Navigating Representations and Warranties in Share Purchase Agreements

By Leon Yee and Sally Kim

When buying or selling a company or part of its shares, the intricacies of representations and warranties within a Sale and Purchase Agreement (“SPA”) play a pivotal role. Representations and warranties serve as assurances provided by the seller to the buyer regarding the condition, status, and other relevant aspects of the target company. These provisions not only influence the negotiations but also significantly impact post-closing responsibilities and liabilities. Understanding the nuances of representations and warranties in SPA is crucial for both parties involved in the transaction. In this article, we explore the nuances of representations and warranties in an SPA, including drafting considerations, breach remedies, and indemnification provisions.

Representation and Warranties

A representation is a statement of fact or assertion made by one party to another during the negotiation or formation of a contract. It is intended to induce the other party to enter into the contract.

On the other hand, a warranty is a statement of assurance or guarantee regarding the accuracy of certain facts or the performance of certain obligations within the contract itself. In practice, the terms “representation” and “warranty” are frequently employed in conjunction. If a representation is not true, it is “inaccurate.” If a warranty is not true, it is “breached”.

Drafting Considerations

In Singapore, the seller typically provides representations and warranties and, depending on the negotiation dynamics and issues uncovered during due diligence, indemnities to the buyer. A buyer-oriented SPA might incorporate a general indemnity covering any liabilities resulting from breaches of warranties, along with specific indemnities addressing particular issues revealed during due diligence.

The representations and warranties need to be customized for each transaction, but common areas of safeguarding include, ownership, authority, and capacity, corporate details (e.g., share structure), financial records, banking and financial matters, contracts related to the business, asset portfolio (including real estate and leases), intellectual property holdings, employee-related matters and benefits, compliance with legal requirements, environmental considerations, litigation status, insurance coverage, taxation matters, and insolvency concerns. Parties typically have the liberty to negotiate representations, warranties, and indemnities, and their extent can vary significantly from one transaction to another, depending on the bargaining power of the parties involved.

Negotiations on the warranties usually focus on their extent and comprehensiveness, along with different qualifiers such as materiality and the seller’s knowledge, which the seller will seek to incorporate but the buyer will resist to a certain extent.

Some of the key factors to consider while drafting the representations and warranties provisions are as follows:

(a) Specificity and Accuracy: Precision is paramount when drafting representations and warranties. Parties must clearly define the scope of each representation and warranty to avoid ambiguity and misinterpretation. Defining the scope involves explicitly outlining what is and is not being represented or warranted. For instance, a representation about the company’s financial statements should clearly specify the time period covered, any accounting principles used, and if there are any known exceptions or material uncertainties.

A comprehensive due diligence is the buyer’s crucial tool for ensuring the accuracy of the seller’s statements. This process involves a thorough investigation of the target company’s financial records, legal standing, and operational practices. By investing time and effort in these areas, both parties can significantly mitigate the risk of disputes arising from vague or misleading representations and warranties. Upfront clarity and diligence pave the way for a smoother M&A transaction and protect the interests of both the buyer and seller.

(b) Materiality Thresholds: Parties often incorporate materiality thresholds to delineate the significance of breaches. These thresholds serve as benchmarks for assessing the magnitude of breaches and play a crucial role in allocating risk and responsibility between the parties. Additionally, transparent materiality thresholds enhance transparency by providing both parties with a clear understanding of their rights and obligations in the event of a breach. For instance, a minor accounting error might not be considered a material breach if it has a negligible financial impact. However, a hidden environmental liability could be a material breach that triggers significant financial repercussions for the seller. By establishing clear materiality thresholds, both parties can effectively prioritize issues that warrant further negotiation and attention. This streamlines the transaction process, fosters transparency, and provides a framework for resolving potential disputes after the deal closes.

(c) Survival Periods: Determining the duration for which representations and warranties remain enforceable post-closing is crucial. Survival periods typically range from 12 to 24 months but may vary based on factors such as industry standards, the nature of the transaction, and specific risks involved (for example, if due diligence uncovers particular areas of concern, a longer survival period might be necessary to provide adequate time to investigate and address the potential issues arising). These survival periods serve as safeguards for both parties. The buyer has a window of time to identify and address any breaches of representations and warranties that might not be immediately apparent after closing. The seller has some protection against claims arising from issues that surface well after the transaction is complete. By carefully evaluating and tailoring survival periods to the unique circumstances of the transaction, parties can effectively manage their post-closing obligations and liabilities. This fosters a sense of confidence and certainty in the agreement, as both parties have a clear understanding of their rights and responsibilities throughout the defined timeframe.

One of the common strategies utilised by sellers to mitigate their exposure to warranty claims is to qualify the warranties based on their knowledge whenever feasible. This is typically achieved by introducing language such as “To the best of the Seller’s knowledge and belief” or similar wording before the warranty statement. By employing this tactic, the seller aims to avoid assuming responsibility for undisclosed issues that it may not be aware of (and, in some cases, could not reasonably be aware of). Whether the buyer is willing to agree to this division of risk will be subject to negotiations, taking into account the nature of the warranty in question and the overall circumstances of the transaction. For example, the buyer may find the qualification acceptable for warranties involving speculative or forward-looking aspects.

If the buyer is willing to agree to a knowledge qualifier regarding any of the warranties, negotiating the definition of what constitutes knowledge or awareness for this purpose will also be necessary. The seller’s ideal scenario is to limit the qualification to its actual knowledge (without any prior inquiry), excluding both constructive knowledge (information the buyer should have) and imputed knowledge (information attributed to the buyer’s agents or advisors by law). However, such a narrow definition of knowledge is typically unacceptable to the buyer. The buyer seeks assurance that the warranties are not given blindly and aims to prevent the seller from avoiding liability by choosing to remain unaware of potential issues. Consequently, the buyer is likely to demand that if a warranty is qualified by the seller’s knowledge, the seller must have thoroughly investigated the subject matter of the warranty.

If the seller is obligated to conduct inquiries, it typically aims to limit this duty to making reasonable inquiries of specific individuals only. This is done to reduce the number of individuals involved in the disclosure process and mitigate the risk of being attributed with knowledge of other employees, agents, or advisors who have not been consulted.

Remedies for Breach

When entering into an SPA, both the buyer and the seller place substantial reliance on the representations and warranties provided by each side. These assertions act as guarantees concerning the accuracy and truthfulness of specific facts and conditions pertinent to the transaction. Most agreements expressly limit the buyer’s remedies for inaccuracy or breach of representations and warranties to indemnification rights or other express remedies. Nevertheless, failing to uphold these representations and warranties can entail significant repercussions for the party responsible for the breach. The specific remedies available to the parties depend on various factors, including the terms of the SPA, the nature of the breach, and applicable Singapore laws and regulations.

(a) Indemnification: One of the primary remedies for breach of representations and warranties is indemnification. In the event of a breach of representations and warranties, the buyer may seek indemnification from the seller for damages incurred. Indemnification provisions outline the procedure for making claims, including notice requirements, limitations on recovery, and dispute resolution mechanisms.

(b) Specific Performance: In some cases, the buyer may seek specific performance, where the seller is compelled by the court to fulfill the obligations outlined in the representations and warranties. This remedy is typically sought when monetary damages are inadequate to remedy the breach adequately. Specific performance may be enforced through court orders.

(c) Damages: Damages are monetary compensation awarded to the non-breaching party to compensate for losses suffered as a result of the breach but this would be subject to a remoteness test under case law. The measure of damages typically aims to put the non-breaching party in the position they would have been in had the breach not occurred. Damages may include direct damages, consequential damages, and incidental damages, among others.

(d) Rescission: Rescission allows the buyer to cancel the SPA and to void the transaction and then recover any consideration paid. It seeks to put the parties back to their original position. Rescission may be available if there is a misrepresentation and the breach is so significant that it undermines the entire purpose of the agreement.

(e) Termination Right: The buyer may have the right to terminate the SPA if certain representations and warranties are breached. Termination allows the buyer to walk away from the transaction without further obligations or liabilities. Termination rights may be triggered by specific breaches outlined in the SPA or by a material breach of the agreement as a whole.

(f) Remedies Limitation: From seller’s point of view, limiting the remedies available to the buyer for breaches of representations and warranties can help mitigate the seller’s exposure to excessive liabilities. Common limitations include caps on indemnification obligations, deductibles, baskets, and thresholds.

(g) Escrow Arrangements: If the representations and warranties provisions in the SPA are particularly inducing, parties may also opt to establish an escrow account to secure funds for indemnification purposes. This mechanism provides assurance to the buyer that adequate resources are available to address potential breaches, while also safeguarding the seller’s interests by ensuring a structured approach to claims. Strong parent company guarantees or alternative security instruments might replace the need for an escrow depending on the specific situation.

(h) Mitigation: Under the common law, both parties have a duty to mitigate their losses following a breach of representations and warranties. This may involve taking reasonable steps to minimize the impact of the breach and mitigate the resulting damages. Failure to mitigate damages may limit the non-breaching party’s ability to recover full compensation.

Remedies for breach of representations and warranties in an SPA are essential provisions that help allocate risk between the parties and provide recourse in the event of a breach. Understanding these remedies and their implications is crucial for both buyers and sellers involved in the SPA.

Indemnification Provisions

Indemnification provisions define the responsibilities of the parties in case of a breach of the representations and warranties. They specify how losses, damages, or liabilities will be allocated between the buyer and the seller. These clauses provide a mechanism for resolving disputes and ensuring that any financial penalties are appropriately addressed. Some of the key elements to consider when drafting the indemnity provisions are as follows:

(a) Indemnifiable Losses: Parties should delineate the types of losses eligible for indemnification, such as direct damages, third-party claims, and legal expenses. Clarity regarding the scope of indemnifiable losses minimizes disputes and facilitates efficient resolution.

(b) Indemnification Procedures: Establishing clear procedures for indemnification claims, including notice requirements, investigation rights, and dispute resolution mechanisms, promotes transparency and expedites the resolution process.

(c) Tax Indemnities: Given the potential complexities in tax related matters, parties often include tax indemnities to address potential liabilities arising from undisclosed taxes, tax assessments, or tax-related contingencies. Thorough tax due diligence is essential to identify and mitigate tax risks effectively.

Often the seller that makes the representations and warranties try to limit the impact of representations and warranties and limit the scope of indemnification. The seller will commonly do so by subjecting the indemnification provisions to caps, baskets, and other liability limitations, which may not apply to claims that are not covered by indemnification, and implementing carve-outs for certain types of losses such as intellectual property breaches and losses due to an indemnified party’s gross negligence, recklessness, or intentional wrongdoing.

On the other hand, the buyer, which is the recipient of the seller’s representations and warranties, seeks to maximize the effect of the representations and warranties, broaden the scope of indemnification, reduce the extent of liability limitations, and insist on joint and several liability in the case of multiple sellers. The buyer may try to do so by retaining broadly worded representations and warranties while resisting those that are overly qualified or limited, negotiating a sufficient survival period, reinforcing qualified and otherwise limited representations and warranties for purposes of indemnification by including a clause that eliminates materiality, material adverse effect, and other similar qualifications for indemnification purposes, and excluding claims relating to selected representations and warranties from caps and baskets.

In conclusion, representations and warranties constitute fundamental elements of SPAs in Singapore M&A transactions, shaping the rights, obligations, and risk allocation between parties. By navigating the nuances of these provisions and incorporating appropriate drafting considerations, breach remedies, and indemnification provisions, parties can enhance the clarity, enforceability, and ultimately the success of their transactions.

For More Information
If you have any questions about this article, please contact Duane Morris & Selvam Chairman Leon Yee or Associate Sally Kim if you would like to discuss this update.

About Duane Morris & Selvam LLP
Duane Morris & Selvam LLP is a joint law venture between international firm Duane Morris LLP and Singapore-based firm Selvam LLC. Duane Morris & Selvam runs a unique Latin American-Asian practice out of Singapore, with a team of international lawyers qualified in multiple jurisdictions including Singapore, the U.S., the U.K., Canada, Mexico and Colombia, with substantial experience in international transactions and disputes. Duane Morris & Selvam also has cooperative relationships with some of the best Latin American and Asian law firms.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm’s full disclaimer.

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The opinions expressed on this blog are those of the author and are not to be construed as legal advice.

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