The good and the bad sides of representations and warranties – a few practical observations | In Principle

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The good and the bad sides of representations and warranties – a few practical observations

Representations and warranties are a common feature in M&A transactions and derive from common law systems. The fundamental aim of representations and warranties is to properly divide risk between the seller and the buyer. In countries with an Anglo-Saxon legal system, statements made regarding the object of sale are in fact explicitly an element of ex delicto liability, as misrepresentation, and contractual liability as breach of warranty. The significance of statements of this kind in contracts governed by Polish law is not entirely clear and has been widely discussed in case law and legal literature. The conclusions reached are summarised below.

Representations and warranties are now a standard feature of share purchase agreements governed by Polish law. They usually relate to an object of sale in a broad sense, i.e. not only to shares (for example that subscription for shares proceeds correctly) but also to a company (for example that it pays its taxes) and the business enterprise (for example that certain assets are part of the business enterprise). In such a case, the parties’ intention is to assign liability to the seller, as the party making the representation, for existence of the circumstances described in the representation and sometimes to give the buyer other, additional rights.

This liability on the part of the seller usually pertains to the obligation to perform a specific act, normally to remedy damage or restore the desired state of affairs, where the declaration made regarding circumstances does not reflect the true circumstances found to exist. This requires all of the representations and warranties to be in line with one of the institutions in Polish civil law or to have a basis under the principle of contractual freedom. If this is not the case, the seller will not be under a valid and effective obligation, and the buyer will not have other rights. In this context, there has been intense discussion in case law and legal literature on the nature of representations and warranties, often in relation to Supreme Court judgments considered a little or highly controversial. The picture it provides is fundamental to correct application of representations and warranties, and this includes in particular the appropriate wording of the respective contractual provisions.

The principal conclusion is that presently, formulating representations and warranties in one of four legal structures no longer gives rise to major disputes. These four structures are a guarantee obligation, statutory warranty, contractual liability, and an error. The possibility of ex delicto liability has also been mentioned. Meanwhile, each of these forms of use of representations and warranties has specific features, and this has implications in particular for the permitted scope of risk secured, the penalties that can be employed, and the wording of the relevant contractual clauses. The most important aspects are examined more closely below.

Guarantee obligation

Representations and warranties are usually used as an element of a separate guarantee obligation. The seller agrees to take strictly defined action if the declarations it has made turn out to be untrue. In jurisprudence, it is in fact emphasised that this is the most effective and the most flexible way of using them, the former because various types of risk can be secured, and the latter because the seller’s obligations can be formulated relatively freely, but certain doubts do arise:

  • Due to controversial Supreme Court case law on the scope of contractual freedom possible in this case (this is discussed in greater detail here),
  • Regarding whether a seller can be liable under a guarantee in cases where the contract contains representations and warranties but no arrangement is reached regarding the actions to be taken if the representations and warranties are not honoured.

Statutory warranty

A very common consequence of use of representations and warranties in connection with guarantee obligations is, in commercial practice, exclusion of liability under the statutory warranty. If this is not the case, some declarations made by the seller could give rise not only to contractual obligations, but also at the same time rights under the respective provisions in generally applicable law.

The prevailing view in case law and legal literature is that representations and warranties should in fact be used primarily on the basis of the statutory warranty (liability for “assurances made by the seller to the buyer that certain properties exist”). This is not necessarily affected by the fact that the item sold is usually shares in a company, and the object of the most important representations is the business enterprise. This is because jurisprudence assumes that there can be physical defects in shares. In such a situation, if the company’s business enterprise is lacking a particular feature, this constitutes a defect in the “material foundation” of the shareholding right. Of course this is highly controversial – especially because this application of the statutory warranty would mean a departure from the principle that the statutory warranty applies to the object of sale. Although, in general, provisions on the statutory warranty can be modified by the parties at will, there are doubts about the extent of freedom of the parties when formulating the seller’s obligations under the statutory warranty.

In fact, recent Supreme Court judgments on both of these issues (judgments of 29 October 2010, I CSK 595/09, and 8 April 2016, I CSK 285/15) and an amendment to the Civil Code (a physical defect understood to be “non-compliance of the item/right with the contract”) are grounds for a more liberal approach.

Ex contractu liability

Case law and legal literature also acknowledge the principle that untrue representations and warranties in a share purchase agreement may be grounds for contractual liability, because sale is an “obligation to place the buyer in the situation in law and in fact vested up until that point in the seller”. Representations and warranties specify the “situation in law and in fact” in question, and also define the seller’s obligation. If the situation in law and in fact in which the buyer is placed is not that described in the declaration made by the seller, this constitutes failure to perform or improper performance of the obligation.

Meanwhile, it is not easy to formulate claims due to incorrect contractual representations because the prerequisites for a compensatory claim in this regard are “related to a lesser extent to the nature of” representations and warranties.  This is primarily a question of the definition of damage and the way in which the damage is ascertained, the possibility of evidence causing liability to be waived, and the specific nature of the secured risks. Meanwhile it has been stated in case law (Białystok Appeal Court judgment of 26 June 2013, I ACa 275/13) that this can be resolved in part by citing failure to fully comply with the disclosure obligation provided for in Art. 548 of the Civil Code.

An error

Representations and warranties exist to enable the buyer to fully assess the situation in law and in fact in which it acquires shares. If the declarations made are untrue, this can produce a false picture and lead to an error. As a rule, an error of this kind is grounds for repudiating the legal consequences of the sale, if the error is material in nature (the buyer would not have entered into the transaction under different circumstances) and relates to the nature of the legal transaction (in particular the item sold – shares).

As in the case of the statutory warranty, a distinction has to be made between the object of the legal transaction (shares) and the object of the key representations or warranties (the company’s business enterprise). An error relating to the declared status of the business enterprise is only an error regarding the nature of the legal transaction if the company’s business enterprise is found to be a defect in the “material foundation” in the shareholding right. Representations and warranties regarding motives, forecasts, or factors relating to risk cannot however give rise to an error of that kind.

At the same time, provisions on errors are mandatory, and the sole solution they provide is complete repudiation on the part of the buyer of the legal consequences of its declaration of intent. In general this is not the ideal scenario for the buyer.

Incidentally, the Supreme Court has said that “conducting a due diligence analysis beforehand does not exclude the option of citing an error” (judgment of 29 October 2010, I CSK 595/09), and contractual clauses defining the level of “reliance” on representations and warranties do not by themselves assure this option.

*  *  *

The systems described above for application of representations and warranties compete with each other and can appear side by side in a single share purchase agreement or not at all, especially where there are no guarantee obligations, modification of the scope of contractual liability, or exclusion of the statutory warranty. It is therefore important to draft the relevant provisions so that the buyer:

  • Firstly has effective security in the event the situation in fact or in law is not that described in the representations and warranties,
  • Secondly, has available to it a sufficient range of instruments enabling it to respond proportionally to a situation in fact or in law that is not that described in the representations and warranties.

Michał Gintowt, adwokat, M&A and Corporate practice, Wardyński & Partners