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September 24, 2008

Contract Representations versus Indemnities

In my previous column, I gave the hypothetical of a seller who refuses to give a flat or unqualified representation in an asset purchase agreement because he is afraid to make a representation that may turn out to be untrue.  He's afraid of the stigma of being sued for misrepresentation (and the impact that might have on his various business ventures), but seems to understand how you (as the buyer) would want to allocate the risk of an envirornmental problem to the seller.

A possible work-around in this situation is to:

  • Negotiate a qualified representation you can both live with (see my columns on flat versus qualified representations, and the materiality qualifier); AND
  • Negotiate a bulletproof indemnity where the seller promises to indemnify you for any damages suffered by you (the buyer) arising from or relating to any environmental law violation, clean up, etc.  In other words, the indemnity is triggered by any environmental problem, not just the seller's breach of its now qualified (i.e., diluted) representation.

This way, the seller won't risk making a misrepresentation, but nevertheless agrees to bear the risk of environmental problems by agreeing to indemnify you for environmental law violations, clean-ups, etc. as though it was making a flat or unqualified representation.

This is just a hypothetical fact situation, and the work-around can be applied to other representations as well.  In other words, I'm certainly not advocating using a work-around to handle something as potentially devasting as an environmental problem.  In real life, it's up to you and your advisors to determine the pros and cons of doing a work-around, versus sticking to your guns (and walking away from the transaction in case you don't get your way).  Hey, maybe the risk of a potential misrepresentation lawsuit is just the kick in the pants the seller needs to go the extra mile to do a really good investigation and preemptive clean-up so that he delivers you a clean piece of property.

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September 23, 2008

Contract Representations as Risk Allocation

Let's say you're negotiating an asset purchase agreement (APA) for your purchase of a retail car repair business.  One of the most important sections in the agreement is the representations section.  Representations are statements of fact made by one contract party to induce the other party to enter into the transaction.  In this case, the seller will be making a litany of representations to induce you to purchase the business.

In this example, let's say that because the seller hasn't owned the business for very long (having acquired it only a few years ago) he's reluctant to make unqualified or "flat" representations about the business.  So he negotiates aggressively to add a knowledge qualifier or a materiality qualifier to most of the representations.  You review his draft of APA, looking at all the qualifiers he's added, trying to figure out which ones you can live with and which ones you have to have "flat".  In particular, you're flabbergasted that he inserted a knowledge qualifier to the representation that there are no environmental law violations with respect to the property.  (You're not surprised either, given the potential devastating financial impact of an environmental law violation.)

During the ensuing negotiations, he explains that as much as he'd like to, he can't take the chance of making the environmental rep flat.  He says that as a short-term owner, he's just not confident that there aren't any problems, and as a matter of principle, he can't make a flat representation that may very well turn out to be untrue.

You explain that you empathize with his situation and appreciate his honesty, but can't accept the knowledge qualifier because he'd be off the hook as long as he didn't know, and you'd be left holding the bag.  You're not real thrilled with the materiality qualifier either because you want him (as the seller) to bear the entire risk of environmental problems.  This risk shift or risk allocation is a central tenet of contract representations.

Sellers won't necessarily shoot down the risk allocation argument.  You may find that the main reason for his refusal to make an unqualified representation is that he doesn't want to be liable for misrepresentation, including the stigma associated with a misrepresentation lawsuit.  If that's the case, maybe there's another way to tackle this issue.  More on that in my next column.  

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September 17, 2008

Compliance with Laws Representation - Materiality Standard - Material Adverse Effect

In a previous column, I discussed ways in which a seller can try to qualify a Compliance with Laws representation in a sale of business transaction (asset purchase version) using a Materiality Qualifier.  I talked about three categories of Materiality Qualifiers that the parties might negotiate, and the advantages and pitfalls of each.  These included the following:
 
Material Breach of Any Law
 
Any Breach of Material Law
 
Material Breach of Material Law
 

Today, I’ll talk about another Materiality Qualifier, one in which the person making the representation (in this case, the seller) doesn’t have to make the disclosure unless the disclosed fact, situation or circumstance has or is expected to have a material adverse impact on the disclosing person’s business.  For an otherwise fastidious seller, this eases the paranoia it might have about the consequences of making an honest mistake in forgetting to list trivial “parking ticket” type violations.  For the reasonable purchaser, this representation should be sufficient to give it a heads up of violations that really matter so that it can walk away from the transaction or remediate and negotiate a price adjustment.    

 
Again, here’s the “flat” unqualified representation that the purchaser would like the seller to make…
 
“The Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 

Here is the revised representation.  The underlined language contains both a List the Exceptions qualifier and the Materiality Qualifier discussed above.

 
 “The Seller is not in breach or violation of any….. law, regulation or other rule of any government authority, … except as disclosed in attached Exhibit A or to the extent that any such breach or violation does not or could not reasonably be expected to have a material adverse effect on the assets, business, financial condition or prospects of the Seller.”
 
Keep in mind that this version is no panacea for either party.  Fact is, you might still end up in court arguing about whether something should’ve been disclosed based on the meaning of “material adverse effect”.  But, you can learn something about your counterparty even from the process of negotiating this provision.  For example, if you are the purchaser, and the seller insists on a qualifier, that’s a good opportunity to find out why.  And if you’re the seller, and the purchaser is insisting that you make all of your representations “flat”, that might be a good sign that the purchaser is going to be tough to deal with (and possibly litigious) in general.

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September 15, 2008

Compliance with Laws Representation - Materiality Standard

In yesterday’s column, I discussed ways in which a seller can try to qualify a Compliance with Laws representation in a sale of business transaction (asset purchase version) using a List of Exceptions or Knowledge Qualifier.  In today’s column, I’ll discuss ways in which a seller can soften its representation by using a Materiality Qualifier.  

Again, here’s the “flat” unqualified representation that the purchaser would like the seller to make…


“The Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 
The seller is afraid that any trivial violation of law will give the purchaser a possible claim for misrepresentation, so it decides to try to negotiate a materiality standard into the representation.  Keep in mind that the trade off of including any kind of materiality standard is always going to be certainty versus flexibility.  In other words, the softer the seller makes the representation, the more uncertainty creeps into its interpretation.
 
Here are several alternate scenarios…..
 
Material Breach of Any Law - 
 
“Except as disclosed in attached Exhibit A, the Seller is not in material breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 
Note how I’ve also taken the liberty of adding a “List the Exceptions” qualifier to the representation.  Keep in mind that representations are statements of fact, that is, disclosures.  As long as the seller discloses the exceptions to its representations, then the purchaser won’t have a claim for misrepresentation.  It’s another story of course, whether after finding out about the exception, the purchaser still wants to go ahead with the transaction or negotiate a price reduction.
 

Okay, let’s examine the above qualified representation a bit more closely.  The revision may not serve the seller well because the representation seeks to capture significant violations of ANY law or regulation, even laws or regulations that are only tangentially related to the business.  Let’s say the seller is in the food business and is compliant with all laws and regulations related to the health and safety of its workers and customers (OSHA, FDA, local health laws, etc.).  Let’s say that the seller forgot to pay a citation it received for failing to shovel the sidewalk in front of its store (no slips and falls, nobody got hurt, but there it is, a $100 citation and fine, a significant violation of the sidewalk shoveling regulation).  This is a significant or “material” breach of a “small” law, and must be disclosed in this scenario.  If the seller forgets to include the citation in the exhibit, then it opens itself up to a misrepresentation claim.

On the other hand, purchasers aren’t well served by this version either.  The seller of the food business in my example can interpret this version to avoid the disclosure of minor infractions of important food safety laws.  Most purchasers of food businesses would want a heads up about even minor infractions of laws so important to the operation of the business.

 
Any Breach of Material Law -   
 
“Except as disclosed in attached Exhibit A, the Seller is not in breach or violation of any….. material law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 
Clearly, FDA or health and food safety regulations are “material” laws with respect to the seller’s food business.  But the revised representation doesn’t give the seller any wiggle room.  If the seller has even a tiny infraction of a food related regulation, then it’s got to disclose it in the exhibit.  Otherwise, it’s making a misrepresentation.
 
 
Material Breach of Material Law –
 
“Except as disclosed in attached Exhibit A, the Seller is not in material breach or violation of any….. material law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 
This one is much better for the seller.  But it goes too far in the other direction - most purchasers are going to object to this version because the disclosure threshold is too high.  It has to be a significant violation of a significant law before the seller has the obligation to disclose.
 
In the next column, I’ll discuss some Materiality Qualification language that may provide a reasonable solution that takes both party’s interests into account.

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September 14, 2008

Compliance with Laws Representation - Flat versus Qualified

A representation is a statement of fact made by one party to induce the other party to enter into the transaction.  In a sale of business transaction (whether an asset or entity sale), the seller makes a litany of representations about the business it’s selling (and about its ability to enter into the transaction) to induce the purchaser to buy the business.

In today’s column, I’m going to focus on the “Compliance with Laws” representation that a seller of a business makes in a sale of business transaction.  The typical buyer isn’t going to want to take over (or pay full price for) a business that it thinks may be breaking the law.  The seller makes the “Compliance with Laws” representation to assure the buyer that the Company isn’t in violation of any law or regulation.

The parties typically spend quite a bit of time negotiating the wording of this representation. 

The buyer would like the seller to make the representation “flat”, that is, without qualification.


Here is a variation of a standard “flat” Compliance with Laws representation (asset purchase version).


“The Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”


In this case, any violation of the law, no matter how trivial, would subject the seller to a possible claim by the purchaser for misrepresentation, even if the violation has no material adverse impact on the business being sold.  (For a rough analogy, imagine that you are applying for a home loan and the bank refuses to approve your application because you have an unpaid jaywalking ticket.  Assuming that the ticket is for a small amount, it has no bearing on your creditworthiness.)


Most sellers, on the other hand, want to qualify this representation with wording that minimizes this risk.


The Seller can qualify the representation several ways.


List the Exceptions –

“Except as set forth in attached Exhibit A, the Seller is not in breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”


In the revised representation, the seller would list all the violations in an exhibit to be attached to the asset purchase agreement.  Note that this method is only as accurate as the memory of the seller.  If the seller forgets to list a violation, then it’s a misrepresentation.  For the seller, although better than a flat representation, it’s still not so forgiving.
 


Knowledge Qualifier
 
“To the best of it’s knowledge, the Seller is not in any breach or violation of any….. law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 
In the revised representation, the seller makes a misrepresentation only if it was aware of the violation (or should have been aware of the violation after making at least a reasonable inquiry). 
 


Materiality Qualifier –
 
“The Seller is not in any [material] breach or violation of any….. [material] law, regulation or other rule of any government authority or ruling or other determination of any court or other tribunal to which the Seller, or with respect to which any of its assets or business, is subject.”
 

In my next post, I’ll explain how the placement of the word "[material]" in the representation can have a dramatic impact on the meaning of the representation, and discuss commonly negotiated compromise language for this representation.

 

 

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