Representations and warranties are critical clauses in a loan agreement as they provide the lender with actionable statements of current or future facts, covering items such as the borrower's financial status and its legal standing, its compliance with laws, ownership of its assets and the quality of information it has provided.
Negotiating the scope and content of these statements is part of the lender’s pre-contractual due diligence process, flushing out information which the lender uses to assess the risk of lending and determine loan pricing. Repeating key representations and warranties at regular points throughout the term of the loan ensures that the borrower meets the required standards (or bears the risk of not doing so). The repeating representations therefore sit alongside and complement the undertakings.
The loan agreement will usually set out the consequences of a false representation or breach of warranty - usually both will constitute an event of default (see: A-Z of banking and finance: E is for Events of Default). The occurrence of an event of default, after the expiry of an applicable grace period, entitles the lender to take various actions, such as placing the loan on demand (enabling the lender to demand repayment at any time), accelerating the loan (demanding immediate repayment of the outstanding balance), and enforcing security interests, as well as acting as a drawstop on the making of further advances.
Negotiating the scope
The Loan Market Association (LMA) standard documentation provides a starting point for the drafting of representation and warranty clauses, but – as the LMA emphasises – it is merely the starting point. The drafting must be tailored and negotiated for the facts of each deal, reflecting the specific nature of the borrower, the industry in which it operates, the lender’s individual requirements and allocating risk for items identified through the due diligence process. The process of negotiation and customisation aims to ensure that the clauses are appropriate for the borrower's particular circumstances and the transaction's specific risks, providing a framework that balances both parties' interests while protecting the lender's position.
Lenders want to ensure that representations are sufficiently broad as to as to flush out information, repeated sufficiently often as to refresh due diligence and, as appropriate, provide a drawstop and constitute an event of default. Borrowers will seek to limit the number of representations and dilute the scope of the remainder, including through the use of qualifiers, by limiting the number of representations which are repeated, and by ensuring that representation and warranty packages are consistent across the loan, any guarantees and any security documents. Borrowers want to ensure they have the flexibility to run the underlying business without undue lender scrutiny.
Knowledge qualifiers
A borrower may seek to soften a representation by including a materiality qualifier (limiting breaches to significant issues), de minimis thresholds (ignoring trivial inaccuracies), or a knowledge qualifiers (restricting warranties to the borrower’s actual knowledge). A knowledge qualifier is a statement or provision that limits the obligations or warranties of a party by reference to its knowledge. For example, the phrase, “so far as the borrower is aware” may be used to qualify knowledge in respect of warranties. A knowledge qualifier acts as a safeguard, aiming to ensure that the borrower is not accountable for information beyond its awareness at the time of the transaction.
Lenders, however, often resist such qualifiers. A lender seeks certainty of drafting and will prefer that an objective standard applies or, if a subjective test applies, that it is the lender’s opinion (rather than the borrower’s) which triggers the test.
Knowledge qualifiers are not a “get out of jail free” card
Whilst better than an unqualified representation, care must still be taken when using knowledge qualifiers in representations and warranties as they inherently imply a certain level of due diligence by the borrower. Case law (primarily in property purchases and share purchase agreements) has established that a representation qualified by "to the best of my knowledge" suggests the representation-maker has undertaken a reasonable investigation. It also might be imputed with the knowledge of relevant documents in its possession. Courts have interpreted this to mean that the borrower must have actively sought to verify the accuracy of the statements made: simply relying on personal or subjective knowledge without proper inquiry may not suffice. For example, the seller in a property transaction would be expected to examine title deeds and other available records before making any representations.
Key takeaway
It is in both parties’ interest that the scope of representations and warranties, and any knowledge qualifiers, are appropriate to the deal in question. Considering the scope of representations and accompanying knowledge qualifiers at an early stage facilitates an appropriate due diligence process, allows time for clauses to be tailored and gives the borrower an opportunity to undertake the appropriate investigations necessary to support knowledge qualifiers. To implement such qualifiers without undertaking the necessary due diligence leaves a borrower exposed to the consequences of default.
Andrew Dodds
Himal Bulathsinhala