M&A Vocabulary – Experts Explain: “Reps & Warranties”

In a transaction, there is generally an information asymmetry between the parties: the seller is usually informed about the condition and all operations within the target company, while the buyer attempts to examine all factors crucial for the purchase for potential risks as part of their due diligence.

The buyer relies on the information provided by the seller during the due diligence process, as they have little to no other opportunity to familiarize themselves with the actual circumstances within the target company or other conditions relevant to the transaction before the contract is concluded. Therefore, a catalog of “Representations & Warranties” (“Reps & Warranties”) is regularly an integral part of a transaction agreement.

As a rule, this catalog is designed as a conclusive regulation regarding the assurances and guarantees given by the parties, and the application of statutory warranty rights beyond this is excluded.

This catalog regularly includes assurances regarding the following areas:

• Ownership, power of disposal, and unencumbered status of the shares in the target company
• Proper organization of the target company, no insolvency event or impending insolvency of the target company and the seller
• Proper accounting in accordance with applicable legal provisions and accounting principles and regulations, in accordance with consistently applied principles, no material adverse change since the last balance sheet date
• Proper preparation and timely submission of tax returns, full payment of due tax amounts or provision for amounts not yet due
• Ownership (and possibly condition) of certain essential operating assets
• Proper fulfillment of material contracts and no knowledge of termination intentions by the contracting party (possibly disclosure of all change of control clauses)
• Existence of all required commercial, environmental, and other permits, no legacy contamination or environmental risks
• Existence of all required intellectual property rights (ownership or license), no infringement of third-party intellectual property rights or by third parties
• Full and accurate disclosure of all employment-related credits and pension agreements, no underfunding in occupational pension schemes, and full provision for pension commitments
• Non-existence of current or threatened litigation, with the exception of disclosed cases
• Accuracy and completeness of the disclosed information and documents, which are also not misleading.

The time at which the Reps & Warranties listed in the catalog must be true is contractually determined by the parties; typically, this includes at least the signing date and the closing date of the transaction. If the accuracy of individual or all assurances is a condition precedent to closing, the buyer may refuse to close if there is a breach of the assurance.

It is quite common to qualify assurances by mere knowledge and to give them only “to the best of one’s knowledge.” In this case, the correct definition of whose knowledge is decisive is of great importance, as the seller or their representatives are not always simultaneously in operational responsibility at the target company, e.g., as managing directors. Furthermore, the question of what should have been known is sometimes regulated, i.e., what standard of care the seller must apply and whether even negligent ignorance triggers a breach of the accuracy of such a qualified assurance.

Finally, the seller’s liability for inaccuracy of an assurance is generally limited by the disclosed documents, so that information properly “disclosed” by the seller limits or even completely excludes their responsibility towards the buyer.

Otherwise, in the event of a breach of an assurance, the buyer is entitled to warranty rights, the scope and limitations of which are also contractually agreed upon. The reversal of the transaction after its completion is regularly excluded, as this is often associated with various problems. The same applies to the regulations regarding assertion, i.e., within what deadlines, in what form, and to whom information about the existence of a breach is to be sent, within what deadlines and in what form a reaction and, if necessary, remedy must take place, and what claims are due to the party invoking the breach of the assurance.

In practically all cases, the assertion of claims due to the inaccuracy of an assurance is time-limited. The claims themselves must exceed a certain minimum amount to be asserted at all (“de minimis”). In addition, they are generally limited in amount (“cap”) and secured by retentions or bank guarantees. For known risks or risks that cannot be estimated in amount, indemnities can be agreed upon, for example, for tax reassessments.

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