Risk Pie, Anybody? How to Negotiate While Reducing Risk

Negotiation – the very essence of the word often conjures up the thought of adversarial trade-offs, however, when negotiating a purchase/sale agreement parties should turn away from opposing positions. A good negotiation takes a more integrative approach, resulting in a deal that satisfies all parties.

The pitfalls of a distributive negotiation often appear when assessing risk, and negotiating the representations and warranties of an agreement. Often, a vendor will simply seek to limit the number and scope of representations and warranties as much as possible, while a purchaser will seek to do the opposite. This tactic will see parties negotiating against each other in a zero-sum game in which they compete for the smallest slice of a fixed “risk pie”. There are, however, some qualifications that vendors and purchasers can use to shrink the overall size of the pie – limiting risk for both sides simultaneously.

Knowledge and belief
By qualifying a representation or warranty with language such as, “to the best of the vendor’s knowledge and belief”, parties can often arrive at an agreement. The vendor can be sure that they aren’t taking on risk stemming from an unknown factor, and the purchaser can be provided with enough comfort to satisfy themselves on the issue. A knowledge and belief qualification can be further fine-tuned to shrink the total amount of risk by taking the often overlooked extra steps to further define the qualification. For example, parties can consider a vendor’s obligation to investigate an issue, or specify the people whose knowledge is to be relied upon.

Immaterial Breaches and Upper Limits
Representations and warranties can be limited so that a breach exists only when the substance of the transaction is materially impacted. Parties can negotiate what constitutes a material breach, and except any breaches that do not meet this threshold. Vendors can, in turn, look to limit the amount that the purchaser can recover from a breach. By defining the scope of what can be recovered for a breach, both parties can find themselves comfortable with the amount of risk that they are taking on. This can shrink the total amount of risk exposure for all parties when these upper and lower limits are set in a way that insulates the purchaser from risk of a material breach, but also limits the exposure to the vendor by ruling out unlikely but significant, as well as likely but insignificant, breaches.

Representations and warranties will either merge on the closing of the transaction (limiting exposure to post-closing claims), or will survive. By explicitly specifying the length of time that a particular representation or warranty is to survive, both parties can find themselves happy with their risk exposure. A purchaser can limit their risk with respect to an issue, and a vendor can insulate themselves from claims arising long after closing. Such provisions can also be fine-tuned to provide comfort to the purchaser where the vendor provides security for their obligations (for example, placing a portion of the purchase price in escrow during some or all of the survival period).

With some creative negotiation and drafting, parties can minimize the likelihood of a breach, and its potential impact. All of a sudden an unpalatable representation or warranty can become acceptable to both parties, and a deal can move forward.

If you are looking for more information on some commonly used qualifications to representations or warranties, please feel free to contact us.

These comments are of a general nature and not intended to provide legal advice.

Robert Jackson
Goldman Sloan Nash & Haber LLP
Direct: 416 597 3398
Email: jackson@gsnh.com