Mergers and Acquisitions
— Don’t miss the sale and purchase agreement’s intricacies of representation and warranties in your M&A deal. Learn more about what they are and why they’re essential. Thinking of lounging at a luxurious resort and sipping on the Karak chai as you take in Dubai’s skyline after you’ve sold your business? Imagine doing just that. Then, an unfortunate ring on your phone informs you that the buyer wants an AED 7.3 million reduction from the purchase price because they reported non-compliance with some financial discrepancies and an overstated EBITDA.
This will surely happen if you’ve skipped thoroughly negotiating representations and warranties. It will almost always come to bite back your transaction and financial security.
Set aside the dream of your karak chai and hit pause on your lounging plans. Let’s get into reps and warranties and understand why it needs all your attention before you sign on the dotted line of the purchase agreement.
Understanding Representations and Warranties in Mergers and Acquisitions
In mergers and acquisitions (M&A), representations (reps) are statements of facts as of a specific date. Warranties ensure that these facts are true, and if found false, the seller takes responsibility through indemnification.
For example, a seller may represent their business as financially stable and free from legal disputes. As a warranty, they might commit to maintaining everyday operations and fulfilling all obligations until the sale’s closing.
Reps and warranties foster trust…
Representations and warranties are part of the purchase agreement and help buyers make an informed decision by defining the risks and obligations of both parties. These statements are heavily negotiated and scrutinized, requiring sellers to disclose exceptions in a separate schedule. So, for example, if there are any pending legal issues, the seller must provide a disclosure to ensure transparency.
The sole purpose of including reps and warranties in the sale and purchase agreement is to protect both parties from future disputes. Any failure to disclose material exceptions can mean serious consequences for the seller, including accusations of fraud.
Two Stages of Negotiations
Negotiations around representations and warranties require precise due diligence to allocate risk fairly for both parties. Buyers and sellers review this negotiation twice: once during the Letter of Intent (LOI) and once during the sale and purchase agreement’s finalization.
Stage 1: Letter of Intent (LOI)
A letter of Intent usually mentions the basic terms of the transaction, acting as a roadmap for the deal. Given the preliminary and non-binding nature of the document, it may not comprehensively include reps and warranties. Therefore, the seller doesn’t get a complete picture of the assurances the buyer might ask for. In some more significant transactions, the buyer may offer a draft of the purchase agreement at this stage.
Stage 2: Sale and Purchase Agreement
The legally binding contract—the sale and purchase agreement—meticulously records reps’ statements and warranties. Buyers and sellers devote all their time and resources to their respective due diligence, identifying potential risks or breaches in business operations or financials, and negotiating the fine details of reps and warranties.
If a buyer’s due diligence reveals unresolved legal disputes, they’re likely to negotiate for more stringent reps and warranties to cover these risks. They might require the seller to provide sufficient indemnification against potential losses.
Reps and Warranties in Public vs. Private Transactions
Representations and warranties work differently in public transactions than in private ones. Private companies lack the oversight of stringent regulations enforced on public companies. For this reason, sellers’ representations have become essential for buyers to understand the business.
Private company transactions usually require detailed and comprehensive reps and warranties, which include various aspects of the business, such as:
The financial health of the business
Key property and asset ownership
Ongoing obligations and legal compliance track
These transactions also include other intricacies, such as provisions to limit seller’s liability with baskets and caps.
Reps and warranties for public M&A transactions take a backseat. The seller in a publicly traded company is usually a large group of shareholders. Once the deal is complete, it ceases to exist as a unified entity. Therefore, reps and warranties in such transactions are minimal since seeking indemnification from a group of individuals can get complicated.
Additionally, public companies must adhere to stringent disclosure requirements as per the UAE’s regulatory authority. There is already a high level of transparency, which makes the need for extensive reps and warranties unnecessary.
Here are a few things to remember when negotiating reps and warranties…
When done right, representations and warranties can ensure clarity and minimize misunderstandings between buyers and sellers during an M&A transaction. Use these tips to negotiate reps and warranties and minimize liabilities:
Understand the buyer’s motives
Why do buyers ask for the inclusion of specific reps and warranties? It’s never just for the sake of legalities. They’re concerned about something, be it a potential risk or assurances about the business’s financials.
Don’t view these requests to include specific statements as an obstacle; use them as a chance to build trust. Open a dialogue on the matter and provide evidence to clarify the concern. The buyer often needs assurance, and you can usually ease their anxieties with creative alternatives.
Ensure accuracy in financial representations
Don’t step into the minefield of financial representations blindfolded. Many times, contracts make general statements like “financial records comply with Generally Accepted Accounting Principles (GAAP).” However, this can quickly backfire if you haven’t ensured GAAP compliance. Say your purchase price comes from EBITDA, but you’ve excluded certain losses.
What happens then? Breaches, costly renegotiations, or an escalated indemnification claim.
Before making financial statements, get a certified accountant to review your financial records. A thorough review helps limit risks and keeps your deal on track.
Limit liability with knowledge qualifiers
When your business relies on third-party suppliers, how could you disclose exceptions that suppliers have not disclosed to you? Are you liable for them, too? No.
You can’t guarantee 100% accuracy of all your statements about your business, and knowledge qualifiers ensure that you limit your liability to only what you truly know. With phrases like “to the best of Seller’s knowledge” or “to seller’s actual knowledge,” ensure you’re not held responsible when an unknown issue arises.
Set survival periods
You aren’t liable for the reps and warranties forever. The purchase agreement provides a specific term—survival periods—for buyers to bring up claims. General reps usually have a survival period of 12-18 months after the deal closes. However, environmental or tax issues can have more extended survival periods for reps.
Define the exposure timeframe carefully to manage and limit risks once the transaction is complete effectively.
Limit with basket and caps
Say you’ve sold your business, and the buyer keeps demanding indemnification for minor repairs. Or, let’s imagine the other extreme – the buyer finds a significant issue and requires an unreasonable sum you can’t afford. You’ll end up wishing to have never gone through with the M&A deals.
But don’t worry—this is where baskets and caps come to the rescue. Baskets and indemnification caps in mergers and acquisitions are guardrails for managing claims-related representations and warranties.
A basket sets a minimum threshold for losses the buyer must incur before seeking indemnification.
A cap sets the maximum amount the seller is liable for, and the buyer can recover.
While the basket helps limit disputes over minor or trivial breaches, the cap ensures that the seller’s financial liability doesn’t spiral out of control. These provisions create a fair balance: Buyers have recourse for legitimate issues, and sellers can confidently manage their risks.
Get insured
A reps and warranties insurance (RWI) can help sellers and buyers while managing potential risks tied to breaches. A seller’s insurance can minimize liability to a certain extent. For example, it may help sellers with compensation in cases such as inaccurate financial data post-closing. However, it’s important to note that RWI won’t cover sellers for fraud or gross negligence.
The cost of RWI may range from 4-8% of the coverage amount but depends on the scope of reps, industry, and survival periods.
You can also require the buyer to secure insurance to cover potential risks in the agreement. Negotiate a reduction of insurance reimbursements from any indemnification and seek a subrogation rights waiver from the insurer so they can’t pursue you for losses covered under the policy.
If you have existing policies, keep them active until the transaction is finalized, mainly if they operate on a claims-made or occurrence basis.
What Happens When There’s a Breach?
Breaches of reps and warranties put both the buyer and the seller at risk. Therefore, it’s essential to be ready to face a breach with the representations and warranties you provided your buyer.
The purchase agreement usually dedicates the “Disputes” section to conflict resolution, which may outline remedification methodologies in case of breaches or inaccuracies in the seller’s representation and warranties. The buyer may seek remedies per this contract if they identify a breach, including arbitration, alternate dispute resolution method, or even litigation.
Working with experienced mergers and acquisitions lawyers in Dubai is best during the reps and warranties negotiation phase. They can help draft clear dispute resolution provisions that align with the interests of both parties. Here are some common remedies when there is a breach:
Set holdbacks: A portion of the purchase price is held in an escrow account for a specified period, which the buyer may use to recover funds in case of losses from breaches. The funds are released to the seller if no valid claims are made within the holdback period.
Setoff in the future payments: Buyer may recover losses by reducing them from future payments to the seller, such as earnouts or promissory notes. This method offers claim resolution without immediate financial burdens.
Litigation: Often the last resort, the parties may go to the court if no other resolution approach settles the matter. In this case, the judge determines the appropriate remedies for the damages.
Note: Claims for indemnification in case of breaches often follow the provisions mentioned in the agreement. However, in case of fraud, intended negligence, or misrepresentation, the buyer can take legal action against the seller.
Best Practices for Sellers
Selling your business is a significant milestone. Prepare for a successful M&A deal by taking the right approach to this complex process. As a seller, these three best practices are a must to reduce risks and ensure a smooth transaction:
Conduct thorough pre-sale due diligence
Due diligence is a non-negotiable part of M&A deals. As a seller, pre-sale due diligence can streamline the process of drafting representations and warranties. It also builds trust with your buyer, showing your thoroughness to minimize claims and disputes later.
You must verify all aspects of your business before the M&A transaction ensues, including (but not limited to):
Business financial audit
Information verification
Potential risk identification
Pro-tip: Resolve any issues identified in pre-sale diligence, such as incomplete compliance records or gaps in insurance coverage, before your buyer’s due diligence.
Disclose material exceptions proactively
Transparency lays the foundation of all successful M&A transactions. Did your due diligence reveal issues that can’t be immediately resolved, such as pending legal disputes or some unreported liabilities? Ensure you report all such material exceptions to the buyer upfront so there are no surprises for them later.
Help your buyer get a complete picture of your business. This will help you build a good relationship and reduce the risks of future claims or fraud accusations.
Why it matters: Failure to disclose exceptions can lead to costly breaches of the sale and purchase agreement, affecting both the sale and your reputation.
Collaborate with legal consultants in Dubai
You will never regret investing in the expertise of an experienced Dubai corporate lawyer to draft the representations and warranties for your M&A deals. They can offer you guidance on negotiating favorable terms, limiting liabilities, avoiding breaches, and managing future risks of breaches and indemnification effectively.
Example: Shoeb Saher, the founder of ELP Legal and an experienced mergers acquisitions lawyer in Dubai, has helped sellers draft M&A deals with necessary knowledge qualifiers that can cover uncertainties and reduce their financial exposure.
Conclusion
Representations and warranties in M&A deals help sellers build trust and clarify their business to buyers. Their role defines each party’s obligations and calls for heavily negotiating risk management terms to mitigate future financial losses.
After reading this guide, sellers can delve further into the nuances of reps and warranties, limit liabilities with baskets and caps, or mitigate future risks through accurate financial audits and RWI.
Economic Law Partners (ELP) has a long-standing track record as one of the best law firms in Dubai. We guide clients through intricate M&A transactions in the UAE’s complex legal structure. We offer the expertise of _ years in:
Drafting and negotiating reps and warranties in purchase agreements to minimize risks
Carrying out comprehensive pre-sale due diligence to report compliance with transparency
Structuring deals with explicit provisions for indemnification and dispute resolution
Get the best lawyers in Dubai on your side as you navigate the complexities of your M&A transaction. Contact us for expert advice, and let us help you protect your interests every step of the way.
