations on liability claims (i.e. the ‘cap’). It is inappropriate if a seller does not to answer questions during a due diligence, anticipating a subsequent first draft of warranties in which the subject matter will most likely be addressed (and also anticipating that it will be able to stay away from making such warranties during the negotiations). Conversely, a seller may expect that if a data room is not as such a disclosure against warranties and it contains important information that clearly and materially contradicts a warranty, such information is addressed during the negotiations rather than that the purchaser raises it as a warranty claim immediately after the closing of the transaction.

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Drafting contracts

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