Representations and warranties are typical contractual clauses in M&A transactions
Declarations and guarantees are typical contractual clauses in M&A operations, widespread among lawyers, businesspeople and financial advisors. Most of the disputes related to the purchase and sale of corporate interests arise from representation and warranty clauses. The main focuses of disputes involving representation and warranty clauses are their different variations and effects, the possible impacts of breach of representations and warranties and the ways to mitigate or increase the strength of the guarantees provided.
HOW REPRESENTATIONS AND WARRANTIES CLAUSES WORK
Declaration and guarantee clauses function as instruments to level the asymmetry of information between the buyer and seller of equity interests, allowing better pricing of the business and optimizing the work of identifying the risks and advantages arising from the operation. Through such clauses, the seller normally reveals a set of relevant facts, information and/or documents to the buyer, certifying that their content is – or at least should be – true.
If, after closing the transaction, the declared facts and information are not verified in practice, or if there is inaccuracy in the data provided, the seller may be held responsible and required to compensate the buyer. In other words, through this mechanism, the seller is persuaded to disclose as much information as possible about the business to the buyer.[1].
[1] ALBA, Maristela Sabbag. Business Succession – Representations and Warranties – the Role of Legal Due Diligence. In: MONTEIRO DE CASTRO, Rodrigo R. (Coord.); ARAGÃO, Leandro Santos de (Coord.). Corporate reorganization. São Paulo: Quartier Latin, 2005. p. 110.
THE EFFECTS OF THE REPRESENTATIONS AND WARRANTIES CLAUSE
Legally, representations and warranties are usually used as a way of documenting a certain factual situation and its knowledge by the parties, allocating risks regarding certain factual situations and/or indicating characteristics considered essential for the formation of the contract, without which the purchase or sale of the equity interest or assets would not be desired by the parties.
For risk allocation purposes, the provision of representations and guarantees will create a relative presumption regarding the veracity of the information, which will exempt its proof by the party in favor of which they were provided in any future dispute (art. 219 of the Civil Code and art. 374, IV, of the Civil Procedure Code)[1]. For example: by providing a representation and warranty that a list of all labor claims known to the target was provided, presumptions are created that the buyer was aware of the existence of the labor claims listed by the seller and the seller was not aware of other labor processes.
In the second case, the objective of the parties is not simply to prove the transfer of certain information or documents, but to create a rule of contractual civil liability, in which the provider of representations and guarantees is obliged to repair the losses caused by the falsity or incompleteness of the data passed on. Returning to the previous example, if the buyer is surprised by the existence of other labor claims not listed by the seller, the buyer may be compensated by the seller due to the losses that the labor claims cause.
It may also happen that the objective of the parties is neither the establishment of relative procedural presumptions nor the reparation of financial losses resulting from the breach of declarations and guarantees, but rather the definition of negotiation factors considered indispensable for the formation of the contract, so that that, without the definition of these factors, the purchase and sale of the equity interest would not be desired[2]. In this case, any falsity of the representations and guarantees may result in the annulment of the M&A contract due to defects in consent – for example, error (art. 138 of the Civil Code) or fraud (art. 145 of the Civil Code).
DISPUTES INVOLVING THE EFFECTS OF REPRESENTATIONS AND WARRANTIES
Precisely because of the variety of purposes and effects that representations and warranties clauses can generate, they are fertile ground for disputes in M&A contracts, especially regarding their use as a basis for invalidation, due to error or willful misconduct, resolution (termination) of the contract and for compensation purposes.
If, for example, the parties intend to use representations and warranties as a way of allocating compensation, it is important to indicate the provision of false information as an event giving rise to compensation in the contract, preferably with the imposition of a fine (compensatory or not, depending on case by case and type of breach of representation and warranty). Likewise, if the objective is to establish objective bases for defects of will, it may be interesting to condition the conclusion of the transaction on the maintenance of the veracity of the declarations and guarantees on the closing date.
In this scenario, the preparation of contractual instruments compatible with the objective of the representations and warranties is of paramount importance for success in this type of disputes in the future.
*Bruno Viana, associate lawyer at Freitas Ferraz Capuruço Braichi Riccio Advogados, collaborated.