What are the most common ways to modulate the representations and warranties clause?
A few months ago, we began a series of articles on the important role played by representations and warranties clauses in M&A transactions. On that occasion, we analyzed the functioning of representations and warranties, the different effects that may emanate from these clauses — notably, the creation of relative presumptions, the allocation of contractual risks for compensation purposes and the establishment of the bases for possible annulment of the contract due to error or intent — as well as the care that must be taken in a possible dispute involving breach of representations and warranties.
In this article, we will work on the most common ways of modulating the declarations and guarantees clause to increase or mitigate the contractual risks assumed by the seller, mainly involving the qualifiers of knowledge, materiality, time and values. We will also address some precautions to be taken in disputes involving representation and warranty clauses with qualifiers of knowledge, materiality and time.
WHY REPRESENTATIONS AND WARRANTIES ARE USUALLY MODULATED
Declarations and guarantees are an instrument for allocating risks and reducing the information asymmetry inherent in M&A operations. In it, one of the parties — usually the seller — reveals a certain factual situation to the other party, guaranteeing that the information provided is true. If the statement proves to be false, incomplete or inaccurate, the party that provided it is contractually obliged to repair the damage caused.
The allocation of contractual risks through these clauses becomes somewhat more complex when the target company is large or has a large geographic area of activity. In such hypotheses, it may be difficult — or even impossible — to categorically attest to a given factual situation, especially after considering that the people tasked with negotiating the M&A operation by the seller often do not know the day-to-day operations of all of society's production units. target at its most diverse management levels. Furthermore, sometimes, the holder of certain business information of the target company has already left its staff and directors and supervening events can cause a true statement at signing to become false at the time of closing.
In the same way that the buyer seeks to limit its risks in relation to the object of negotiation, it is reasonable that the seller also seeks to limit its duty to indemnify. It is common for the parties to negotiate the intensity of representations and warranties, with the buyer's advisors insisting that the statements be solid and concrete, while the seller's advisors argue that the statements are merely informative.
THE MAIN WAYS TO MODULATE THE INTENSITY OF REPRESENTATIONS AND WARRANTIES
Modulating the intensity of declarations and guarantees is a matter affecting the private autonomy of the parties, who have broad freedom to adjust the most diverse ways of mitigating or increasing the risks assumed in the contract. However, practice reveals that the most common ways of modulating declarations and guarantees involve the insertion of the qualifiers of knowledge, materiality and time.
The knowledge qualifier aims to limit the scope of representations and warranties to facts that the seller knows, or at least should know. In this case, if the information revealed to the buyer is false, but the seller is unaware of this falsehood, there will be no breach of representations and warranties. The buyer will only be entitled to compensation if it proves that the information provided by the seller is not true and that the seller knew — or should have known — that that information is not true.
In the materiality qualification, the content of the information provided is limited to issues that, if known to the other party, could impact their decision to conclude the deal or not. Small inaccuracies and falsehoods, unable to substantially affect the buyer's decision-making, will bypass the contract and will not give rise to a breach of representations and warranties. A very common example concerns declarations of compliance with laws and regulations applicable to the target company. On a practical level, it is quite common for companies to be unable to comply with all legal and infra-legal rules that apply to them — therefore, it is reasonable to limit the seller's exposure to only materially relevant infractions.
One of the most frequent uses of this materiality qualifier involves declaring the absence of legal or administrative proceedings against the target company. Often, those responsible for negotiating the M&A contract have little knowledge of the number of demands against the target company and, especially in retail companies, it is common for the number of processes distributed between the signing and closing of the transaction to be quite different. In these cases, it is customary to modulate the guarantee provided to state that “there are no lawsuits with a claim value greater than R$ 'X' thousand against the seller”, or that “the seller's judicial contingent is less than R$ 'X' thousand".
In the time qualifier, in turn, the parties establish a temporal limit on the veracity of the information provided. This is what happens when the seller certifies, for example, that until July 1, 2019, the date of its last audit, the target company had not entered into any contracts with related parties. Even if the target company has signed contracts with its administrators and controllers after July 1st, there will be no breach of representations and warranties.
DISPUTES INVOLVING MODULATION OF THE INTENSITY OF REPRESENTATIONS AND WARRANTIES
The issues involved in conflicts involving breach of modulated representations and warranties tend to have more factual content than legal content. As a rule, the parties do not have major differences regarding the nature and effects of the qualifier used in the contract. The dispute normally concerns the actual breach of representations and warranties; that is, whether the seller knew the information provided was false and whether the inaccuracy in the data is substantial. In both cases, the buyer's success or failure largely depends on the evidence she can gather.
A solid evidentiary instruction is essential to the buyer's success when the dispute involves the qualifier of best knowledge. Official letters, audit reports and extrajudicial notifications with confirmation of receipt are fundamental evidence in this type of dispute. In the absence of documents, testimonial evidence will be the possible alternative.
When the M&A transaction involves the qualification of materiality, the discussion will mainly revolve around the potential impacts that false representations and warranties will have on the buyer's objectives and expectations with the transaction. In cases like this, the communications exchanged between the parties and the testimonies of technical witnesses gain special relevance for the success of the dispute.
-mails in which the buyer externalizes its interest in gaining synergies, accessing new relevant markets or consolidating a dominant position in the market to the seller are of paramount importance to move away from the mental reserve regime (article 110 of the Civil Code) and prove the material nature of untrue statements for the operation. Likewise, statements from expert witnesses can be extremely useful in showing how the falsity of a given statement directly affects the buyer's objectives with the contract — especially when the materiality involves a non-pecuniary event, such as the entry of a new competitor into the relevant market of the company. target society.
In all cases, it is highly recommended that the initiation of the dispute be preceded by a stage of gathering and analyzing evidence. The party and its lawyers must know, before initiating the dispute, which facts they can prove in advance and which will depend on the presentation of documents held by third parties and the hearing of technical and factual witnesses. All these factors must be carefully weighed in order to assess the chances of success, the potential settlement scenarios and the risks of litigation.
*Bruno Viana, associate at Freitas Ferraz Capuruço Braichi Riccio Advogados, collaborated.