By George M. Taylor, III – Burr & Forman
With basic acquisition agreements, the front end of the document is loaded with provisions that are of critical importance to the dealer. First and foremost are the pricing clauses, which set forth formulae for the purchase of new cars and demonstrators, the conducting of parts inventories, appraisal of fixed assets and that all-important blue-sky figure. There are also some important general provisions, such as the amount of the earnest money deposit, the timing for the transaction (closing deadlines) and due diligence deadlines.
Beyond that critical initial section, other sections of the agreement fall into a realm inhabited mostly by lawyers and accountants. Those customarily receive much less scrutiny from either side as the document is negotiated. However, these sections can be of critical importance if something goes wrong down the road.
The section I will focus on is the area containing seller’s representations and warranties. These provisions cover facts represented by the seller to the buyer on which the buyer is relying on when deciding to purchase the store. They cover a variety of issues, such as corporate authority, title, compliance with laws, manufacturer relationships, litigation, taxes and so on. The topics covered are not peculiar to car deals, but rather are used in asset purchase agreements for virtually every type of business.
What happens if the seller makes a representation that is untrue? If the transaction has not yet closed, the falsehood could be the basis for the buyer to terminate the deal. If the transaction has already closed, breach of a representation could be the basis for a claim by the buyer against the seller. Looked at in that light, representations deserve considerable attention, particularly from the seller side.
No buyer should expect a seller to make a representation that is false. The customary response to this issue is for the seller to attach various schedules to the agreement containing exceptions to the representations. There might, for example, be a schedule containing exceptions to the statement that there is no litigation, which provides an opportunity for the seller to list pending cases. There might be a schedule containing a listing of contracts that the seller is expecting the buyer to assume. Yet another schedule might list changes in circumstances not reflected in the financial statements.
Frequently, a seller will say something like: “I am not 100 percent certain that these statements are true. Why do I have to make these representations?” The curt response from the purchaser is that significant money is being paid for the store, therefore assurances are needed as to these various issues, and the seller is the person best suited to make those assurances.
The seller might respond: “But I don’t know if these are true or not!” It is at this point that seller’s counsel swoops in with a brilliant response to this dilemma: “Look, we’ll tell you everything we know, but we cannot guarantee that these representations are true.” This gives rise to the most overused qualifying phrase in any asset purchase agreement—”to seller’s knowledge.”
The idea from the seller’s perspective is to take as many representations as possible and limit them to the seller’s knowledge. The representation may end up being false, but if the seller did not know about the falsehood, there is no liability for breach. It seems eminently fair, right? How can you expect someone to make a representation about something not in his or her realm of knowledge?
There are two buyer responses, both of which carry much weight. The first one is procedural. If a representation is qualified “to the knowledge of seller,” any party alleging breach (usually the buyer) will bear the burden not only of proving the falsehood but also that the seller knew that it was false. Short of crawling into the seller’s mind, it is frequently impossible to meet this burden of proof, with the result that the value of the representation is lost.
The second point is equally valid. The buyer will ask not whether it is fair for the seller to be responsible for something outside his or her knowledge, but who ought to bear the risk of the representation being false. If seller has consistently violated some law, the breach of which will devalue the business being acquired in the hands of the buyer, does it matter whether the seller knew of the breach?
The breach and the damage resulting from the breach is what matters, not whether the seller knew about it. Under this line of reasoning, it matters not whether the seller knows or not, the question is who ought to bear the economic risk of the representation being false. The buyer can persuasively argue that good money is being paid for the dealership, and the risk of a representation being false ought to fall on the seller, whether he knew of the breach or not.
This line of analysis, which is termed “benefit of the bargain” argument by scholars, has been the subject of much debate in the world of mergers and acquisitions beyond the buying and selling of dealerships. There are multiple cases on the issue of “sandbagging”, which considers the extent to which a buyer ought to be able to close with a representation in place and then sue based on something it already knew at the time of closing. Roughly half of the U.S. jurisdictions have held that the buyer is paying for the representations and it matters not whether the seller knew of a breach at the time of closing. He can still sue based on the misrepresentation.
This column is not directed at resolving the “to seller’s knowledge” issue in favor of buyer or seller, but merely at highlighting an argument that has become routine in negotiating asset purchase agreements and of which both buyers and sellers should be cognizant. Sellers who can persuade buyers of the fairness of knowledge qualifiers have done a good day’s work by making it difficult for a buyer to recover for breach. Buyers who stick to their guns and require the seller to guarantee the truth of representations irrespective of the seller’s knowledge have managed to obtain for themselves the benefit of the bargain that they likely priced into the deal at the outset.
George M. Taylor is the chair of Burr & Forman’s Corporate Section, which consists of the Corporate and Tax Practice Group, the Banking and Real Estate Practice Group, and the Creditors’ Rights and Bankruptcy Practice Group, encompassing lawyers from the entire five-state footprint of the firm. He can be reached at (205) 458-5254 or firstname.lastname@example.org.