What are the differences between qualified and unqualified representations and warranties?

As discussed last week, representations and warranties are truths or assertions made by a party to a purchase agreement. Representations and warranties can either be qualified or unqualified and are often used to shift risk between the seller and the buyer.

The following seller representation and warranty is unqualified: “The company’s financial statements are GAAP-compliant.” Whether the seller is in breach of this representation and warranty depends entirely on whether the statement is true or false. If the company’s financial statements are GAAP-compliant, the seller is not in breach of the representation and warranty. If the company’s financial statements are not GAAP-compliant, the seller is in breach of the representation and warranty.

In comparison, the following seller representation and warranty is a qualified representation and warranty: “To the seller’s knowledge, the company’s financial statements are GAAP-compliant.” The qualifier in this representation and warranty is what is known as a “knowledge” qualifier. In this instance, if the company financial statements are not GAAP-compliant and the seller knows that the financial statements are not GAAP-compliant, the seller is in breach of the representation or warranty. If on the other than the company financial statements are not GAAP-compliant and the seller does not know that the financial statements are not GAAP-compliant, the seller is not in breach of the representation and warranty. Since qualifiers narrow the scope of a seller’s liability for breach of a seller representation and warranty, sellers will typically negotiate for qualified seller representations and warranties and buyers will typically negotiate for unqualified seller representations and warranties.

When using knowledge qualifiers, it is important to define whose knowledge matters. In the sale of a business with a single owner who runs all facets of the business, often knowledge will be defined as the knowledge of that owner. Where there are multiple owners and multiple key employees, knowledge may be defined as the knowledge of the active owners and key managers. Since buyers generally don’t like knowledge qualifiers, they want “knowledge” to be as broad as possible. For example, consider the following:

•  the seller reps and warrants that, to the best of seller’s knowledge, the company financial statements are GAAP-compliant
•  the company financial statements are not GAAP-compliant
•  the company owner is not aware that the company financial statements are not GAAP-compliant
•  the company CFO is aware that the company financial statements are not GAAP-compliant.

In this situation, if “seller’s knowledge” is defined as the knowledge of the owner, the seller is not in breach of the representation and warranty because the owner does not have knowledge that the company financial statements are not GAAP-compliant. However, if “seller’s knowledge” is defined as the knowledge of the owner and the CFO, the seller would be in breach of the representation and warranty since the CFO has knowledge that the company financial statements are not GAAP-compliant.

When using knowledge qualifiers it is also important to determine whether you are using an actual knowledge standard or a constructive knowledge standard. Actual knowledge means just that – the seller is deemed to have knowledge of things the seller actually knows. Constructive knowledge is broader and means that the seller is deemed to have knowledge of things the seller actually knows and things the seller would have known had seller been diligent.  For example, consider the following:

• the seller represents and warrants that, to the best of seller’s knowledge, the company financial statements are GAAP-compliant
• the company financial statements are not GAAP-compliant
• the company owner is not aware that the company financial statements are not GAAP-compliant
• an audit or review of the company financial statements would have shown very clearly that the company financial statements are not GAAP-compliant

If we use an actual knowledge standard, the seller is not in breach of the representation and warranty because seller does not have actual knowledge that the financial statements are not GAAP-compliant. However, if we use a constructive knowledge standard, the seller likely is in breach of the representation and warranty because the seller should have known that the company financial statements are not GAAP-compliant. The constructive knowledge standard is intended to protect a buyer against a seller who has buried his or her head in the sand. Sellers typically want an actual knowledge standard and buyers typically want a constructive knowledge standard.

If you have any questions on how to use representations and warranties effectively to put together your next deal, contact Jon Siebers.