Buying or selling a business is a major step for any enterprise, but especially an individual or small business owner. It takes many years of dedicated commitment to what has or may become your life’s work to get there. It is important to be no less careful at that stage than you would for any other aspect of operations because the consequences of failing to be on guard can be devastating. It could lead to a breach of representation or warranty, and you may find yourself unable to realize a retirement dream or left holding the bag for something substantially different than what you expected to obtain.
Beyond conducting an in-depth review of the business, its prospects and status, and investigating your counterparty in the process commonly referred to as “due diligence,” the means of seeking to protect yourself from loss in the event of buying or selling a business comes about primarily through the “representations and warranties” made in the sale agreement.
A breach of representation or warranty can be a very costly affair (for both sides). If unable to resolve a dispute by discussion and further agreement or amendment, the only way to potentially recover or defend against further loss is through litigation. It is important to understand your rights and legal options early on when a dispute becomes apparent, because litigation itself is often a make-or-break proposition for the individual and small business owner.
The Purpose of Representations and Warranties in Business Sale Agreements
A transfer of ownership in a business typically occurs by one of two methods: (1) purchasing the stock of a company itself or (2) purchasing only the assets of the business it runs.
Acquiring the stock of a legal entity (whether a corporation, limited liability company, or other form) is simpler overall but also means inevitably acquiring all the liabilities of that company (which can include completely unknown and unanticipated third-party claims). Buying only the assets of a business—such as its property, equipment, knowledge, and customer data—makes it easier to exclude unknown liabilities but then also runs the risk of a key asset that is needed being left out or missed.
Representations and warranties supplement the due diligence to allocate further risks of such unknown or unexpected matters among the parties to the transaction. Such representations constitute affirmative statements of fact made by one side (or both) that are formally relied on and can result in the right to economic compensation if they turn out—regardless of fault—to be untrue, while warranties provide for certain types of security against a loss should it come to pass. One important type of security is the indemnification that a seller or buyer agrees to provide to the other for any claims made by third parties or other losses, which allows those involved in a transaction to divide up the responsibility between them as they see fit. That usually follows the natural dividing line of ownership as demarcated by the “closing” date of the transaction. Obtaining a written representation or warranty in the sale agreement has to be supplemented by due diligence on the counterparty and their assets, however, as having a right to recovery is mostly meaningless if the other side ends up unable to pay for any losses.
As with any other type of contract or term, the representations and warranties in a sale agreement can be negotiated between the parties to the transaction in several ways that allocate the assets, liabilities, and risks between them as they see fit and agreed to do. Sometimes a seller wants the buyer to assume all liabilities—whether arising or relating to matters before or after closing—to have better assurance of being completely done with a business once sold. Some buyers will agree to accept the risk of such unknown claims (based on their own evaluations of course) in return for a lower upfront price to reflect a discount based on the unknown risk, which then becomes a part of the economic terms of the deal.
Typical Items Covered by Representations and Warranties in a Sale Agreement
In a business sale agreement, the representations and warranties might address only a handful of key items or dozens of categories. The nature of the industry, stage of business being sold, type of transaction (asset or stock purchase), and information revealed by due diligence will determine the exact number of representations and warranties.
In general, buyers want to obtain all the fruits of a business that has been established and developed already while excluding all unknown liabilities or issues associated with the seller’s prior affairs. Sellers, on the other hand, want to ensure they are not increasing their liability by remaining on the hook for things attributable to failures of a buyer that may arise or occur after the closing (or that the buyer agreed to assume as part of the negotiation).
The representations and warranties in a purchase agreement—for a small business as well as large transactions—thus can (and usually should) cover a number of topics, such as:
- The organization, standing, and qualification of the business
- The capital structure of the legal entity
- Title to shares, property, equipment, and other assets
- Authorities and consents necessary to enter into a transaction
- Subsidiaries, affiliates, and separate divisions
- Business assets (including patents, licenses, contracts, customers, goodwill, inventory, real estate, and much more)
- Debts and other obligations of the business
- The accuracy of financial statements, tax returns, and other books and records
- The absence of a variety of liabilities, including the existence of pending litigation
- Environmental compliance and related issues
- Employees and employee benefit plans
- Product warranties for past sales
- Related-party transactions
- Compliance with laws and regulations
- How to deal with changes in the business between signing and closing
- How to deal with third-party claims and other matters arising after closing, including the inaccuracy of disclosures or representations, by way of indemnification rights
Whether you are the buyer or seller, it is smart to have an experienced transactional attorney help make sure everything important to you and your business gets covered to protect you against or mitigate the risks of unknowable or undisclosed information. A litigation attorney can also help review and assess any pending third-party claims or litigation against a business you are looking to purchase. When it turns out a representation made in the sale agreement was not true or the other side refuses to fulfill a warranty though, then you need a skilled litigator to help you hold the other party to account.
What Should I Do If I Think There Has Been a Breach of Representation or Warranty?
The types of breaches that can occur in connection with representations or warranties or limited only by the terms of the sale agreement. Some common examples include:
- Manipulated or falsified financial statements and projections
- Fraudulent statements made during negotiations
- The existence of material circumstances contrary to affirmative representations
- Not continuing to operate the business in its ordinary course, or siphoning off funds or customers, in the period after signing and before closing
- Failing to assume or take responsibility for liabilities after closing
- Refusing to provide indemnification for third-party claims or other losses after closing
- Breaching a non-compete agreement provided in connection with the transaction
The first thing to do if you suspect a breach of representation or warranty in connection with the purchase or sale of a business is to try to gather as much information as possible, including from the former owner or new buyer, and read the contract closely. Texas law places special emphasis on the terms of a business transaction and will enforce the plain language.
If you still have a legitimate complaint, that is when it is beneficial to get a litigation attorney involved to review and advise you on the steps to perfect your right to a full recovery. That includes making a written assertion of loss or right to indemnification (often referred to as a “demand letter,” although it does not have to be adversarial in nature) to ensure you can recover attorney’s fees as well if they refuse to hold up their end of the bargain.
Getting a litigation attorney who is focused on achieving economic resolutions involved can also be beneficial in that the parties may be able to resolve their dispute at that point by informed discussion alone and further agreement or amendment, which is always preferable to litigation given the costs and time involved with a lawsuit. If not, however, then you need a skilled litigation attorney to prosecute or defend against claims of a breach of representation, warranty, or indemnification, as well as other types of claims often made in connection:
Claims Often Related to a Breach of Representation or Warranty
When a breach of representation or warranty has occurred, the buyer or seller may be able to bring additional (or alternative) claims as well. Those include equitable claims such as “money had and received,” quasi-contractual claims like “quantum meruit” or “unjust enrichment,” and claims for misrepresentation, omission, or even statutory fraud based on a stock or real estate component of the transaction.
In addition, for transactions that fall under the maximum $100,000/$500,000 thresholds for a Deceptive Trade Practices Act (DTPA) claim in Texas, it may be possible to plead and prove a claim that entitles the harmed party to recover not only economic loss and attorney’s fees, but also treble damages, when there is a knowing or intentional violation of the DTPA – which specifically includes a breach of certain warranties. That is a powerful option for the buyer or seller of a small business to help level the playing field against a much larger counterparty who tries to force its way through economic leverages.
Discuss Your Case with a Dallas-Fort Worth Business Litigation Attorney
Breaches of representation or warranty can occur in nearly every type and size of a business transaction, but they can create significant problems especially for the small business or individual owner.
If you are the victim of a breach of representation or warranty in a small business acquisition or have been accused of being the breaching party yourself, Wright Commercial Litigation is here to help. The firm’s principal attorney has years of experience dealing with and resolving all kinds of disputes involving such business transactions and can help you quickly assess the risks and benefits of litigation. That can include an analysis of potential insurance options and resources as well.
Feel free to contact the firm if you would like to set up an initial consultation to discuss your case involving a breach of representation or warranty in a business transaction.
