COMPANY SELLING - Warranties and Representations, what are they and why?

Posted by: 10. 7. 2024
Update: 4/7/2024

One of the most important parts of the purchase agreement - SPA (share purchase agreement), for both the seller and the buyer, are guarantees and declarations. It is usually several pages of text listed somewhere at the back of the contract as one of its annexes. Please do not underestimate this part of the contract, it can be very important. With declarations and guarantees, the seller describes the "condition" of the bride being sold. What are its characteristics, how does it stand in business, what are its limitations, what are its problems. This is actually similar to the introduction of equipment on the car you are buying. The seller thereby guarantees that the company being sold has the characteristics specified in the individual statements. The buyer buys it knowing this condition and offers the given purchase price for the given condition.

I often hear that the seller has disproportionately more obligations in the contract and issues far more guarantees than the buyer. Yes, it is, and quite rightly so. The company being sold is a complex set of rights, obligations, assets and legal relationships that must be described and their status guaranteed. Yes, the buyer also makes representations, for example, about the ability to enter into and perform the contract, but frankly, the buyer has one basic obligation - to pay the purchase price. Therefore, they can logically make do with a much narrower catalog of declarations and obligations.

When negotiating the content and scope of guarantees and declarations, there is always a debate between the buyer and the seller as to whether the seller is responsible (knowledge) of certain negative facts objective (it is indifferent whether the seller knew about the given negative fact or should have known and could or not) or subjective ("not known to the seller" - i.e. that the seller knew or should have known or could have known about the given fact). The buyer wants objective guarantees, the seller wants subjective guarantees, and where the parties end up intersecting is the result of the negotiation skill of one or another contracting party.

The seller wants to limit his liability from guarantees, and therefore allows the buyer to familiarize himself with the company and its condition in the due diligence process. The seller then logically demands that, to the extent of the information made available in the due diligence, he is exempted from any responsibility for the buyer's ignorance of the company.

What TYPES OF WARRANTIES can be encountered?

1. Guarantees of legal integrity of the object of transfer

· Status of shares (shares): guarantees regarding the legal integrity of the transferred assets (share or shares), information about their acquisition by the seller.Guarantees of legal integrity of the subject of the transfer:· Status of shares (shares): guarantees regarding the legal integrity of the transferred assets (share or shares), information about their acquisition by the seller.

· (Non)existence of third party rights: information on the (non)existence of any rights of third parties to the shares (shares), for example liens, retention rights, options, the right to increase the share capital, which would cause the buyer to acquire a company with restrictions in relation to third parties, or that his ownership share may be diluted.

· (Non)existence of separately separable rights: information on whether any right has been separated from the shares (shares), for example the right to pay a share of profits.

2. Warranties of property

· Physical property: includes guarantees regarding the condition and quality of the company's physical assets, such as equipment, machinery, vehicles, etc. Specifically, they may include assurances about technical condition, functionality, existence of hidden defects, etc.

· Real estate: guarantees regarding the condition and ownership rights to real estate, including assurances of the absence of legal defects, liens or legal disputes concerning real estate.

· Stocks: assurances regarding the condition and quality of inventory, including inventory, raw materials, finished goods, etc. They also include warranties regarding conformity to description, market value, and potential risks associated with inventory.

3. Warranties About Legal Matters

· Contractual obligations: assurances about the validity and enforceability of contractual agreements concluded by the company, including leases, supplier contracts, service contracts, etc. They also contain assurances about the absence of unfulfilled contractual obligations or potential disputes.

· Litigation: warranties regarding existing or potential litigation, arbitration or other legal proceedings, including assurances about the financial costs associated with such litigation and the risk of adverse business impact.

· Intellectual property: assurances about the validity and scope of intellectual property rights, such as patents, trademarks, copyrights, etc. They contain guarantees about the absence of legal disputes related to intellectual property.

4. Warranties of Financial Data

· Performance Guarantees: assurances about the achieved financial results of the enterprise in past periods, including profits, revenues, EBITDA, etc. They also include guarantees about expected performances in the future in accordance with forecasts.

· Financial position: guarantees regarding the correctness and completeness of the company's accounting information, including the current state of assets, liabilities, capital, income and expenses.

· Debts and liabilities: assurance of the existence and correctness of information on debt obligations, loans, mortgages, leasing and other financial obligations of the company, including details of maturities, interest rates, etc.

· Tax guarantees: guarantees regarding the compliance of the company's business activity with tax regulations and a statement about the (non)existence of the risk of tax deductions or other sanctions from the tax administrator.

5. Warranties of Operations and Operation

· Compliance guarantees: assurance of the company's compliance with all applicable legal regulations, including labor law, environmental protection, health and safety legislation, etc.

· Business continuity guarantees: assurance of the ability of the business to continue normal operating activities without material interruption, including guarantees regarding key suppliers, customers, employees and other factors affecting the stability of the business.

6. Guarantees in the field of employee relations

· Legal relations with employees: guarantees regarding compliance with the Labor Code and other labor law regulations, the existence of properly concluded employment contracts and agreements on work performed outside the employment relationship.

· Compliance with legal requirements in relation to employees: correct handling of overtime, correct adjustment of home office, correct processing of personal data.

· health and safety: fulfillment of obligations in the area of health and safety at work.

· Absence of illegal employment: a guarantee that the company does not use illegal forms of work performance, especially the blackmail system.

Each of these types of guarantees has its own specific meaning and importance for the buyer in assessing the risks associated with the transaction and ensuring the successful completion of the acquisition. Their correct determination and formulation are key to minimizing risks and protecting the interests of both parties.

The above catalog of guarantees is only indicative and includes, in my opinion, the main areas of the company's business activity that need to be covered. The specific catalog of guarantees in individual cases may be modified with regard to the nature of the company being sold and its operational specifics.

What are the RIGHTS OF BREACH OF WARRANTIES?

1. Right to compensation

· If the seller is found to have breached any of the warranties listed in the SPA and thereby caused damage to the buyer, the buyer has the right to financial compensation.

· The amount of compensation is usually determined based on the difference between the actual condition and the condition that should have been guaranteed.

2. Right to Redress

· The buyer also has the right to have the seller remedy the breached warranty.

· This right to remedy may include correcting defects or deficiencies, providing missing documents or information, or taking other steps to remedy the situation.

3. Right to cancel the contract

· In extreme cases where the breach of warranty is serious and fundamental, the buyer has the right to cancel the contract.

· This right can usually be exercised only in the event of a serious breach of fundamental guarantees that fundamentally affect the value of the transaction.

4. The right to reduce the purchase price

· The buyer may also request a reduction in the purchase price if the breach of warranty does not lead to a complete cancellation of the contract, but affects the value of the business.

· The reduction in the purchase price should be proportionate to the extent of the breach of warranty and the extent of the reduction in the value of the business as a result of the breach.

5. Right to Reimbursement of Costs

· In addition to compensation for damage, the buyer may also be entitled to compensation for costs associated with identifying and resolving warranty violations, such as legal costs, expert opinions, negotiation costs, etc.

· It is customary to distinguish between intentional and unintentional breaches of representations and warranties.

· Limits are usually agreed, from which amount of damage claims are made. In the case of an intentional (knowing) violation of the guarantee, the compensation is zero. The same applies in the case of so-called indemnity, i.e. in the case of explicitly listed negative facts, where any negative impact is borne by the seller.

How are warranty rights EXERCISED?

· Exercising rights for breach of warranty usually requires written notice to the seller of the alleged breach.

· The SPA often stipulates a certain period within which the buyer must exercise his rights for breach of warranty.

· The exercise of rights may be followed by negotiations between the parties with the aim of reaching an agreement regarding the rectification of the situation or the amount of compensation.

· If no agreement can be reached, the dispute may be resolved through court proceedings or arbitration.

The buyer's rights for breach of warranty are an important mechanism for ensuring the protection of the buyer's interests and minimizing the risk associated with the transaction. Their correct application and solution contributes to the successful course of the acquisition and the maintenance of trust between the parties.

Next time we will move one step further. We will close the contract transaction and talk about what happens after the "signing" and before the "closing" and how the "closing" itself takes place.

Do you need advice or representation at sale of the company? Do you have any comments about our series? Contact us! We have many years of experience in selling companies!