Contract Representations as Risk Allocation
Let's say you're negotiating an asset purchase agreement (APA) for your purchase of a retail car repair business. One of the most important sections in the agreement is the representations section. Representations are statements of fact made by one contract party to induce the other party to enter into the transaction. In this case, the seller will be making a litany of representations to induce you to purchase the business.
In this example, let's say that because the seller hasn't owned the business for very long (having acquired it only a few years ago) he's reluctant to make unqualified or "flat" representations about the business. So he negotiates aggressively to add a knowledge qualifier or a materiality qualifier to most of the representations. You review his draft of APA, looking at all the qualifiers he's added, trying to figure out which ones you can live with and which ones you have to have "flat". In particular, you're flabbergasted that he inserted a knowledge qualifier to the representation that there are no environmental law violations with respect to the property. (You're not surprised either, given the potential devastating financial impact of an environmental law violation.)
During the ensuing negotiations, he explains that as much as he'd like to, he can't take the chance of making the environmental rep flat. He says that as a short-term owner, he's just not confident that there aren't any problems, and as a matter of principle, he can't make a flat representation that may very well turn out to be untrue.
You explain that you empathize with his situation and appreciate his honesty, but can't accept the knowledge qualifier because he'd be off the hook as long as he didn't know, and you'd be left holding the bag. You're not real thrilled with the materiality qualifier either because you want him (as the seller) to bear the entire risk of environmental problems. This risk shift or risk allocation is a central tenet of contract representations.
Sellers won't necessarily shoot down the risk allocation argument. You may find that the main reason for his refusal to make an unqualified representation is that he doesn't want to be liable for misrepresentation, including the stigma associated with a misrepresentation lawsuit. If that's the case, maybe there's another way to tackle this issue. More on that in my next column.
