PRACTICAL IMPLICATIONS OF A SELLER’S REPRESENTATIONS AND WARRANTIES IN A HIGHLY COMPETITIVE COMMERCIAL REAL ESTATE TRANSACTION Billie J. Ellis and Douglas A. Yeager1
One of the most pivotal aspects of any contract for sale in a “sophisticated real estate transaction” is the negotiation of the representations and warranties between the seller and the purchaser, and the attendant provisions related to enforcing and securing subsequent breaches of those representations and warranties. While much of this presentation would also be applicable to the real estate aspects of a corporate acquisition, we have intentionally limited the scope of this presentation to the typical real estate purchase, which usually does not involve many of the representations and warranties that are normally associated with a corporate acquisition, such as those concerning labor, tax, antitrust and other such matters.
In complex real estate transactions, sellers try to avoid making representations or warranties. The typical seller form in a complex transaction has a lengthy “as is” provision, as well as language that limits the scope, breadth, and number of representations and warranties, with various knowledge qualifiers. Sellers will go to great lengths to minimize the survival of representations and warranties and seek to avoid indemnifications, baskets or holdback of funds for their breach. Sellers frequently take the position that there are many representations and warranties that they do not need to make because the purchaser can acquire the information related to the representation or warranty from third parties or by securing title, environmental or other insurance. In addition, no seller wants to be the insurer who backs up the purchaser when the purchaser discovers after closing that there is a problem – such as an environmental condition – with the property, particularly when the seller did not cause the problem or even know it existed prior to closing. After all, isn’t the seller allowing the purchaser and its numerous, highly-trained consultants, to examine the property to the purchaser’s satisfaction? If there was a report or study that the purchaser could have obtained that would have revealed the problem, shouldn’t the purchaser bear this risk?
Purchaser’s counsel will respond, in turn, with a litany of representations and warranties that have the seller opine on everything from its valid existence as a Delaware limited liability company to the marketability of its title to the absence of environmental conditions affecting the property. After negotiation and the exchange of several redline drafts, the parties will ultimately agree on a fairly standard set of representations and warranties that are customary for similar properties and market conditions.
But, what happens when the seller is selling into a hot market? What happens, as we are seeing in many markets with many different products around the country, when the seller places the property out to bid with the caveat that the seller will review all offers taking into consideration not only the purchase price, but also the strength of the purchaser, the form of the contract submitted, and all aspects of the contract that effectively dilute the purchase price?
In a hot market or a competitive bid scenario, a sophisticated purchaser will go to his counsel and utter those four dreaded words: “Don’t overlawyer the contract!” He will ask his counsel to think outside of the box – to decide which representations and warranties are really necessary and which ones are not. For, as every seller and purchaser knows, the most a seller will ever get for its property is the stated contract purchase price, and each and every representation he is required to give only has the potential to chip away at his return, or slash it altogether.
B.The Purpose of this Presentation
This presentation will address those situations in which purchasers and their counsel cannot rely on their all-inclusive contract form with page after page of representations and warranties. We will examine the economic impact of representations and warranties and discuss how our experience as real estate counselors helps our clients determine which representations and warranties are absolutely necessary and which ones can be left for another day. Finally, we will discuss due diligence actions that the purchaser and its counsel and consultants can employ that will give comfort to the acquisition team when seventy-five percent (75%) or more of your boilerplate representations and warranties are left on the editing room floor.
C.Representations and Warranties
Black’s Law Dictionary defines a representation as “a statement express or implied made by one of two contracting parties to the other, before or at the time of making the contract, in regard to some past or existing fact, circumstance, or state of facts pertinent to the contract, which is influential in bringing about the agreement.”2 The Merriam-Webster Dictionary of Law states that a representation is “a statement or account made to influence opinion or action” or “an incidental or collateral statement of fact on the faith of which a contract is entered into.”3
A warranty is defined by Black’s as:
A promise that a proposition of fact is true…. An assurance by one party to agreement of existence of fact upon which the other party may rely. It is intended precisely to relieve promisee of any duty to ascertain facts for himself, and amounts to promise to indemnify promisee for any loss if the fact warranted proves to be untrue…. A promise that certain facts are truly as they are represented to be and that they will remain so, subject to any specified limitations.4
One court has defined a warranty as “a statement or representation made . . . contemporaneously with and as a part of, the contract of sale . . . having reference to the character, quality or title of the goods and by which he promises or undertakes to insure that certain facts are, or shall be, as he represents them.”5 Warranties may be express or implied. This paper will focus on express warranties, which are “created in a contract by a statement of fact (as a description) which is made about the object of the contract and which forms the basis of the bargain.”6
The various definitions of representations and warranties often overlap; the terms are often used interchangeably or jointly. This paper will do the same. Representations and warranties are usually included in contracts between sellers and purchasers to confirm the existence or non-existence of various circumstances with respect to the property being conveyed or the parties involved. Representations and warranties are important, because when a seller makes an affirmative representation, the common law imposes a duty on the seller to know whether that statement is true.7
2. Functions of Representations and Warranties.
Representations and warranties typically serve a variety of functions in a real estate purchase contract. They provide a forum for the seller to disclose or amplify known risks to purchasers. Provisions regarding environmental issues, any pending condemnation proceedings, or the condition of personal property contained within the purchaser’s contract form (if they remain in) will force the seller to disclose any potential issues that may impact the purchaser’s willingness to purchase the property or pay the purchase price. If the seller is given the opportunity to prepare the contract, the seller will often make no, or try to limit the number of, representations and warranties, and it is then up to the purchaser to try to convince the seller to make those representations and warranties that the purchaser thinks it really needs.
Through the use of representations and warranties, the seller has the opportunity to disclose information to the purchaser that only the seller knows or to which only the seller has access. For example, a representation about tenant leases or the rent roll would be important to a person who is purchasing an apartment complex or shopping center. The provision would likely confirm that an attached rent roll is a true, complete, and correct list of all leases, which is significant because most leases are not recorded and could not be obtained by the purchaser unless received from the seller. Other examples of representations and warranties that provide information the seller only knows (or has a much easier time obtaining) include “no condemnation” provisions or “no pending litigation” provisions. It should also be noted that representations and warranties often describe, and provide the purchaser with a picture of, the property it is acquiring. When the purchaser is provided with certain representations and warranties, the purchaser knows certain matters about the property from the outset, without ever having to visit the property.
Representations and warranties also allow the parties to allocate responsibility for risks among themselves. For example, a representation by the seller that it is currently insured against loss and that all insurance payments are current with the further provision that the seller will rebuild or assign the proceeds to purchaser allows the purchaser to be protected against uninsured loss prior to the time the risk of loss transfers to the purchaser under the contract. This representation by the seller assures the purchaser that its due diligence costs and the benefit of its bargain will not be compromised in the event of a casualty.8 Another important example of how representations and warranties can impact allocation of risk regards the survival of warranties provision, which will be discussed at greater length below.
A major function of representations and warranties is that they operate in conjunction with, and may act as a partial substitute for, due diligence by the purchaser. For example, a warranty by the seller that there is adequate ingress and egress to and from the property provides protection to the purchaser in that regard. The representation and warranty also potentially saves the purchaser money by possibly eliminating the need for the purchaser to obtain an access endorsement from the title company under its title insurance policy. Given that the purchaser would have to pursue the seller for a breach of such a representation and warranty, however, the purchaser may nevertheless elect to purchase the endorsement, especially if it is relatively inexpensive. As we will discuss later, the tradeoff between due diligence costs and an increase or decrease in the overall purchase price is important for the purchaser to consider. The strength of the market will also influence whether the purchaser will have to balance saving money on due diligence costs with the expense of losing the deal because its purchase contract contained more representations and warranties than its competitor’s contract.
3. Types of Representations and Warranties.
There are three basic types of representations and warranties: (1) those that ensure the status and authority of the seller, (2) those that describe the status of the real and personal property, and (3) those that govern the operation and maintenance of the property.9 The first type of representation and warranty -- regarding the seller’s status and authority -- gives the purchaser assurance that the seller is an entity existing and in good standing in its state of organization and that the persons executing the contract are authorized to execute on behalf of the seller. This is important for the purchaser to obtain because it affords a separate claim for damages against the seller for breach of the representation and warranty if the seller did not have the power or authority to enter into the contract.10 The second two types of representations and warranties, which describe the status of real and personal property, are designed to require the seller to disclose facts that aid the purchaser in making an informed decision as to whether the property is in an acceptable legal and physical condition.11 Many of these representations and warranties are or can be covered by title, environmental or other insurance, and sophisticated sellers will make this argument when negotiating these representations and warranties.12 When the property is improved, the purchaser is concerned with the income-producing operations of the property. Therefore, representations and warranties regarding tenant leases, operating agreements, books and records, and maintenance of the property are of the utmost importance to the purchaser. These statements are especially important, as we discussed above.
4. Seller’s Knowledge.
Another important item that will likely be heavily negotiated is the extent to which seller’s “knowledge” regarding a particular representation or warranty is qualified. Sellers will often request variations of “knowledge” such as seller’s “best knowledge, information and belief,” “actual knowledge,” “current actual knowledge,” or “actual knowledge after due and diligent inquiry.”13 Actual knowledge includes not only that knowledge of which a party has express knowledge, but also that knowledge which would have been gained from a reasonably diligent inquiry and exercise of the means of information at hand.14 Sellers should note that a misrepresentation often imposes liability under the remedies provisions of the contract.15 A seller should be especially cautious when giving a general, open-ended representation and warranty (such as the “Material Disclosure” representation set forth as item 7 on Annex B) because these representations and warranties can often have unintended consequences, especially when there is a matter the seller was not thinking of or did not have knowledge. If the purchaser can later prove that the seller knew about the matter, or should have known about it, the seller has potentially exposed itself to liability.
For these reasons, it is important that “knowledge” is properly defined in the purchase contract. Edward A. Peterson, in his fine work “The Effective Use of Representations and Warranties in Commercial Real Estate Contracts” suggests the definition should include such considerations as (i) whose knowledge (i.e., if the seller is an entity rather than an individual, does the term include employees, agents, representatives, affiliates, etc.), (ii) is knowledge to be “actual” knowledge (taking into consideration the fact that negligent ignorance is equivalent to actual knowledge), (iii) should the duty of inquiry be limited, and (iv) should the knowledge be limited to that possessed at the time of execution of the contract. 16