Fundamental Representations and Warranties

Continuing with the theme of representations and warranties, this week’s M&A Monday update is about fundamental representations and warranties, survival periods, and caps. In many deals, some representations and warranties are deemed to be more important than others. Those representations and warranties that are most important are termed “fundamental representations and warranties.” The determination of what representations and warranties will be deemed fundamental is a negotiating point in the purchase agreement. The fundamental representations and warranties often include:

• Organization and Standing
• Capital Structure (in a stock or membership interest sale)
• Brokers and Finders’ Fees
• Power and Authority
• Title to Securities (in a stock or membership interest sale)
• Title to Assets (in an asset sale)
• Taxes

Any representations and warranties that are not categorized as “fundamental” are by default “non-fundamental representations and warranties.” In some deals, the parties have a third category of representations and warranties, often referred to as “intermediate representations and warranties,” that fall between fundamental and non-fundamental categories.

So what’s the difference between fundamental, non-fundamental and intermediate representations and warranties? First, the more important the representation and warranty, the longer the period after closing (called a “survival period”) within which the buyer can sue the seller for breach of a representation and warranty. Fundamental representations and warranties may have a 3-5 year survival period, whereas intermediate and non-fundamental warranties may have 18-24 month survival periods respectively.

Second, the more important the representation and warranty, the greater the seller’s liability for breach of that representation and warranty. For instance, in many deals, the seller’s liability to the buyer for breach of non-fundamental representations and warranties is limited to (known as a “cap”) 25% of the purchase price. However, in the same deals, the seller’s cap for breach of fundamental representations and warranties may be the entire purchase price (or no cap at all).

Generally, sellers want short survival periods and low caps, and buyers want long survival periods and high caps. Use of fundamental and intermediate representations and warranties, when done effectively, can help the parties strike a balance between the seller’s and buyer’s risks and goals.

If you have any questions about fundamental representations and warranties, survival periods, or caps, please contact Jon Siebers.