Allocating Risk in Real Estate Sales: Representations and Warranties

Although a majority of buyers in real estate transactions rely on their own inspections of property, most real estate purchase and sale agreements contain some seller representations and warranties regarding key factual matters that the buyer cannot independently verify. These representations and warranties serve as closing conditions as well as a basis for post-closing indemnification. Given these critical functions, the scope of these representations and warranties — and the allocation of associated risk between buyer and seller — are often heavily negotiated. This article outlines the current “market” position on a few of these deal points.

Scope of Representations and Warranties

Entity Representations: Typically, each party will give the other representations and warranties as to its organization (validly existing and in good standing) and as to the fact that each has obtained all necessary consents to enter into the purchase and sale agreement. Each party usually gives representations that it is not a party with whom it is illegal to transact business under anti-money laundering or anti-terrorism laws. Sellers are usually asked to represent that there is no litigation that could affect their ability to consummate the transaction and that there are no bankruptcy proceedings pending against them.

Property-Specific Representations: Additional representations are often requested by buyers and vary depending on the nature of the property being purchased (improved, vacant, industrial, office, residential, hospitality) and the availability of relevant due diligence materials. The most common representations and warranties involve: (i) compliance with laws, including environmental laws; (ii) the completeness of seller deliveries such as leases, service contracts, tax bills, and warranties; and (iii) the non-existence of any liens, litigation affecting the property (pending or threatened), pre-emptive rights (option or right of first refusal), or violations of recorded agreements. Sometimes, sellers also make representations regarding revenue and costs associated with the property, such as certifying financial statements and rent rolls. For some assets, representations are made regarding key agreements (such as a hotel management agreement) or to address employee concerns.

Qualifiers: Representations are often qualified as being to the actual knowledge (as opposed to constructive or imputed knowledge) of a specified individual or group of individuals, either with or without a duty to investigate by making reasonable inquiry of those who would have relevant materials or knowledge. Knowledge qualifiers make it harder for buyers to succeed in claims for breach of warranties, as the buyers need to demonstrate that the sellers in fact had knowledge that the representation was false. Sometimes representations are also qualified to the extent matters are disclosed in due diligence materials (such as a Phase I environmental site assessment report). Sellers often seek to limit breach of warranties to “material” matters, though such limitation can be the source of post-closing disputes if the definition of “material” is not clear (such as exceeding a certain monetary threshold on an individual or aggregate basis).

Survival Period

Buyers will always want to specify that sellers’ representations and warranties “survive” the closing and delivery of the deed. If the agreement is silent regarding survival, then the representations are deemed “merged” into the deed and limited to only those representations and warranties contained in the deed itself (if any). Survival is not typically a contentious issue, but some initial draft purchase and sale agreements are silent as to survival.

Typically, the buyer and the seller contract as to the duration of the post-closing period in which the buyer may bring claims for breaches or misrepresentations (usually limiting claims to those brought within a period of 6-12 months). Buyers want to have enough time to discover any misrepresentations and bring related claims while sellers want to limit their post-closing liabilities to as brief a period as feasible.

Limitations on Damages

Some agreements include a liability “basket,” specifying a minimum threshold for recovery (or floor) and capping liability at a specified maximum recovery amount (or ceiling). The floor is often $5,000 to $50,000. The floor protects the seller from “petty” claims post-closing, though usually the seller has exposure from the first dollar once the floor is exceeded. The ceiling sets a maximum exposure for the seller, usually subject to a carve-out for fraud. Ceilings are often between 1 percent and 5 percent of the purchase price, depending in part on the size of the purchase price. Sometimes, post-closing reconciliations are also expressly excluded from any ceiling. In addition, most agreements provide that the buyer cannot have actual knowledge of the breach prior to closing.

Security for Post-Closing Obligations

Sellers of commercial real estate are often single-purpose entities, with the sale property and associated revenues being their only assets. To avoid a scenario where such a seller has insufficient remaining assets to cover the buyer’s claims, buyers often require sellers to provide security for post-closing indemnity obligations. Such security can take many forms. For example, a portion of the sale proceeds could be held in escrow (typically with the title company) for the survival period. This approach is advantageous to buyers but ties up funds that could otherwise be distributed to sellers’ investors and requires negotiation of an escrow agreement and, sometimes, payment of an escrow fee. Alternatively, a seller’s parent entity or a principal of the seller could provide a guaranty, which has the advantage to the seller of not setting aside funds in advance. However, buyers should be aware that guaranties are only as good as the guarantors who make them and are more complex to enforce than a holdback. Some buyers are satisfied with a seller covenant to maintain sufficient net worth during the survival period, but this approach offers less protection to buyers than a holdback or guaranty. Unlike in corporate transactions, representation and warranty insurance policies are not usually obtained for commercial real estate transactions (though this practice is growing for portfolio deals).

Conclusion

This article outlined a few typical positions taken with respect to allocation of risk for misrepresentation and breach of warranties. However, the outcome in a particular negotiation will often vary if there are differences in pricing (discount or premium) or if the buyer has extensive knowledge of the property or expansive due diligence opportunities.

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