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Imagine that you’ve bought a business that runs a web app, and a few months later you discover that a key piece of code was written not by an employee, but by an independent contractor, and that the contractor had no written agreement for that work (which under Canadian law means you don’t own the work), and wasn’t paid for it. And imagine that the contractor left after an argument with the seller, and is still so annoyed that she now wants to be paid extra for that work.

Or that you discover that the company had been withholding income tax from its employees but not remitting that money to the government. Or that it had been collecting HST on sales of products, but not remitting that. And the money is not in the bank account.

Who should bear those losses – the seller or the buyer? I think most people would agree that these (assuming they are material) are risks that should fall on the seller’s shoulders – every business has ‘warts’ and nothing in life is perfect, but the buyer will expect that certain aspects of the business are ‘in order’, and if they aren’t, will expect to pay less for the business because of it.

Representations and warranties (I’ll call them “reps” from now on) are the contractual tool that buyers and sellers use in an M&A (M&A means ‘mergers and acquisitions’) transaction to allocate the risk of these imperfections. Fred covered these in his last MBA Mondays post (I’ve titled this post playing off of his title mainly because it’s a riff off of his), so I thought I’d write a few posts explaining, from the Ontario lawyer’s perspective, some of the basics of representations and warranties in an M&A context. This is the first post – others will follow soon.

First, some terms. A representation and warranty is simply a statement of fact – for example: “we have properly collected and remitted all HST and other excise taxes required to be collected and remitted by us in the course of operating our business” or “we own or properly license all of the intellectual property that we use in our business.” It can be about the past, the present or the future. For example, “Our financial statements dated December 31, 2010 fairly present the financial condition of the Company at that time” or “We have 25 employees and their names and job titles are on Schedule A” or “The use of the Intellectual Property in the Business after the Closing Date in the manner in which it was used in the Business before the Closing Date will not infringe the rights of any third parties.” Fred’s post mentions a difference between a representation and a warranty, but in Ontario, purchase and sale agreements no longer distinguish between them – the difference is a historical footnote. The critical point is that a rep is a statement of fact which, if false, entitles the buyer to a remedy.

An “indemnity” is that remedy – it’s a promise to pay someone an amount if an event occurs. In this context it’s a promise by the seller to the buyer to pay for any loss the buyer suffers if any rep is false. Taken together, reps and indemnities allocate risk between seller and buyer. The issue is not so much whether a rep is true as it is which party bears the risk of the rep being false.

The M&A process involves (typically) the buyer preparing a draft agreement that includes a wide variety of reps (pages and pages of them – there are some very simple US examples starting on page 5 here in this example of the ABA’s Model Asset Purchase Agreement). The agreement will generally have one or several schedules in which exceptions to the reps are listed. So, if a rep is not true, the details will be disclosed by the seller to the buyer and noted on the schedule. The parties also haggle over the wording of the reps – the seller trying to make them narrower (with narrower disclosure more risk gets pushed to the buyer), the buyer trying to require full disclosure. This process of negotiation and disclosure is one of the main ways the buyer learns about the business and whether it corresponds to its expectations.

The buyer will also be doing due diligence to verify the truth of the reps and warranties. Why do the due diligence? Well, it’s one thing to have a right to sue someone if a rep is false, but wouldn’t you rather know *before* you pay whether a rep is false? That way, instead of paying and then suing for money back, you can reduce the price. So, due diligence is a critical supplement to the reps, but many things about a business cannot be meaningfully investigated, so the reps need to stand on their own as ‘insurance’ for the buyer. Due diligence is partly a legal exercise, and partly a business exercise. Lawyers will review contracts and minute books and so on, business people will review contracts, financial records, code, and so on.

Another way of looking at this is to think of the phrase “as is” – when you buy something “as is”, the buyer is at full risk of the thing not corresponding to the buyer’s expectations – there is no remedy against the seller for any variance (except perhaps for cases of fraud or other deception). When you’re buying a business from a receiver or a trustee in bankruptcy, with few exceptions that is generally the scope of the reps and indemnities you will get from the seller – very, very narrow. But when you’re paying full price, you expect to be made whole if the business is not what you reasonably expected it to be. That’s where reps and indemnities come in. This perspective also illustrates the link between the price the buyer pays and the scope of the reps and indemnity. A fully-priced deal will come with lots of protection for the buyer, while a bargain basement price (for example, from a receiver or trustee in bankruptcy) – not so much.

More on negotiating reps, and on indemnities, soon.