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Drafting contracts

(l) Warranty aspects in major transactions (M&A)

In this paragraph, we will address a few other particularities of warranties and limitation of liability as they are used in the context of major transactions (e.g.M&A or financing transactions).

Sandbagging. Negotiating for contractual provisions that create burdens to actually receiving compensation is referred to as ‘sand-bagging’. Sand bags are used to protect against invasions and may indeed imply the impossibilities  associated with battles taking place in the trenches. Sand-bagging behaviour obviously insinuates that a seller is creating contractual burdens and is overly complicating a purchaser’s ability to recover damages. As Dutchmen, however, we should emphasise that sand-bagging is also a modest alternative to a dike and yet is a proper means to prevent a flood.

Making incorrect warranties. In line with the principle of allocating risk, some people consider that it is appropriate for a seller of a company to make warranties about information which it already knows to be 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 answer questions during a due diligence exercise, 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 should be addressed during the negotiations rather than that the purchaser raises it as a warranty claim immediately after the closing of the transaction.

Categories of M&A-warranties. Warranties commonly made in the context of an M&A transaction can be classified in three basic categories:

  • Warranties about the transaction as such. The first category includes warranties related to the transaction. The purpose of these warranties (also known as enforceability warranties) is to ascertain that the party making them has the contractual capacity and authority to enter into the agreement, and that the contract is enforceable and does not violate a law or regulation. These are standard warranties. Under EU member state laws they are often also largely (if not entirely) redundant since modern legal systems will most likely protect the other party against such warranties being incorrect (in any respect). Therefore, enforceability warranties rather serve information purposes. They are rarely negotiated, except that a purchaser may try to extend their scope to subject matters in the second category.
  • Subject matter warranties. A second category of warranties relates to the subject matter of the transaction. These warranties are made to en­sure that a party is acquiring what it agreed to and may reasonably expect, and are tailored to the specific context of the transaction. Some examples:
    • an ordinary sales agreement may include warranties that the products are unused, of good workmanship and free of any material defects;
    • a software licence would include warranties that the software will be free of worms and viruses and will not perform any operation other than specified in the Specifications;
    • a business and asset purchase agreement will include warranties that the sold property is free from encumbrances;
    • a patent licence contains warranties by the licensor that the patent is properly registered and does not infringe other (pre-existent) patented technologies;
    • a share purchase agreement includes warranties that the target company has withheld all taxes required to be withheld and paid all taxes in a timely manner.
  • Warranties about the parties. Many contracts require the parties to make warranties about themselves. These are desirable if a party must be (and remain) able to perform its contractual obligations. Examples relate to the financial condition of the party, and in particular its creditworthiness.

To ‘bring down‘ warranties. Warranties are made as of a particular moment in time. That moment can be the signing date of the contract, the closing date of the transaction or any other date provided for in the contract. Without further specification, a warranty will be deemed to be made on the date that the relevant product is delivered. Warranties that are deemed to be repeated on a later date are referred to as being brought down.

Bringing down warranties is usually required at times when a significant event occurs under an agreement. For example, a share purchase agreement may provide for completion of the transfer only after the required approvals are obtained; the pur­chaser will require the seller to bring down its warranties at the closing. This bring-down implies an extra incentive for the seller to make sure that the quality of the transferred business remains as it was at the signing date by leaving any deterioration for the account of the seller.

Warranty bring-downs are also found in other types of agreement. In master sale agreements with ongoing deliveries of products pursuant to purchase orders, the purchaser needs the warranties to be made as of each delivery date. Similarly, a borrow­er is required to bring down its warranties to the lender each time it draws under a loan or credit agreement. If a warranty in a credit agreement provides that all of borrower’s subsidiaries are listed in a schedule, the bring-down of that warranty may become impossible (and rightfully so): when new subsidiaries are created or acquired, the creditworthiness of the borrower will probably change. In such cases, additional drawings cannot be made without violating the warranty, unless a specific waiver is obtained or an appropriate amendment made to the schedule. Obviously, such waiver or amendment will trigger the lender to scrutinise the creditworthiness of the borrower after creating or acquiring the subsidiaries.

Survival of warranties. Other than the bringing down of warranties at some future moment in time, there is also the concept of warranties ‘surviving the closing of a transaction’. Survival of the warranties in fact refers to the right of the purchaser to claim under those warranties. Normally, the seller will limit this right by stipulating that all claims related to a warranty being incorrect must be made (or made known) within a certain period of time. In such case, it is appropriate to distinguish between the various types of warranties. Accordingly, short periods would apply to running business and tangible assets, whilst warranties related to real estate and environmental contamination would probably be subjected to longer periods. Warranties related to taxation are often subject to the statutory period during which tax authorities may continue to impose taxes related to the period before closing of the transaction.

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