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Fundamental representations and warranties are key in M&As

When a business is being sold, whether through a sale of shares or assets, the risks associated with the transaction can be divvied up between the seller and buyer through contractual mechanisms, such as representations and warranties.

In general, it is in the purchaser’s interest that the representations and warranties from the seller be as broad and numerous as possible to minimize the risk of pre-closing issues being discovered after the transaction. The reverse is generally true for the seller. The seller will seek to minimize exposure to indemnification proceedings and the risk of being found liable after closing.

Normally parties spread some of the risks associated with the transaction by giving special treatment to a limited set of representations and warranties deemed to be of greater importance to the transaction, typically referred to as “fundamental” representations and warranties.

“Fundamental” representations and warranties in Quebec civil law

As important as they are to negotiating the purchase and sale of a business, it seems Quebec case law has yet to pass judgment on the characteristics and legal effect of fundamental representations and warranties.

Nevertheless, when compared to standard representations and warranties, fundamental representations and warranties can be distinguished by one or more of the following features:

  • a longer, sometimes indefinite, survival period;
  • the exclusion of an indemnity basket, where applicable; and
  • the exclusion of an indemnity cap.

In the absence of a legislative definition of the concept, it is up to the transacting parties to define the parameters of such representations and warranties.

The following, based on comprehensive reviews in M&A transactions in recent years, are generally characterized as “fundamental”:

  • the seller’s authority and capacity to complete the transaction;
  • the organization and status of the seller and the target company;
  • the enforceability of the obligations undertaken by the seller; and
  • the capitalization of the target company.

Other elements should also be considered, including the scope and nature of the transaction, the business environment, the nature of the target company and the parties’ risk tolerance. But in the end, that remains a matter of negotiation between the parties. As with standard representations and warranties, the seller — unlike the purchaser — will have an interest in limiting the number and scope of its fundamental representations and warranties.

The characterization of a representation and warranty as “fundamental” could make a difference in determining whether the conduct of the party that made a false or inaccurate representation and warranty was deceitful or vitiated the consent of the aggrieved party. Under Quebec civil law, knowingly engendering error in the mind of another to induce him to enter into a contract or to enter into it on different terms is akin to fraud.1 If it is determined that the misstatement of a fundamental representation and warranty would invalidate the transaction, then it would be reasonable to conclude that a party would not have entered into the contract were it not for the fraud or the misstatement of a fundamental representation and warranty.2

The Fontanella case

Despite the absence of Quebec case law on this subject, a recent decision by the United States District Court for the District of Delaware illustrates the importance of fundamental representations and warranties in the context of the sale of a business.

In Heritage Handoff Holdings, LLC v. Ronald Fontanella,3the Court took into consideration the fact that Ronald Fontanella, the seller, had made a fundamental representation and warranty about the relationship of the target company with its principal customers in its finding that the Seller had violated the terms of the share purchase agreement with Heritage Handoff Holdings, LLC, the purchaser, as well as the Securities Exchange Act.

In this case, the seller and the purchaser entered into a share purchase agreement to acquire Rex Forge, a maker of forged steel parts primarily for the automotive industry, for US$12 million. The agreement contained a fundamental representation and warranty that in the 12 months prior to closing, no customer of the business had cancelled, materially decreased or otherwise modified its relationship with Rex Forge.4

However, during the diligence period, the seller failed to inform the purchaser of the loss of several important contracts with some of Rex Forge’s major customers. Given that the parties had characterized this representation and warranty as “fundamental,” the Court held that the seller knew the importance to the buyer of the relationship between Rex Forge and its customers and that the seller’s failure to disclose relevant information to the purchaser would have been motivated by a desire to maintain the purchase price.

The decision yields more guidance. The Court provided a definition of the “fundamental” nature of a representation and warranty. It underscored that a misstatement of a fundamental representation and warranty would “cause a deal to fall apart.”5

On top of that, the action was brought more than a year after the closing of the transaction. This was possible in part because the representation and warranty in question was “fundamental” and its survival period was longer than the six months applicable to the other representations and warranties in the contract.

Conclusion

Following this decision, it is important for parties to a transaction to pay particular attention to the number, scope and purpose of the fundamental representations and warranties included in a business purchase and sale agreement. Sound management of the risks associated with a transaction often depends on the parties ensuring that such representations and warranties are properly negotiated.


1 Jean-Louis BAUDOUIN and Pierre-Gabriel JOBIN, Les Obligations (French only), 6th ed. by P.-G. JOBIN with the collaboration of Nathalie VÉZINA, Cowansville, Qué: Éditions Yvon Blais, 2005, para. 233.
2 See in particular s. 1407 of the Civil Code of Quebec.
3 Heritage Handoff Holdings, LLC v. Fontanella, see Memorandum of Opinion rendered by the United States District Court for the District of Delaware on March 6, 2019.
4 “Section 2.13(a) of the Shareholder Disclosure Schedules sets forth a complete and accurate list of the ten (10) largest customers of the Company for the most recent fiscal year. No such customer has within the last twelve (12) months (i) cancelled, materially decreased or otherwise modified, or to the Shareholder’s Knowledge, threatened to cancel, materially decrease or otherwise modify its relationship with the Company… or (iii) notified the Shareholder or the Company of any dispute of any nature.
5 “A failure of a “core rep” is so serious that it causes a deal to fall apart.” Heritage Handoff Holdings, LLC v. Ronald Fontanella, page 13.


This article was originally published in the Langlois lawyers’ website.

Jean-Simon Deschênes
Partner at Langlois lawyers LLP | Website

Jean-Simon Deschênes is a partner in the business law group in Langlois lawyers’ Quebec City office. He represents corporations and institutions in business transactions such as mergers, acquisitions, restructuring and financing.

Miriam Robitaille
Lawyer at Langlois lawyers LLP | Website

Miriam Robitaille is part of the corporate and commercial law team at the Quebec City office of Langlois lawyers, specializing primarily in mergers and acquisitions and in real estate law.

Olivier Scheffer
Lawyer at Langlois lawyers LLP | Website

Olivier Scheffer is a lawyer in the business law group in Langlois lawyers’ Montréal office.

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