The significance of representations and warranties by the seller in transactions involving the sale of shares
The institution of representations and warranties, originally derived from Anglo-Saxon practice, is one of the typical legal constructions used in agreements involving shares in companies.
Representations and warranties are most often understood as factual declarations made by one party as an inducement to the other party to conclude the agreement. They also place the buyer in a specific legal and factual position with respect to the company.
Function of representations and warranties
From a practical point of view, two basic functions of the seller’s representations and warranties may be identified.
First, they specify the subject of the consideration involved (i.e. the share rights) and provide information to the buyer about what is being sold. It should be stressed that even though a share deal directly involves the transfer of ownership of the shares in the company, the indirect result of the transaction—and its essential purpose—is to transfer ownership of the company itself.
In most instances the buyer’s principal source of information about the company and any encumbrances on the shares is the due diligence conducted prior to the transaction. (For more on this topic, see Izabela Zielińska-Barłożek, “Don’t buy a pig in a poke—use due diligence,” Wardyński & Partners 2012 Yearbook.) But because most of the information and documents about the company used during due diligence come from the seller, the fact that the buyer has conducted due diligence does not necessarily mean that the buyer has obtained complete knowledge about the company. Therefore, the agreement under which the buyer acquires the shares typically contains representations and warranties concerning the condition of the company, including its legal status. This is in the buyer’s interest, particularly when due diligence was limited in scope or dispensed with entirely.
Second, inclusion of representations and warranties in the transaction agreement may be used to define the grounds of the seller’s liability to the buyer, particularly for defects (e.g. if the seller has assured the buyer that there are no defects, or is aware of defects but concealed them), and also to provide an evidentiary foundation through acknowledgement of certain facts and circumstances in the text of the agreement.
Effects of making and violating representations and warranties
It should be stressed here that the institution of representations and warranties is not specifically governed by Polish law. They may be used in agreements controlled by Polish law pursuant to the freedom of contract set forth in Civil Code Art. 3531, but the substance of the contractual obligations assumed by the parties is of primary importance in determining the legal effects exerted by representations and warranties.
Based on commercial practice, supported by the legal scholarship, representations and warranties by the seller generally may exert two types of effects.
First, they may be clauses in which the seller declares that a certain state of facts (concerning the company or the shares) exists (for example, a representation that no judicial proceedings are pending against the company for an amount exceeding a certain threshold). In the event of violation of such representations (i.e. if such a proceeding is in fact pending against the company), an obligation in the nature of a guarantee arises on the part of the seller to pay the buyer an appropriate amount of money. Such an obligation arises regardless of whether the buyer (or the company itself) has suffered any loss as a result of the falsity of the representation.
Significantly, if such a representation is not included in the agreement, the mere fact that a given circumstance is later disclosed (e.g. a proceeding pending against the company) would not automatically result in liability of the seller. First it would be necessary to assess the overall circumstances and grounds for the seller’s possible liability, e.g. under Civil Code Art. 556 (warranty) or Art. 471 (loss).
Second, such clauses may provide for an obligation by the seller to take certain defined efforts with respect to the circumstances covered by the representations and warranties. In such case, the seller’s obligation is to assure that the actual state of facts corresponds to that indicated in the representations and warranties. The liability of the party making the representation will then be in the nature of liability in damages.
Maciej Szewczyk, Mergers & Acquisitions Practice, Wardyński & Partners