LBO: Representations And Warranties

Joseph W. Bartlett, Special Counsel, McCarter & English, LLP

Traditionally, after the deal has been described, the Purchase Agreement plunges into the issuer's representations and warranties, one of the longest sections in the agreement. This is the section with which lawyers inexperienced in venture financings feel most comfortable, and the overwriting in this section becomes almost competitive. Thus, investors" counsel from one of the major New York firms, accustomed to billion-dollar merger and acquisition transactions, will write in representations dealing with multiemployer collective bargaining agreements for a company with two employees. The way to approach the representations and warranties section, accordingly, is to understand the underlying dynamics. [1]

Representations and warranties are not designed to serve the same purpose in venture finance as in giant merger and acquisition (commonly abbreviated as M&A) transactions between solvent investors and issuers. If the start-up issuer misstates its balance sheet to prospective investors, the inclination of the damaged investors to seek restitution must be restrained because the guilty party, almost by definition, will be out of money. As an aid in making aggrieved investors whole from the pockets of the issuer, the representations and warranties in an early-round financing are usually a bust. Moreover, it is arguable that explicit representations and warranties are superfluous since the investor enjoys common-law remedies for the tort of deceit and statutory protection under Rule 10b-5 of the '34 Act. Why, then, bother with elaborate representations and warranties?

First of all, the section is designed, although not explicitly, as a device to draw into a lawsuit, given a misrepresentation, the perennial "deep pockets" in the financing: the law firm, the accountants, and the investment bankers (if any) serving as placement agents. Although the representations as to the financial statements are made by the issuer and the issuer alone, the existence of the representation makes it plain, if the question were ever in doubt, that the investors were relying on the accuracy of the statements and all the ancillary parties engaged in preparing the Purchase Agreement are, or should be, aware of such reliance. Since reliance to one's detriment has historically been an element of a plaintiff's case in the tort of deceit (although not universally required in the modern cases) [2] (memorialization in writing of the investors" reliance may obviate problems of proof. The issue of scienter [3] —a claim by the issuer that it did not know of the critical omission-is also avoided by explicit "warranties."

Further, those representations that have to do with the legal facts surrounding the issuer's existence-its due organization, the number of shares outstanding-form the reference point for an opinion of issuer's counsel validating those propositions which counsel are in a position to verify; again, a deep pocket if a damaging error is made. (A point of particular interest in a high-tech start will often be counsel's opinion concerning the validity of the patents, copyrights or trade secrets protecting the issuer's technology.) Moreover, participation in the process of preparing the written representations-drafting the language in the case of counsel-may be enough to draw counsel into the zone of responsibility as a matter of law; the lawyers become "participants" in the entire transaction. Similarly, the founder can sometimes be induced to endorse certain of the representations personally, putting his pocketbook (for what that's worth) behind the statements made. If the founder balks, claiming he cannot be held to know certain facts absolutely, a representation can be softened to a so-called "knowledge rep" -that is, "to the best of my information and belief" -thereby catching the founder who is demonstrably lying. If the founder cannot pay in cash, the worst case is that investors can pick up some or all of his equity .

The representations also serve to motivate all hands-founder, investment bankers, lawyers, and accountants-to reexamine the facts. This is an incontestably salubrious use of the section: to energize these parties to do their investigations carefully so as to minimize subsequent disputes. In fact, if the investors want to make (as they usually should) their own investigations-an "acquisition audit" as it is sometimes called-they may be deterred by a fear that the issuer will attempt to defend a charge of misrepresentation by claiming the investor is estopped by its own inquiries. Unconditional written representations, perhaps accompanied by a statement that the investors may rely even in light of their own audit serve to diminish that concern.

The representations serve an important ancillary function: as closing conditions. Assuming that the Stock Purchase Agreement is not closed simultaneously with its execution, the investors will be able to withhold their investment if they discover imperfections in the period between execution and closing. In fact, one of the traditional representations is to the effect that there will be no materially adverse change in the issuer's business between signing and closing, which gives the investors an "out" even though the issuer has told the truth throughout. [4]

Finally, the warranty flavor of the representations and warranty section indicates the function of these provisions as a risk allocation device. Thus, it assumes a contingency the warranting party did not know about and could not have known about. The resultant loss is the responsibility of the warranting party even though the representation was not, at least consciously, untrue.

[1] The use of the term "representations and warranties" is, in a sense, a typical legal redundancy. Whether representing or warranting, the issuer is making a statement of fact (although promises often seep into this section) which it agrees to stand behind, responding in the event of a misstatement or omission. The question is whether the issuer is liable only for a misrepresentation entailing a breach of some standard of care or is absolutely liable. The term "warranty" implies the latter and, if so, the term "representation" is superfluous. See the last paragraph of this section.

[2] Prosser & Keeton on Torts, § 108 (5th ed. 1994).

[3] According to the United States Supreme Court, a plaintiff seeking redress on the basis of Rule l0b-5 of the "34 Act must allege and prove the defendant's scienter. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976). The notion is that plaintiffs seeking statutory relief must show the representation to be false to the knowledge of the speaker or made with reckless disregard as to truth or falsity.

[4] This is sometimes called a "bring down" provision. It appears as a generic provision, bringing down all the representations so that they speak as of the closing date. It is also used specifically, bringing down the financial statements, in which case supplementary material should be filed or a statement made that the interim changes-changes which necessarily have occurred-are "in the ordinary course of business."

Joseph W. Bartlett, Special Counsel,

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