Representations and Warranties in contracts as the foundation of legal certainty

Representations and warranties (R&W) made by the parties to a contract and included in its provisions are a mechanism for managing risk by allocating liability between the parties. They are particularly important in mergers and acquisitions (M&A) transactions.

I. Definition of Representations and Warranties.

Although these terms are often used together, they have slightly different legal meanings.

A representation is a statement of fact made by one party to a contract (the representing party) in order to persuade the other party to enter into the contract. A representation usually concerns the current or past state of affairs (e.g., “The company is not a party to any pending litigation”).

If the representation proves to be untrue, it may lead to liability for damages on the grounds of misrepresentation and entitle the aggrieved party to withdraw from the contract.

A warranty, on the other hand, is a contractual promise in which the warranting party undertakes to be liable if a certain fact, state of affairs, or condition proves to be untrue or does not meet certain requirements, regardless of fault. A warranty forms the basis for a claim for damages (breach of warranty) provided for in the contract if the facts change or do not correspond to the warranty. Such a warranty applies to both present and future circumstances.

Therefore, bearing in mind the above distinction, it should be noted that a representation focuses on the cause of the contract (inducement), while a warranty focuses on the effect (a promise of contractual liability for a specific fact).

II. Purpose and function of Representations and Warranties (R&W).

One of the main purposes of R&W is to allocate risk and assign responsibility for specific risks to one of the parties to the agreement. For example, a party purchasing shares in a limited liability company seeks to obtain the broadest and strongest Representations and Warranties regarding:

- legal title to the shares/assets being sold.

- financial matters (audited financial statements).

- absence of liabilities, disputes or pending litigation

- compliance with the law in the conduct of business (licenses, permits).

- intellectual property and key agreements entered into by the company.

III. Basis for claims for damages. Limitations and exclusions of R&W.

If, after the transaction is closed, it turns out that the actual situation differs from what was stated in the Representations and Warranties submitted by the party (e.g., a hidden legal dispute suddenly comes to light), the injured party may claim damages in accordance with the contractual provisions.

Although the buyer conducts legal due diligence, R&W serve as additional protection. Some risks are impossible to detect during legal due diligence, and R&W transfer the responsibility for undisclosed or misrepresented information to the seller.

In negotiations, the seller seeks to limit its liability as much as possible.

These limitations include:

• Compensation caps (caps), i.e., the maximum amount that the seller will have to pay if the R&W prove to be false. This is usually a fraction of the purchase price, e.g., of shares.
• minimum thresholds (baskets/thresholds), i.e., a contractual provision according to which claims may only be made if their total value exceeds a certain minimum amount specified in the agreement.
• survival periods, which should be understood to mean that R&Ws do not apply indefinitely. For most R&Ws, a period of validity is set (e.g., 12-24 months), but for key issues such as legal title and taxes (so-called fundamental warranties), this period is significantly longer or limited by law.
• disclosures: the seller's liability is usually excluded for matters that have been properly disclosed to the other party to the agreement in the so-called Disclosure Schedule. If the buyer was aware of a given fact, they cannot later make a claim under the R&W in this regard.

It should be remembered that negotiations on R&W and indemnification mechanisms are one of the key elements of most complex transactions.

IV. R&W insurance (W&I Insurance). Summary.

Warranty & Indemnity Insurance (W&I) is increasingly used in modern M&A transactions. It is an insurance policy that assumes the risk of a breach of R&W by the party making the representations and warranties.

Representations and warranties are an essential element of any reliable commercial agreement, serving as a mechanism for building trust and establishing clear rules of liability between the parties. The actual legal protection of the interests of each party depends on their content, detail, and related limitations on compensation.