Saturday, October 10, 2015

Breach of Representations and Warranties in M&A: A Buyer’s Guide

[The following guest post is contributed by Goda A. Raghavan and Kirthi Srinivas G, who are advocates with HSB Partners, Chennai and can be contacted at and respectively. Views are personal and do not represent the views of the firm.]

Purchase price in a mergers and acquisitions (M&A) transaction is normally fixed after factoring the risks and liabilities that are being incurred by the buyer. Such risks and liabilities are arrived at after a thorough financial and legal due diligence. Nevertheless, as Ronald Reagan famously said “Trust, but verify”, the buyer demands numerous representations and warranties as a means of assurance relating to several facets of the seller or target company in the definitive documents. Definitive documents in such transactions are usually an investment agreement, a share purchase agreement or a business transfer agreement.

The Indian Contract Act, 1882 (“Act”) provides for consequences in case of misrepresentation and breach of warranties. Section 19 of the Act states that in the event an agreement has been entered into by coercion, fraud or misrepresentation, the aggrieved party has the following remedies:

1.     The contract shall be voidable at the option of the aggrieved party.

2.     The aggrieved party may require specific performance.

3.     There shall be a restitution for unjust enrichment by the parties.[1]

It must be noted that the power to avoid a contract is not an unfettered right and section 19 of the Act provides for an exception to the general rule, i.e., that if misrepresentation or fraudulent silence[2] is capable of being discovered by ordinary diligence by the aggrieved party, then the contract cannot be avoided by the aggrieved party.

The term “ordinary diligence” is not defined under the Act. However, in the case of Erie Bank vs. Smith,[3] the phrase “ordinary diligence” has been interpreted to mean “that degree of care which men of common prudence generally exercise in their affairs, in the country and the age in which they live. These last words are quite material quite important, in this case i.e. “in the country and the age in which they live” thus, what might be ordinary diligence in one country, be negligence, even gross negligence in another country, be negligence, even gross negligence

Based on this interpretation, a due diligence may diminish the ability of the buyer to claim for any remedy under law or the definitive documents upon discovery of breach after the transaction has been concluded. The same would apply in the case of a disclosure letter provided by the seller. Two judgments of the English Courts worth mentioning in this regard are New Hearts Limited vs. Cosmopolitan Investment Limited[4] and Infiniteland Limited vs. Artisan Contracting Limited.[5]

In the New Hearts case, warranties were given in a share purchase agreement as being subject to “matters fairly disclosed (with sufficient details to identify the nature and scope of the matter disclosed) in the disclosure letter”. The Court laid down a qualitative test, which was broad in its scope and required the seller to disclose the matter fairly and in sufficient detail. However, the Court of Appeal, in the Infiniteland case, rejected the qualitative tests and observed that adequacy of disclosure must be measured against the requirements of the share purchase agreement executed between the parties and not against the requirement of any general common law concept of “fair” disclosure. It also observed that whether a buyer’s knowledge prejudices its ability to bring a warranty claim depends on how this is expressed in the share purchase agreement.

The practical implication of the aforementioned judgments are that the buyer seeks fair and sufficient disclosure to identify the nature and scope of the matter disclosed or seek a specific disclosure against specific warranties. Another qualifier in the definitive document is “what would constitute buyer’s knowledge, considering that due diligence is generally outsourced to a law firm or to chartered accountants. Therefore, “knowledge of consultants and advisers” are excluded from the “buyers knowledge”.

Be that as it may, to protect the interest of the buyer, an indemnity clause is inserted in definitive documents as protection from any losses that may be incurred despite knowledge of certain facts. This post lists out certain mechanisms adopted by a buyer in case of breach of any of the representations and warranties, in addition to any remedy available under law:

1.     Indemnity

Indemnity contracts as defined under section 124 of the Act are contracts by which one party promises to save the other from loss caused to him by the conduct of the promisor himself, or by the conduct of any other person. It is the most common form of protection sought by the buyer.

Indemnities may be uncapped in monetary limit and without any time period restriction. Parties may negotiate a time period restriction or a monetary limit for claim.

(a)        To the advantage of the seller, monetary limits in terms of the indemnity amount i.e. de-minimis threshold (being the minimum amount of accrued claims above which the indemnity may be enforceable) and/or claims limitation (being the maximum amount of claims that may be entertained by the seller) are often negotiated.  However, with respect to the tax warranties, buyer seeks to be indemnified to the entire amount of tax claim.

(b)       Non-Tax representations and warranties: In relation to time period restrictions, sellers often negotiate for a maximum of 1-2 years as the validity for discovery of a breach or misrepresentation or for a statutorily prescribed limitation period prescribed.

(c)        Tax representations and warranties: In light of the ambiguities surrounding tax implications associated with cross border mergers and acquisitions in India, the buyers seek for specific tax indemnities to survive for the period of limitation (normally being a period of 7 years).

Common representations and warranties, which are fundamental to the transaction itself, are often carved out from the aforementioned limitations, including those relating to ownership, incorporation and authority to enter into the definitive documents.

It is often seen during negotiations that sellers vehemently resist the idea of giving uncapped indemnities to the buyer and this generally leads to protracted discussion between the parties rationalizing the “why” and the “why not”, until better commercial sense prevails and parties decide to move on.

2.         Escrow / Holdback

Another safety net sought is a hold back of the purchase price in an escrow account. An escrow or a hold back is a mechanism by which a certain part of the purchase price is placed in an escrow account. The account is controlled and operated by a neutral escrow agent, for a period of time with instructions from both sellers and buyers under an escrow agreement, to secure payment on indemnification. Often, a process of tiered release of the escrowed funds over a period of 18-24 months is used. It effectively preempts settlement of disputes between the parties in a sale transaction, which could otherwise become a deal breaker.

In India, there are no regulatory restrictions on the creation of escrow accounts relating to transactions between two Indian parties and the consideration being in Indian rupees. In the event of any transaction involving a non-resident, the Reserve Bank of India (RBI) vide Circular RBI/2010-11 /498 A. P. (DIR Series) Circular No. 58 dated May 02, 2011 has permitted authorized banks (Category 1) to open and maintain escrow accounts keeping in mind the time lag between payment of purchase consideration and the receipt of the shares under the automatic route. However, certain conditions attached to such approval inter alia are (i) a maximum period of six months for maintaining the escrow and (ii) the amount kept under escrow must be interest free. The RBI however, requires parties to obtain its prior permission for creation of indemnity escrows, which commence from closing of the transaction and may extend for a period of 3-5 years thereafter.

3.         Bank Guarantee

Legal sanction to a guarantee is provided under section 126 of the Act which defines a contract of guarantee as a contract to perform the promise, or discharge the liability, of a third person in case of his default.

In definitive documents, bank guarantees are sometimes sought as a protection measure for the buyer in case of breach or misrepresentation of certain representation and warranties by the seller which affect the very basis of the assets or properties of the business being acquired. Bank guarantees may be sought by the buyer in lieu or in addition of an escrow or purchase price holdback.

More often than not, buyers seek an unconditional bank guarantee since the courts in India, through a catena of judgments [See Svenska Handelsbanken v. Indian Charge Chrome and Ors.;[6] National Highway Authority of India v. Ganga Developers and Anr.[7]] have resisted the idea of granting an injunction against invocation of an unconditional bank guarantee except in case of proven fraud, special equities or irretrievable injury (See Itek Corporation case[8]). A caveat may be placed that while obtaining of a bank guarantee in the case of a breach of a representation and warranty is rare, it is not unheard of.

4.         Representations and Warranties Insurance (RWI)

A useful but relatively untapped option protecting the interests of the buyer is the option of purchasing a RWI. It is still at a very nascent stage in the Indian market.

The concept of an RWI is like any other insurance providing coverage over contingent liabilities, arising out of breach or misrepresentations of representations and warranties. The major advantage is the safety net that the insurance provides for investments by the buyer in uncharted waters by reducing the dependence on indemnity clauses, escrows, the uncertain tax regime in India and also proceeding against multiple sellers with disproportionate indemnity liability, especially in a jurisdiction like India. RWI is also preferred in the event that the seller is an investment fund and the life of a fund is nearing an end.

In India, there are a few insurance brokers, for e.g. Optima Insurance Brokers and Marsh who procure underwriters to provide such RWI. Anecdotally, we understand that premiums for such RWI are in the range of Rs. 30-50 lakhs and consequently such RWIs would make commercial sense if the transaction value were in excess of Rs. 25 crores. While the brokerage charges are dependent on the premium that is charged, some companies charge in the range of 4-8% of the premium.

5.     Put Option

Put option is a remedy available at the hands of such option holder to sell certain specified number of shares or percentage of shares and requiring the obliging party to buy such shares at a predetermined price or based on some agreed formula provided for in the definitive document. This is applicable only in a stock purchase transaction. It must be understood that a put option is a severe consequence as it has the potential of reversing the entire transaction.

While specifically relating to a transaction involving a non-resident, put option must be structured having regard to the pricing guidelines issued by the RBI (A.P. (DIR Series) Circular No. 4 dated July 15, 2014) to ensure that when shares are transferred from:

(i)        a non-resident (seller) to Indian resident (buyer), the share price shall be not more than the fair market value worked out as per any internationally accepted pricing methodology for valuation.

(ii)       a resident (seller) to non-resident (buyer), the share price shall be less than the fair market value worked out as per any internationally accepted pricing methodology for valuation.


While these are a non-exhaustive list of commonly used industry practices adopted by a well advised buyer, the bargaining power and the resolve of the buyer across the negotiating table are the ultimate determinants of the clauses that finally see the light of day in the definitive documents. However, it is in the interest of the buyer that these clauses be agreed upon, at a macro level, at the stage of the term sheet, so as to avoid a sabotage of the deal at the very end, after time, effort and money have been expended by all parties. While an absolutely risk insulated position is the utopia for the buyer, the buyer must leverage business prudence vis-à-vis negotiating in hope for a comfortable position, in the interest of sealing the deal.

- Goda A. Raghavan & Kirthi Srinivas G

[1] Section 65 of the Act states that “When an agreement is discovered to be void, or when a contract becomes void, any person who has received any advantage under such agreement or contract is bound to restore it, or make compensation for it, to the person from whom he received it”.
[2] As defined under Section 17 of the Act.
[3] (Pa.) 3 Brewst 9
[4] (1997) 2 BCLC 249
[5] (2005) EWCA Civ 758
[6] AIR 1994 SC 626
[7] AIR 2003 SC 3823
[8] 566 Federal Suppl. 1210

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