Key Strategies Concerning Representations and Warranties in Commercial Real Estate Purchase Agreements
Representations and warranties are often the most heavily negotiated section of commercial real estate purchase agreements because of the parties’ competing objectives. Sellers typically seek to limit the nature and scope of any representations as much as possible, preferring that the buyer rely on its own investigation. The buyer’s objective, on the other hand, is to require seller to be forthright and exhaustive in its disclosures about the condition of the property and a myriad of other issues. A number of factors can influence the extent to which a seller provides or does not provide detailed representations, including the discounting or premium pricing of the property being sold, the length of the due diligence period, buyer’s pre-existing familiarity with the property, competition in the marketplace, and the like.
The following strategies should be considered when negotiating the representation and warranty section of a commercial real estate purchase agreement:
THE AS-IS CLAUSE
A typical AS-IS, WHERE-IS clause provides that, except for representations that are expressly set forth in the representation and warranty section of the purchase agreement, buyer is relying solely on its own investigation as to all matters concerning the property. Note that an AS-IS clause is not a license to commit fraud. If a seller is aware of facts concerning the property that materially and adversely affect the value or desirability of the property, and those facts are not known to or readily ascertainable by the buyer, then the AS-IS clause will typically be insufficient to protect the seller. The best practice is for seller to make accurate and fair disclosures, with appropriate qualifiers (discussed below), and to provide that any other matters are subject to the AS-IS clause and buyer’s own due diligence.
DURATION OF REPRESENTATION
The representation section will typically provide that representations are true and correct as of the execution date and as of the closing date. But what about after closing? The parties to the purchase agreement generally need to identify how long, if at all, the representations survive after the Closing. The reason is that the “merger doctrine” provides that all discussions, negotiations and agreements, including the purchase agreement, are “merged” into the deed at the time of recording. Unless there is a writing to the contrary, the only obligations that survive closing (other than common law claims) are those set forth in the deed. In the typical agreement, representations, confidentiality covenants and indemnifications provisions will expressly provide for a designated survival period – typically between six months and two years (the longer period favoring the buyer). This allows a reasonable time for the buyer to discover any breaches, but also allows the seller to have some certainty as to the duration of its exposure.
BASKET AND CAP
Although more common in corporate transactions, the parties to a real estate transaction can establish a floor (also known as a “basket”) and a ceiling or cap on liabilities relating to breaches of representations concerning the property. The basket keeps a buyer from nickel-and-diming the seller with petty complaints after the closing, and the cap helps a seller manage its maximum exposure. Claims of fraud would not be subject to the cap. In the normal provision, once the basket is exceeded, the seller has exposure from dollar one.
KNOWLEDGE AND MATERIALITY QUALIFIERS
Buyers want to have clean, unqualified representations, but in some cases a seller needs to be able to limit the representation to matters that it knows about (e.g., threatened litigation). A seller will want to limit some of its representations “to seller’s actual knowledge.” Black’s Law Dictionary defines actual knowledge as “direct and clear knowledge, as distinguished from constructive knowledge.” Black’s Law Dictionary, 10th Ed. (2014). Sellers may further limit the knowledge qualifier with the following statement: “As used herein, “actual knowledge” means the knowledge of [insert individual name(s)], without duty of investigation.” By limiting the qualifier to a specific individual, seller can avoid the imputation of knowledge from any number of employees or agents of the seller if the representation is ever scrutinized. Sellers may also seek to modify their representations with materiality qualifiers, but in order to avoid post-closing disputes, the parties will often insist on a clear definition of what is “material” or what constitutes a “material adverse effect.”
DEEP POCKETS AND HOLDBACKS
Sellers of real estate are often single purpose entities which means that, upon sale and distribution of sale proceeds, the seller may have insufficient assets to cover any post-closing claims for breach of representations or indemnity claims. Some possible solutions to this problem include (a) requiring one or more of the principals of seller to provide a personal guaranty to cover such losses, typically subject to a cap, or (b) holding back a portion of the sale proceeds in escrow for some or all of the duration of the representation period. Holdbacks can also be effective to address a specific, quantifiable, open item that is to be accomplished post-closing. Often 150% of the estimated amount will be held in escrow pending completion of the item. Finally, representation and warranty insurance has become increasingly popular for both buyers and sellers in M&A transactions, and in larger portfolio sales of commercial real estate, usually for a fee of around 3% of the coverage amount, subject to a host of factors, exceptions and conditions.
NARROWING OF SCOPE
The scope of the representations in a purchase agreement can vary widely as a result of the negotiations between the parties. Each representation should be thoughtfully analyzed and, from a seller’s perspective, narrowed as much as possible. This can sometimes be accomplished by referencing specific documents (e.g., a specific environmental report), and disclaiming any knowledge beyond the matters set forth in the referenced document, and/or by incorporating schedules that set forth exceptions to the applicable representation being made (e.g., a list of consents that may be required in order to sell).
WHEN BUYER LEARNS OF DEFECTIVE REPRESENTATIONS BEFORE CLOSING
There are times when a buyer becomes aware of an issue before closing, nevertheless proceeds to close, and then sues for breach post-closing. To combat this risk, sellers will sometimes seek to include a provision that says, in effect, that if buyer learns that a seller representation might be untrue prior to the Closing, and buyer elects to purchase the property anyway, then buyer waives any right that it may have to bring an action or proceeding against seller regarding that representation. Buyers argue that a breach is a breach, and seller should not be able to avoid liability based on an argument that buyer knew or should have known that buyer’s representation was untrue. Most agreements remain silent on the issue, but a buyer should be aware that a decision to close will likely be viewed as a waiver of any issues that buyer was aware of on the closing date.
The foregoing are some general strategies for dealing with representations and warranties in commercial real estate purchase and sale agreements. Additional considerations should be explored in dealing with the individual representations and warranties found in the typical agreement. The attorneys at Lagerlof LLP are experienced and equipped to assist buyers and sellers in achieving their objectives in the purchase and sale of commercial real estate.
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