Seller Reps and Warranties – the Overlawyering Battleground?
Everyone has his or her list of pet peeves when it comes to paperwork aspect of dealmaking. I’m no different. This may come as a bit of a surprise, but my biggest pet peeve is overlawyering.
Far more often than not, counsel purporting to serve as a zealous advocate for his or her client will fight tooth and nail over every negotiable aspect of a transaction, often with no real thought as to the business realities or overall applicability of the particular issue being discussed, whether big or small. Competitive spirit and the clash of egos between the “combatants” devolve the discussion into mini battlefields, where “victory” over the subject at hand is the only acceptable outcome.
Eventually one side will “win” the debate. Deal or possibly even client fatigue often carries the day, rather than logic or market norms. But the truth is that both lawyers really lose. Their respective clients are often frustrated from the slowness to closing, legal bills that exceed expectations or, even worse, getting called in to decide a largely legal issue, which highlights the fact that the transaction was overlawyered in the first place.
There are few places in an acquisition agreement where overlawyering is more prevalent than in the section housing the representations and warranties. More particularly, the reps and warranties made by the seller.
I’m literally in the throes of an overlawyering situation right now. My client is on the buy-side of an acquisition. Seller’s counsel is using the reps and warranties for what seems to be a law school exercise on adding every qualifier known to man to what have always been a very standard (yet, tailored to the particularly industry) of reps and warranties.
Like it or not, seller representations and warranties are a necessary evil for most acquisition. The overriding purpose is to give a buyer some measure of comfort that the purchased asset is essentially as advertised, in terms of its overall “due diligence cleanliness.” They also allow a buyer to close over disclosed and undisclosed potential issues without necessarily having to haggle over significant pre-closing price adjustments, since the reps and warranties go hand-in-hand with the indemnity clause.
One would imagine that, with hundreds of acquisitions closed each year, a relatively standard set of seller and issuer reps and warranties has developed over time, with some variation based on industry. That is absolutely true. So, where does overlawyering occur?
I’m sure you guessed it -- deviating from the prevailing market standard without having a rational business reason for doing so. That is the big fight that occurs in deals time and time again. And the fight most often plays itself out through the use of qualifiers in combination with indemnity caps and baskets.
Sellers obviously love the use of knowledge and materiality qualifiers because they limit liability for blown reps and warranties. They do that in two ways. First, knowledge qualifiers eliminate liability for unknown issues. The concept of “knowledge” is often taken one step further in an acquisition to include issues that the seller should have known about through reasonable investigation, though aggressive sellers typically argue against that expansion. Second, materiality qualifiers basically eliminate trivial liability, thereby preventing a seller from being nickel and dimed post closing.
Buyers obviously have a different perspective. Too many knowledge qualifiers largely neuter the indemnity clause, since unknown liabilities are exactly what a buyer is worried about in the first place. If a seller knows about an issue and fails to disclose it against an applicable rep, then the buyer will have a fraud claim. That is typically less of a concern for buyers than protecting against the unknown. Similarly, buyers often agree that sellers should not be nickel and dimed post closing, but several immaterial issues arising in the year after closing (or whatever the indemnity period happens to be) can add up to equal a significant problem for the buyer.
Qualifiers are good for sellers. Bad for buyers. Therein lies the rub of qualifiers, so there has to be balance. Absent disproportionate leverage in a deal, in which case, all rules go out the window, the balance is typically struck with the use of an indemnity cap and basket. That is the point that often gets lost during overlawyering.
Almost all acquisitions include an indemnity cap. Its basic purpose is to limit the maximum exposure for the seller for blown reps and warranties. Once in a blue moon the cap is the full purchase price. Far more often, it is some percentage of the purchase price -- typically between five and 30 percent of the purchase price, depending on the size of the deal, the particular industry, the company’s operating history and other factors. The exception to that rule is for blown fundamental reps, which is almost always capped at the full purchase price.
An indemnity basket basically prevents a seller from getting nickel and dimed on the indemnity by establishing a threshold amount that a buyer deems to be material in light of the transaction. The actual number is often dependent on the size of the transaction. A larger transaction typically means a higher threshold and vice versa. A buyer cannot trigger the indemnity until the total liabilities suffered meet or exceed the basket amount.
As you can imagine, the cap and basket amounts are often hotly negotiated numbers during the letter of intent stage. The business principals are involved in these discussions because they have a material impact on the overall deal. Thus, the issue of balancing the risk of unknown liabilities is typically settled before the first draft of the definitive acquisition agreement is distributed among the parties for comment. Yet, seller’s counsel often feels the need to re-open those discussions through the non-market use of qualifiers.
Hey, I don’t fault anyone for trying once. Proliferating the seller’s reps with qualifiers on a first turn is often to be expected. But when the document comes back with basically all of them removed, seller’s counsel should pick the few places, if any, where such additions are actually appropriate based on the unique circumstances of the seller. That is more likely to move the needle than continually pounding the table in favor of drowning cap and basket protected reps with qualifiers.
If pounding the table works, then I tip my hat. But experienced buy-side dealmakers won't give in on the issue, absent an instruction from their client to stand down. Thus, pounding the table results in little more than increased time to closing and deal costs, which doesn't benefit anyone, except the lawyers.