"My mama always said life was like a box of chocolates. You never know what you're gonna get." goes a dialogue in Forrest Gump.
This holds true in all cases. It is however natural to expect that there are less surprises, i.e. the not so pleasant ones, and see what can be done to try and avoid the not so pleasant surprises.
Hence in most contracts including acquisition transactions one of the key provisions is representations and warranties provided to the buyer by the seller. The buyer is typically cautious as any liability would ordinarily attach to the buyer or the subject matter of acquisition.
Whether the transaction is one of an asset purchase, business purchase or shares of a company, the buyer would expect that the seller provide a confirmation that 'all is well', and that no liabilities would arise in the future. Liabilities could be of several kinds, i.e. statutory liabilities including tax liabilities, employment related liabilities, asset related liabilities, or liabilities arising due to contractual litigations or claims.
This aspect is critical since the buyer agrees on a consideration with the seller, on the basis of the value of the asset forming part of the acquisition as well as any potential liabilities. If any of the representations/ warranties turn out to be untrue or inaccurate, the buyer would claim indemnity from the buyer for any losses suffered.
Given the indemnification liability that could arise, the seller would prefer to fairly disclose if any liabilities are expected or threatened. It is in this context that the knowledge qualifiers come to play. A representation when made, is a statement of fact. So when the seller represents that there are no claims or proceedings pending, it means that there are absolutely none.
If it is later discovered that there were pending claims/ proceedings, the buyer can claim from the seller losses that arise pursuant to such matters. Hence, the seller would typically be advised to state that 'to its knowledge' there are no pending claims or proceedings. This would mean that if there are any matters which are not to the seller's knowledge, the seller would not be liable even if it is later discovered that there were indeed some claims.
The nature of the transaction as well as the assets, contracts, and other aspects comprising the transaction determine the extent of representations and warranties. What is important is to ensure a balance, between the representations that can be qualified by knowledge and representations that cannot. While a seller may be able to justify as to why litigation matters can be knowledge qualified, the same may not hold good for representations on title to any assets or shares, which have to be unqualified and absolute.
If the seller has carried out the necessary investigation, which has not revealed any litigation, it may be fair to state that the representation be knowledge qualified. However, if a seller proposes to qualify representations which are reasonably expected that the seller would be in the know of, it places the risk on the buyer who may then evaluate the value attached to the transfer of risk.
Going a step further, it is also common to define what 'knowledge' means, to distinguish between actual knowledge and constructive knowledge. By defining 'knowledge' a buyer would understand the extent of diligence duly exercised by the seller, for accepting a knowledge qualified warranty. From a seller's perspective, this ensures that where representations are knowledge qualified and if due diligence is exercised, the seller would be safeguarded from liability and not otherwise.
A buyer also seeks representations and warranties as to whether any claim is expected or anticipated. This is to ensure that there is no issue impending that could come to the fore post-closing of the transaction. It is expected that the seller provides comfort to the buyer that there are no such issues or claims that are expected or anticipated. Typically, the seller also discloses to the buyer the liabilities and the claims under a disclosure letter, and the buyer then takes those into account while arriving at a valuation.
A clearer understanding of the issues at hand, market practice and practicality of the issues would help parties successfully negotiate such provisions with due safeguards for both parties to the transaction.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.