Should Directors or Shareholders be Responsible for Representations & Warranties in a Share Purchase Agreement?

Authors: Andrew J. Zammit & Jacob Crossey

In any Share Purchase Agreement (SPA), Representations and Warranties play a crucial role in allocating risk between the buyer and the seller. They serve as assurances about the state of the company being acquired, highlighting known risks and providing the buyer with a degree of certainty and confidence in the transaction.

Within this context, a key question arises:

‘Who should provide these Representations and warranties; the Directors of the Company or its Shareholders?’

On the one hand, the directors bear the responsibility for running the company’s business affairs and possess an in-depth understanding of its financial position, operating intricacies, risks and liabilities. On the other hand, it is typically the shareholders who stand to derive financial benefit from the sale of their interest in the company. In smaller companies where the shareholders and directors are the same individuals, this distinction is largely inconsequential. However, when the identities and interests of these parties diverge, the matter becomes more nuanced and necessitates careful consideration.

This article provides a concise examination of the legal and practical implications of representations and warranties granted to the buyers in SPAs governing the transfer of ownership of shares in private limited liability companies. It analyses the distinct roles and responsibilities of directors and shareholders, drawing comparisons and contrasts between them while identifying potential risks, and outlining corresponding risk mitigation strategies. In doing so, particular reference is made to the principles of Maltese company law, particularly the Companies Act (Chapter 386 of the Laws of Malta).

It is important to emphasise from the outset that the legal, commercial and practical considerations relating to larger companies, particularly public limited liability companies (whether listed of not) having a larger number of shareholders, would be significantly different to those outlined in this analysis.

Understanding Representations & Warranties in SPAs

Representations and warranties are contractual statements made by the seller/s[1] in respect of, inter alia, the target company[2]’s financial position, legal standing, assets, liabilities, regulatory standing (where applicable), relationships with counter-parties, and overall compliance with laws applicable to its business. The primary functions of such representations and warranties include:

(i) Accountability:

Ensuring the buyer receives accurate and reliable information in good faith, thereby establishing a basis for legal recourse in the event of misrepresentation or, in extreme circumstances, fraud.

(ii) Due Diligence Support:

Confirming the accuracy of information provided during negotiations and the disclosure of sensitive company information to the buyer, as a basis for their offer.

(iii) Indemnification:

Establishing liability in the event that the statements in the representations and warranties provided are found to be false.

In an SPA, these statements typically cover:

• Ownership of shares and authority to sell;
• Third party rights over the shares (share options, security rights, contractual undertakings restricting the transfer of shares etc.), particularly those that are not ascertainable from the pubic domain;
• Financial statements and undisclosed liabilities;
• Compliance with applicable laws and regulations;
• Potential claims and/or disputes;
• Regulatory considerations (where applicable);
• Tax compliance matters;
• Intellectual property rights and contracts.

Whilst the necessity of these fundamental assurances is evident to any party contracting in good faith, the critical question remains “who should be responsible for giving and standing behind these representations and warranties?” It would be illogical for the target company itself, as a separate legal entity, to assume this role, as such an arrangement would render any remedial action by the buyers effectively meaningless. In the event of a breach, pursuing legal action against the very entity they have acquired would be futile.

This therefore leaves the target company’s directors or its shareholders as the parties who would be expected to stand behind the representations and warranties upon which the buyer relies in the course of acquiring the target. The determination of which party will ultimately provide such assurances in any given transaction will largely depend on the commercial dynamics at play in each specific deal. The following section will examine key considerations in this regard.

Role of Directors in Representations & Warranties

Directors are responsible for managing the company’s affairs and ensuring compliance with laws. While they perform a fiduciary function and are subject to specific fiduciary obligations, their role in providing representations and warranties in a SPA is typically limited, unless:

1. They are also acting as Sellers: If directors hold shares in the company and are selling them, they may be required to provide representations and warranties as shareholders.
2. They sign the SPA in a Personal Capacity: In exceptional circumstances, directors may be asked to provide additional assurances regarding the company’s affairs, particularly if the buyer has concerns about the accuracy of information.
3. They Provide Management Warranties: Buyers may request that key directors (such as the CEO or CFO) provide specific warranties on operational and financial matters.

Risks for Directors

Directors generally seek to avoid giving personal representations and warranties unless contractually obligated to do so. The key risks for the directors in such circumstances include the following:

• Personal liability:

If a director provides warranties in a personal capacity which are subsequently found to be false, the director may be held personally liable for damages.

• Breach of fiduciary duties:

Pursuant to Article 136A of the Companies Act, directors are required to act in the best interests of the company and its shareholders. In certain circumstances, a director providing representations and warranties to a prospective buyer may give rise to, or be construed as giving rise to, a conflict of interest.

• Limited knowledge of past events:

Directors (especially new ones) may not have been involved in historical decisions and may not have full knowledge of past liabilities.

Mitigation Strategies for Directors

In order to mitigate these risks, directors could:

• Avoid signing the SPA in a personal capacity unless they are also shareholders of the company.
• Ensure that relevant representations and warranties are given by the selling shareholders.
• If they are providing specific management warranties, the language should be carefully drafted to limit them to specific areas within their knowledge and control.
• Obtain warranty and indemnity (W&I) insurance cover to protect them from any claim based on the breach of any such representations and warranties.

Role of Shareholders in Representations & Warranties

Shareholders are typically the primary parties responsible for representations and warranties in an SPA, as they are the ones selling their shares and receiving the proceeds from such sale. As such, they are the stakeholders who stand to benefit the most from the transaction. The representations and warranties typically given by shareholders include:

1. Ownership of Shares: Confirming they have the unfettered right to sell and transfer their shares.
2. No Encumbrances: Ensuring the shares are free from right or claims in favour of third parties.
3. Corporate Compliance: Assuring the buyers that the company has complied with legal and regulatory requirements, including obtaining and maintaining any necessary approvals for regulated businesses.
4. Financial Statements and Tax Matters: Providing assurances on financial disclosures, and compliance with tax, VAT, social security and other fiscal obligations.

Risks for Shareholders

While Shareholders bear the primary responsibility of providing representations and warranties, they also face significant risks:

• Financial Exposure:

If a warranty is found to be false, shareholders may be held liable for indemnification claims, exposing them to complex and lengthy litigation proceedings.

• Incomplete Information:

The shareholders may not be privy to certain information to be able to provide the assurances requested by the buyer.

• Joint and Several Liability:

Pursuant to Article 1124 of the Maltese Civil Code (Chapter 16 of the laws of Malta) and Article 115 of the Commercial Code (Chapter 16 of the laws of Malta), multiple shareholders may be held jointly and severally liable, where one shareholder could be pursued for the entire claim, subject to his right to seek recourse against the other shareholders.

• Post-Completion Liabilities:

Shareholders typically remain exposed to representation and warranty breaches for a defined period after the completion of the transaction.

Risk Mitigation Strategies for Shareholders

To minimise their exposure to potential liability arising from representations and warranties in an SPA, shareholders may adopt the following strategies:

• Negotiate liability caps to limit their financial exposure.
• Negotiate the inclusion of “knowledge qualifiers” to ensure that liability arises only in circumstances where the shareholder had actual knowledge or could not reasonably have been unaware of a particular issue or risk.
• Include time limitations on warranty claims.
• Obtain warranty and indemnity (W&I) insurance cover to protect them from any claim based on the invocation of such representations and warranties.

Key Considerations in SPA Negotiations

When drafting an SPA, buyers and sellers must carefully consider which party will provide respective representations and warranties. Important factors include:

• Nature of the Transaction:

In a share sale, warranties are typically provided by the shareholders. In an asset sale, however, the company itself, as vendor, is generally responsible as the counterparty to the transaction.

• Regulatory Approvals:

For companies in regulated industries (e.g. financial services, telecommunications, gambling), regulatory approval may be required before a change in ownership and control. This should be structured as a condition precedent rather than a representation on the part of the seller/s.

• Management’s Involvement:

If key directors remain within the target company post-sale, buyers may seek to have them provide certain operational warranties, potentially linking such obligations to any earn-out arrangements or incentive-based remuneration incorporated into the deal structure.

• Extent of Due Diligence:

The buyer may be willing to accept limited warranties upon conducting enhanced due diligence. It is in the shareholders’ interest that all relevant company information is disclosed to the buyer (subject to the appropriate confidentiality and non-circumvention measures) during the due diligence stage to limit the nature and extent of the warranties.

• Negotiation Leverage:

As in every deal, the stronger party in negotiations typically pushes for more favourable terms in respect of the warranties.

Conclusion

In a share purchase agreement governed by Maltese law, the allocation of representations and warranties is a critical issue that can materially impact both the directors and shareholders of the target company. While Shareholders typically bear the responsibility for such warranties, directors should be cautious about giving personal warranties, unless they are also shareholders.

To protect themselves, directors and shareholders should carefully negotiate warranty provisions, seek legal advice, and consider insurance, liability caps, and strict compliance with Maltese legal formalities to mitigate risks. Addressing these nuances with the necessary professional support ensures that all parties enter into the transaction with clear expectations and minimised risks under Maltese law.

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[1] Seller/s in the context of an SPA are the individuals or entities that are selling their shares in the target company to the buyer.

[2] A target company is the company that is being acquired in a merger, acquisition, or share purchase transaction.