In an acquisition, part of a buyer’s goal is to make as informed a decision as possible and to close the deal efficiently and inexpensively. Costly, post-acquisition litigation is the last thing any party to a transaction wants. So, how can litigation be avoided? The short answer is . . . it can’t. Despite the best intentions of the involved parties and the resources put into a deal, disputes will always arise. However, the risk of litigation can be minimized (and the potential success of a deal maximized) through the combined use of thorough due diligence and strong representations and warranties in the purchase agreement.
Due diligence as an effective tool
Due diligence is a prospective buyer’s investigation and review of a target company or property. Its object is to obtain public and non-public information to ensure the target is what the buyer thinks it is. It can include inspections, interviews, and reviewing documents related to the target’s financials, legal and regulatory issues, assets, leadership, and industry.
There are several benefits to performing thorough due diligence. Primarily, it helps the buyer avoid unpleasant surprises that, if found too late, could sink the deal’s profitability or require litigation. It also helps close the informational gap between a buyer and seller, which could give the buyer more leverage in negotiating a purchase agreement. For example, through due diligence, a buyer can determine the true value of a target through its financials and confirm that key assets are operational and compliant with laws and regulations.
But due diligence has its limits. It can be expensive. Depending on the resources available or the magnitude of the deal, a buyer may not be able to afford a team of lawyers to conduct legal due diligence, engineers to ensure the regulatory compliance of the assets, or auditors to review the financials. Moreover, even in a world where the buyer has unlimited resources, a buyer still cannot expect to discover everything there is to know about a target.
Benefits of strong representations and warranties
To overcome these limitations, a buyer should pair due diligence with strong representations and warranties that adequately protect what is important to the buyer.
Representations and warranties are commonly used contract provisions that bind a party, often a seller, to a statement of fact and give the party to whom they are made recourse if some aspect of the target is not as it was held out to be. Although there are technical differences between representations and warranties, they are often used synonymously.
Representations and warranties can provide a buyer with significant leverage should issues arise post-acquisition. Following the close of the transaction, if the buyer discovers the target was emptying its chemical waste into a nearby stream illegally, and the seller warranted that the target did not, a seller is unlikely to feel very good about its chances in a court of law. The seller will be more likely to settle out-of-court, avoiding litigation, and, even if litigation is required, it will be faster and less expensive if the seller is bound by a contract provision with no viable defense. Representations and warranties are therefore powerful tools in an acquisition.
Unfortunately, purchase agreements are not drafted in a vacuum. Lawyers for the seller will be doing everything they can to narrow and minimize the contractual provisions that create risk for their clients. Conversely, a buyer will want broad representations and warranties that can cover not only situations the buyer can foresee but also those it cannot. Additionally, a buyer will want tailored representations and warranties ensuring that the most important aspects of the deal, such as a key asset, are covered.
With this in mind, a buyer should prioritize what is important and use a combination of due diligence and representations and warranties to ensure it is protected. If a buyer feels it can perform adequate due diligence on an aspect of the target, it may not prioritize a representation or warranty related to that aspect. However, if, for example, the target is a multi-national company with locations or property overseas, due diligence may not be feasible, and strong representations and warranties will be required.
By learning about a company on the front-end of a deal through due diligence, issues that arise can be negotiated and addressed in the purchase agreement rather than in post-acquisition litigation. When due diligence is too expensive or otherwise inadequate, strong representations and warranties can encourage disclosure and possibly deter post-acquisition litigation or, if litigation is required, provide a quick path to victory. Strategic due diligence and contract drafting may take time, effort and money but can be worth it when compared to the alternative of miring a buyer in multi-year litigation that drains the profits from a deal.