John: Hey everyone, this is John Di Giacomo, and you are listening to the May it Please the Internet, and I’m joined by my partner, Eric Misterovich. Eric, how are you?
Eric: Hey, John, good. How are you?
John: I am deeply excited to talk about representations and warranties today, in Asset Purchase Agreements. These are the most exciting of all of the clauses in an APA.
Eric: This is another part in our mini-APA series that we’re doing. We started off talking about the nuts and bolts of purchased assets and what you’re actually selling, what’s being excluded. We got into the purchase price and closing, and how do you determine that, getting into earn outs, and all that stuff. And now we’re into the real exciting stuff, reps and warranties, can’t get enough of them.
John: Well, let’s start with what they are. And I want to walk through what I think they are, because you and I were, not arguing about this, but we had a conversation about it when I was in the airport in Chicago, because a deal was falling apart based on some arguments over rep and warranties. And you actually, very succinctly, described the categories of these things, and I want to do it as well, because I want to walk back through what you said.
John: So we have representations, and my understanding of representations is that these are statements about what is being sold, that are made by the seller. Then we have warranties, which are statements about the effectiveness or the use of the things that are being sold, so something beyond a simple representation, maybe about how they will perform in the future, or whether there will be title to them in the future. And then we have covenants, which are really things, and this might not be the best definition, but things that are represented by the sellers, what they won’t do, so non-competes, non-solicits, non-circumvention clauses, confidentiality clauses. Is that a fair assessment of the categories that you think we should talk about?
Eric: Yeah. Yeah, definitely.
John: Yes.
Eric: So, reps and warranties. Yes, you got it right. Reps and warranties are usually grouped together, although they are technically different things. And then covenants are usually in a different part of the Asset Purchase Agreement. And yeah, covenants are kind of like, I kind of view all of these as promises, one way or the other. There’s some fine tuning, and if you go around and Google this, you’ll see attorneys fighting about what is what. To me, they’re all promises, they’re kind of promises in different aspects, like you said, representations and warranties are these promises of maybe the business as is, and what has happened to date, where these covenants are kind of promises that they’re going to keep going forward, like they’re not going to compete, they’re not going to solicit.
Eric: But, when I’m talking to sellers, if I’m representing a seller, what I always just say is, reps and warranties are promises, and they’re promises you’re making to the buyer. And the buyer is not just buying your assets, not just buying the Amazon account, or listings, or reviews, it’s buying the promises that go along with those things. Because unless you can promise that your financial statements are true and accurate, that you have complied with all material laws, that you have the title to the assets to sell, then the assets are meaningless. You have to have all of these promises that go along with it, and that’s what they are in my mind. The simplest way to explain them is reps, warranties, covenants, they’re all promises that the buyer is paying money for.
John: Yeah, it’s like buying speakers. You could either buy speakers at Best Buy, or you can buy them out of a trunk of a car. Now, if you buy them out of a trunk of a car, there’s probably not a reliable rep and warranty as to title, but if you’re buying them from Best Buy, there probably is. And what we’re really trying to do in these clauses is to capture the sense of trust and the sense of duty that is built into the transaction itself. Now, let’s talk through some examples. What are the kind of major reps and warranties that you typically see in an APA?
Eric: It’s always very lopsided in terms that the promises, or reps and warranties, that the seller has to make. There’s a lot, right? There’s going to be probably somewhere between 15 to 30 sections, many of those with several subsections, where the buyer is probably making like three or four promises total. And that’s because the buyer is paying money, and the seller is selling promises. That’s normal, it’s going to be lopsided.
Eric: The reps and warranties that the seller has to make, they follow a pretty similar pattern. There’s always going to be a lot that are based on, are you an entity that exists, right? Are you organized? Where are you organize? Are you in good standing? Does that entity actually exist? Yes.
Eric: Do you have the authority to enter into the agreement? Whatever seller entity is signing this, or principal is signing individually, has the authority to sign this agreement. You’re not doing this behind the board of directors back and they’re going to turn around and say, “Whoa, you didn’t have the ability to sign that.” And, a kind of related one, that there’s no conflicts, by signing this contract to sell all the assets, you’re not creating a conflict with any other agreement, law, promise, you don’t need the consent or notice of anyone else. Those are usually the first two or three. Reps and warranties are all about really basic stuff. Do you exist? Do you have the authority? And is signing this going to conflict with anything else?
John: The other ones that I usually see are, do you have title to the assets? Do you have full title to the intellectual property? Are there registrations that you’ve listed in the annex to the APA, on the back of the APA, all the registrations that you have? Have you been sued or are there any pending lawsuits? Things like that. Taxes, have you paid all your taxes? The kind of material things that you want to hear in a transaction.
John: And then from the buyer side, same type of things, you’re talking about things like, are you an entity, like you said previously. Do you have the authority to sign this? Are your financial statements, in some cases, if there’s some hold back amount, are your financial statements accurate? One of my favorite ones, Eric, and maybe you think differently about this, is, do you have the funds? And I want to talk about this for a second because I find this so absolutely absurd. A rep and warranty from a buyer that they have the funds. What the hell does that do? Is there any value in that? If they don’t have the funds, you’re going to sue them for breach of contract. Do you agree with me on that? Or am I absolutely insane for thinking that?
Eric: I don’t think there’s a ton of value to it, but I think there is, first of all, if you’re the seller, the buyer’s probably not going to object to it, because it’s not real substantive, I don’t think they’re real scared of it. Theoretically, if you got into a situation where the buyer essentially ran out of money, maybe it could open up the door to like a fraud claim. Like, “Hey, you said you had sufficient funding, and actually at that time, you had no money at all, and you were borrowing money to pay this.” This is not a good claim, I’m not saying this is a very strong position at all, but maybe it’s a shred of something to hang onto. But yeah, it’s not going to get you very far.
John: Yeah, I always find it interesting when it’s in there. I guess the fraud thing makes sense though, that’s actually a really great example. Okay, so how should people be looking at these reps and warranties? What should they be doing when they review them?
Eric: Read them, closely, unfortunately is the answer. They’re really long. I have one up right now, Section 401 through 422, and there’s several areas that have multiple sub parts. There’s a lot to read, but these are important, these are really important, because you want these to be as accurate as you can possibly be, because the reps and warranties work together with indemnification, which is probably a topic for another episode. But, short story, if you breach these promises, you might owe them money for it, the buyer. So, you have to read these closely, and your attorney really should be going through these one-by-one. I mean, when I represent sellers, I walk through these one-by-one. Depending on the seller, depending on the size of the deal, depending on their level of comfort, we’re either reading every sentence together or I’m reading it and giving them a condensed version of it and poking them to see if there’s things that we can’t promise.
Eric: So, just for example, if you read any kind of IP rep, there’s going to be a sub rep about you own it all and you have title. Like you said, there’s going to be one about, our intellectual property doesn’t infringe on anyone else’s, and no one infringes our intellectual property. Okay, well, when I see that, then I have to ask the seller, “Well, have you ever received a cease and desist letter?” “Oh yeah, we have.” “Okay, have you ever sent any?” “Yes, we have.” “All right, then that promise isn’t true anymore.”
Eric: You have to now explain why it’s not true, and that’s where you get into these things about what we call disclosure schedule, right? So section 4.10C, I have to disclose that I sent the following cease and desist letters, and you usually just throw in a copy of those so the buyer can see it. Now that way the buyer is on notice that you have sent out cease and desist letters, they’re on notice that you thought these other people were infringing. Maybe it was resolved, maybe it wasn’t, but the buyer is now on notice of that. The point of disclosing that is now it kind of shifts the risk back onto the buyer that this is part of the agreement, it’s been disclosed, they can’t now come later and try to sue you for that issue.
John: I just had a recent one where I’ve representing the buyer, and we were, day of closing, and we got the final disclosure schedules and there was a lawsuit listed in there. And so I searched for the lawsuit, and I look, and it materially impairs the assets. And I’m just like, “What is going on here?” Those types of things that should have been disclosed early on so you can have a conversation about them.
John: Another one that I think is worth mentioning is independent contractors. Under intellectual property law, if you hire an independent contractor to create something for you, like a logo, you have to get an assignment agreement assigning those rights to you, otherwise you don’t have those rights. And in disclosure schedules, or within reps and warranties, you’ll often see these reps, strict hard reps that say we own all of our intellectual property.
John: And when you’re representing a seller, you have to say, “Okay, do you have all of the assignment agreements for all of the IP associated with the products or whatever it might be that you’re selling?” And if they say no, then you’re going to have to disclose those and have a conversation about them.
John: And then from the buyer side, I’m always looking for, how are the sellers qualifying these reps and warranties? So, good example is, many times attorneys will insert seller’s knowledge qualifications, where, instead of it being a hard rep and warranty that says, “I have this,” or “I did this,” it says, “To my knowledge, I did this,” or “To my knowledge, I have this.” And it’s tough, from a buyer’s perspective sometimes, to accept those because if you end up in litigation, you’ll have to show that the representation was false, that they did have knowledge or that they should have known at the time that they made that representation. So it’s the way to back off the rep to be as hard as you’re requesting.
John: And then the same is true for another qualifier, material adverse effect. So sometimes a seller will say something like, in indemnification clauses, the clause will be triggered only if there is a material adverse effect rising out of a representation of warranty. And what that means is that the breach of the representation and warranty has to be long term and material. And there’s some case law on this, and it basically just says that if the breach is not substantial and it does not have a long term effect on the business, then it is not a material adverse effect. So again, it’s a way that sellers raise the standard so that they cannot be held liable for a breach of those reps and warranties later on down the line.
Eric: As I think anyone can tell right now, there’s a lot going on. There’s a lot going on in these reps and warranties, and it’s a vital part of the agreement, and it’s one that sellers and buyers, it may be the one that is easily glossed over because it’s long, it’s boring, you’re not going to understand a lot of the language on just an easy read of it, but, that’s the exact wrong way of approaching it. These are very, very important, and if anything ever goes wrong, this is right where the attorneys are looking. What’s in the reps and warranties, and then who promised what.
Eric: I have a case going on right now where we sold, I represented the seller, Amazon business, we made very limited promises about inventory, and what kind of inventory we were providing, and the amount and extent of the inventory. And now, eight months later, the buyer is complaining about inventory. And the answer is, “Well, we didn’t really promise you anything more than what we did, so I don’t think you have a case because of the limited rep warranty we made about it.”
Eric: So, these reps and warranties are vitally important, the disclosure schedules, something to really understand. People get really freaked out about disclosure schedules for some reason, they just don’t know what it is. It’s just a word document. You go through the reps and warranties, which are all numbered, and if you have something to say, that you have to carve out of that promise in the rep and warranty, then you do that in the disclosure schedule.
Eric: For the types of stuff we do, there’s usually something about complying with all of Amazon’s rules. Well, we all know that’s practically impossible, and many times there’s been warnings, sometimes there’s been take downs. Maybe you didn’t break any rule, but a competitor submitted you, and submitted some false complaint, and you were taken down. Well, you need to disclose that, because a year down the road, they may get taken down for something different, and they may turn around and go, “Oh, we didn’t know this listing had been taken down two times before. Now, Amazon’s algorithm has triggered this as a third time, and we got some greater penalty than we ever should have gotten.”
Eric: I’m making stuff up, but it’s a pretty plausible fact pattern that could happen, and you’ve got to disclose these things. It’s very unlikely the things a seller will disclose will kill a deal, outside of, John, what you just have been going through, which has been really bad stuff, being disclosed in the last second. Most of the stuff people disclosing, “Hey, I don’t know, this independent contractor that took these pictures of the products.” Okay, well now the buyer can just retake those photos, take those down, and they have no risk. Most of the time, disclosing it will not endanger the deal in a material way.
John: I agree entirely, and a lot of times you can address it in the indemnification section with specific provisions related to specific instances, like in the case of the contractor, not having an assignment agreement, you can have an indemnification hold back, or whatever it might be to protect your interests, as long as that information is disclosed. And I agree entirely that deals never die as a result of being too truthful, unless the seller or the buyer really don’t want the deal to go through. I don’t see fully disclosing these issues as being an impediment to closing deals in any way.
John: And we should talk about the connection of these reps and warranties to the process of getting paid out on them. So under an APA, usually they’ll be an indemnification provision, and sometimes it’s a sole remedy for a breach of a rep and warranty, sometimes it isn’t. Sometimes there are caps, baskets, and fundamental reps, and non-fundamental reps. Eric, let’s talk a bit about that. What’s the connection between reps and warranties and indemnification, or breach of contract claims, in an APA?
Eric: So, when I’m working with a seller, my goal is when we’ve made it to this section of the agreement, I tell them, I say, “Okay, I’m going to explain how reps and warranties work. I’m going to explain how indemnification connects, and by the time I’m done with the initial explanation, you should be scared. You should be feeling pretty uneasy about how this is going to work. But then by the time we’re done going through all the reps and warranties, and we go through the limits on your liability, you should feel comfortable.” That’s what I want people to feel when they go through this, because the reality is, if anything in the 10 pages of promises that you’re making turns out to be false, and the buyer suffers damages because it is false, you are on the hook for it, right? So section 4.01 through 4.22, and all sub parts, that are very long and difficult to read, if something in there is not true, and the buyer suffers damages because it’s not true, you owe the buyer the money for those damages. That is indemnification, and that’s how it’s tied together.
Eric: Usually, there’s 10 pages of reps and warranties, and then there’s one section of indemnification that says, seller has to indemnify buyer for any breaches of the reps and warranties. So this one little sentence incorporates 10 pages of promises. And once you really understand the connection between those two, I would hope you have enough motivation to read those reps and warranties closely. And usually when you read through them, let’s say there’s 20 of them, 15 of them you’ll have no problem making that promise at all, they’ll be kind of easy and you have no risk at all, and you’re comfortable with it. But there’ll be like five or six where you’re saying, “Eh, that’s not exactly true.” This happened or that happened, and that’s where you end up spending a lot of time.
John: Yeah. And there’s this idea of baskets and caps to indemnification, and the application of indemnification to fundamental and non-fundamental, or general, reps and warranties. Baskets are the idea that you can’t come after us unless the damage that you suffer exceeds X amount, so let’s say $50,000, because I don’t want you calling me if someone complains about a $2 issue. And then cap is, if it is over 50 grand, we’re not paying you out any more than a million, or three million, or whatever it might be. And those limits may apply to fundamental reps, or they may apply to general reps, and they’re probably going to be different. For general reps, there’s going to be a lower cap, right? It’s going to be things that aren’t really material to the operation of the business, or aren’t as material. And then fundamental reps, it’s going to be things like, do you own the assets? And if the answer is no, we get to sue you for the full purchase price, or whatever it might be.
John: And this is an area of deep gas lighting with other attorneys, because when you’re either a seller’s attorney or a buyer’s attorney, you’re going to get on a call with somebody, and they’re going to say, “That’s not market. That’s not market.” This is the word you always hear, market. What is market? Eric, I don’t know if you’ve experienced this like I have, but over the last two weeks, this is all I’ve been doing is having arguments about, what is market, for these indemnification caps and baskets, and reps and warranties. And the short answer is, material is material, and non-material isn’t material. And the answer is, do you want your money back or do you not want your money back? I mean, do you agree with that, Eric?
Eric: Yeah. I mean, it’s not market, it’s not market, it’s not market. And it’s like, “Okay, it doesn’t matter. It doesn’t really matter.” Like to me, there is generally accepted things that are market. Of course, everyone’s going to fight about it, depending on what side of the table. So to say it’s not market, it does matter, and it doesn’t. If you’re coming way out of left field, then, that’s not market, and I think there’s credibility in it. If you’re trying to limit your damages for actually not owning what you’re selling, that’s not market, and it’s not acceptable.
Eric: If we’re talking about, well, I think the cap on non-fundamental reps, the cap on damages, should be 30% instead of 20%, okay, now we’re just negotiating, and I don’t think market has a ton to do there, because every deal is different, and at that point you’re negotiating. But there are certain aspects of these deals that are so ingrained and accepted that to come and say something that’s completely out of whack with it, that’s where I wish attorneys were more, using the kind of market fight for those kinds of things. Everything else, you’re negotiating, and you can always fall back on the not market thing, it’s just not real persuasive because everyone goes, “I don’t care. This is what I’m doing, or not. Take it or leave it.”
John: Yeah. I mean a great example of this is indemnification for intellectual property. So, concrete example, you buy a business, seller doesn’t want to get sued 10 years down the road so they’re asking for, one, a cap on potential damages, and two, a sunset of the period of indemnification for a breach of the rep and warranty related to intellectual property. And in those cases, what we’re really negotiating over is how long should they be on the hook? And it is a negotiation, it’s not a question of whether or not it’s market, it’s a question of whether or not we will accept the risk or you will accept the risk. And the way the dance typically goes is we propose five years, they come back with one, we meet somewhere in the middle at three, and everybody’s happy because three years is close to the statute of limitations, and we’ve arrived at a number for what the cap will be, and it ends up being somewhat reasonable. When both parties are not extremely happy, it’s probably a good deal.
John: So, most of the stuff is, I agree, the conversation about market is useless, it is non-substantive. Most of this is negotiation, unless it’s deeply out of whack. If someone says, “We are not going to represent and warrant that we own title to the assets,” that’s not market, that’s a big red flag. Or “To the best of seller’s knowledge, we own all the assets.” Big red flag. Do not-
Eric: Not a good-
John: Yeah, do not sign that deal. But, work with an attorney, and you can work through these things, and some of this is just noise.
Eric: For the buyer side, it’s a good idea to have a roster of seller attorneys that you have worked with in the past that understand this. I know several buyers that do that, they have a roster and they’re sourcing their own deals. The seller doesn’t have an attorney, and they say, “Here’s five people. Talk to any of these people, they’re all great attorneys,” because the pain level is going to go down a million percent. When you get the old country lawyer who’s talking about including the phone system and the paper clips in the deal, and it’s like, “This is not what we’re talking about, man.” They’re in a different universe of experience and they slow things down and practically kill deals. So, it’s something to think about if you’re on the buyer side, getting that roster together of people to refer people to.
John: Yeah. It’s the same with big firms too. I’ve had so many run-ins with big firms where you’re like, “Okay, cool. This is going to go really well because these people are highly educated, and they’ve done a lot of deals, and much larger deals than the one we’re doing.” And then you get four months of arguments over taxation, like, “Well, he needs to have an 83B election, and these stock options are going to subject us to a 409 issue.” And it’s just like, okay, why are we doing this? We’re just spinning our wheels going nowhere because somebody is padding the bill. Yeah, from both sides, whether it’s a small firm or a large firm, work with somebody who is competent and who is within the industry. And if you don’t know who that is, call us, we’ll refer you to somebody, we know all the major players in the space. Eric, I think this has been helpful. It sounds like you’ve got another parting shot. What do you want to say?
Eric: Parting shot is, if you formed a business entity with more than one person, get your agreement in together, get your operating agreement done. Shareholder agreement, operating agreement, something, get it done. It really should be a priority because if you don’t get it done now you’re not going to get it done later, and the problems come up later. Operating agreements, they’re very important. It doesn’t mean you’re married to it, if you two have an operating agreement and it’s done, and then you decide a year later or something comes up and you don’t want to follow that, you don’t have to, as long as you two agree. But it gives you a baseline, it gives you a floor of how things work. Get it done, save it, hopefully you never have to look at it again, but if you ever do need it, and you don’t have it, your problem just got 10 times more expensive, trying to figure out who owns what, how much, recreating the wheel through text messages and phone calls and promises. Just get the operating agreement done and make it a priority.
John: Yeah, it’s easy, it doesn’t cost a whole lot, just get it done. I agree. Well, thanks, Eric. This has been great. Again, this is the May it Please the Internet podcast, and we’ll talk to you next time.
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