In my last article I was writing about some pitfalls in the reps and warranties. Today I want to write about some noteworthy oddities.
Recitals, Representation, Guarantees
Even I learn from time to time. So now I was looking into recitals of facts, opinions and intents at the beginning of an investment- and shareholder agreement. They looked somewhat like representations. But they aren’t. They are merely preamble elements which shall help any later reader of the contract understand the context and circumstances of the agreement. Nothing more, nothing less. They are non-material to the contract.
When looking at representations, they are a bit more material. They are in fact likely reassurances that a party in the transaction needs in order to enter the transaction. They are givens. Conditions that everybody understands to be met. And the representation says it is indeed true that what everybody hopes and thinks is true is true. The entire purpose of the contract may hinge on the truth of the representation. That is relevant for potential damages. And that is why representations are material to the contract.
Is it a co-incidence that certificates of incorporation and bylaws regulate the right to act on behalf of the company is called rights of representation? Probably not. The representations are made by someone with representation, someone with the power to represent the company, someone that can speak for the company which otherwise is voiceless. A representation is made by company basically. But because the company cannot speak, someone else makes the representation. He or she is liable for the statements made. Which is why we have D&O insurances. The officer who might represent the company can also gear the liability of his statement by saying how he infers that something is fact. „Based on the process in our company that gives me the data for this statement and given that the process passed an external audit, i represent that the number of our customers is 1“. This is different than stating the fact „we have 1 customer“. A representation in such contract is a written statement by the representing officer that undersigns the contract. Aaah. Makes sense.
And now we also have guarantees. What is the difference to a representation? I think it is the personal effect of a guarantee. An officer of a company does not guarantee on behalf of the company, he represents. The company also does not guarantee that fact is fact. It presents its facts and an officer represents them. A representation is made by a representative of something on behalf of that something. Could be a shareholder as shareholder. Could be the executive for the company.
The guarantee is a statement made by a guarantor on behalf of something he is not necessarily representing. But in a guarantee that does not matter. The guarantor steps in personally in his capacity and under full liability for what he is guaranteeing. That stresses the fact that the plausibility of the guarantee must be checked. The guaranters ability to guarant and step in. And It raises the question why it shall be okay that someone who is possibly not able to represent the entity he is taking a guarantee for is guaranteeing it. The reason is simple : personal liability rather than liability as an officer.
Apart from that, there are title guarantees and business guarantees made in some contracts. Typically when founders are the only shareholders, the shareholders are forced to guarantee certain elements. You would usually not find a later stage independent executive guaranteeing such things. He would represent to the best of his knowledge that the facts he states as true are true.
Covenants, Conditions, Warranties and more Guarantees
Now with covenants, the parties that are able to represent do covenant that they will do and undertake action. The things that are covenanted are typically THE central elements that are requirement after the signing of the agreement for the agreement to be meaningful. Any breach of covenant typically follows a breach of contract and termination. That is quite tough.
Less tough is the warranty. The warranty merely states that something that might be true and might not be true right now is true or – if it is not – can be deemed true or will be true certainly in the future. The warrantor warrants that the other party can sleep assured and does not need to worry. It is a „no action needed“ flag. „I am handling this.“
So in a covenant both parties agree work needs to be done. Such as the house needs to be build. We cannot see it yet. The covenant says it will be built. It would be more difficult to claim „oh, don’t worry about the house, that is so easy and it will be done.“ As you can see, the warranty is something that is material and relevant and should not be breached without sanction and possible remedy plan or termination of the contract. But it is not the one and central element of the contract.
Now in this context, covenants and warranties hook into the future. And in some point of time that is clearly defined, there is a condition. A condition may be a break condition – that allows someone to terminate the contract and thereby being a covenant – or it may be a condition precedent. A condition precedent structures a transaction in time. Any obligation under the contract after such a condition precedent is not owed or needs to be performed if the condition is not yet met. While a party can be in default on a covenant, the other party might still be in need to perform contract obligations. With a condition precedent, it does not need to perform. Good thing in some litigations.
In M&A and financing transactions, conditions regulate when who needs to do what untill when and what happens untill then and after that and in default on meeting the condition. The covenants can be used to describe actions between such points. And warranties can be used to ensure at some particular time all is clean and there can be a new representation issues that all covenants and warranties are not done and true.
Oddity one: Assymmetry
Now in the US, you have guarantees and reps and warranties for both parties. In Europe I continue to see contracts where only the founders have to make such guarantees or warranties. Which is not only a bit unfair and odd. It is also a clear reflection of the risk aversion here. And it looks a bit absurd that the parties do not negotiate equally fair and demanding on both sides. This renders founders incompetent. While it is indeed a strict discrimination that prevents founders from raising money fairly. Weird. Isn’t it.