Guide to Negotiating Reps and Warranties in Commercial Real Estate Contracts
One of the most important terms in any commercial real estate transaction is the set of representations and warranties, or "reps and warranties," included in the contract as they serve as a primary means of allocating risk between the parties. Reps and warranties provide important information to the buyer and also provide protections for both parties that can be critical in resolving disputes that arise before or after closing. In this article, we'll take a closer look at the typical types of reps and warranties in commercial real estate contracts, as well as some of the key negotiation points and best practices for successful negotiation.
What are Reps and Warranties?
Reps and warranties are statements of fact made by the seller to the buyer in a commercial real estate transaction that confirm specific details about the property. The “representations” provide assurances to the buyer to purchase the asset, while the “warranties” provide protection after the closing should any of the representations prove false. Reps and warranties can cover a wide range of topics, including the property’s ownership, condition, and financial performance.
Why are They Important?
The purpose of reps and warranties broadly is to (i) provide the buyer with information about the condition of the property that would often be difficult to ascertain through due diligence, and (ii) allocate risks between the parties. Keeping these concepts in mind is instructive in understanding how reps and warranties are negotiated. A buyer may insist a seller provide a rep that it has not received any notices of legal violations on the property because it may not be able to discover such violations absent disclosure by the seller. The seller, on the other hand, will want to be careful to ensure the reps are only broad enough to cover the limited information sought by the buyer. For example, a rep regarding violations of law may be limited to “Seller has not received written notice of any violations of law affecting the Property.” The seller is not saying there are no violations, just that they have no notice of violations that they are hiding from the buyer. By making certain statements about the property, the seller is taking on a level of risk that the statements are true. From an allocation of risk perspective, the seller is best suited to take on this risk, because it should be able to determine if it ever received notice of a violation. For unknown violations, the buyer is assuming the risk of issues with an “as-is” sale and is best suited to assess this risk by doing its own due diligence.
As a practical matter, reps and warranties are also important in that they convey specific rights to the buyer should the reps and warranties be untrue. If discovered prior to closing, the buyer can terminate the agreement and receive a refund of its deposit and potentially also damages depending on the reason for the failure of the representation. If the buyer discovers that any of the reps and warranties are false after closing, it may be able to seek remedies such as rescission of the contract, damages, or indemnification.
Types of Reps and Warranties
Reps and warranties can be broadly classified into several categories, including:
General Reps and Warranties:
These are broad statements of fact that cover a range of topics related to the property. They typically include statements about the seller's authority to sell the property, facts about the property, such as its zoning designation, and the property's compliance with applicable laws and regulations.Title Reps and Warranties:
These are specific statements about the title to the property. They typically include statements about the validity and enforceability of the seller's ownership of the property, the absence of other claims to the property, and the status of any liens or encumbrances.Environmental Reps and Warranties:
These are statements about the environmental condition of the property. They typically include statements about the absence of known environmental hazards, compliance with applicable environmental laws and regulations, and any known environmental liabilities associated with the property. Given the ongoing potential liability for environmental conditions, these provisions can often be a sticking point in the negotiations.Financial Reps and Warranties:
These are statements about the financial condition and performance of a property. They may include certification of rent rolls, operating expenses, and any outstanding debts or liabilities. They may also include reps about the number and status of leases and other contracts affecting the property, as well as specific details about such contracts, such as the absence of tenant lease defaults or obligations to pay tenant improvement allowances.Other Types of Reps and Warranties:
Depending on the specifics of the transaction, there may be other types of reps and warranties that are included in the contract. For example, if the property is subject to an ownership association, there may be reps and warranties related to compliance with any such association agreements affecting the property.
Key Negotiation Points
Negotiating reps and warranties in a commercial real estate contract can be complex and time-consuming. Here are some key negotiation points to keep in mind:
Materiality Qualifiers:
These qualifiers typically limit the liability of the seller by limiting its scope. For example, a seller may look to qualify a rep regarding violations of laws to say it is not aware of any “material” violations of laws. The idea here is that a minor violation that has little risk or cost cannot be used by the buyer as a pretense to terminate the deal. It is important to be as specific as possible when defining materiality qualifiers, such as by assigning a dollar amount to what is considered material, to avoid disputes down the road.Scope of Reps and Warranties:
The scope of the reps and warranties is a critical point of negotiation. The buyer will typically want a broad set of reps and warranties that cover all aspects of the property, while the seller may want to limit the scope to specific issues or areas of concern. As noted above, a seller may want to limit the scope of a rep to not having received a “notice of a violation” as opposed to broadly stating there are no violations. Finding a middle ground that provides adequate protection for the buyer while being reasonable for the seller is key, and again, keeping in mind which party is best suited to identify and mitigate such risk is a helpful approach to arriving at this balance.Survival Period:
Another key point of negotiation is the time limitations on reps and warranties, otherwise referred to as the survival period. The survival period is essentially how long the seller’s warranty is effective, such that the buyer can no longer make claims against the seller for breach of a representation after the expiration of the survival period. The buyer will typically want a long period of time, often several years, to discover and bring claims related to any false reps and warranties. The seller, on the other hand, will want to limit the time period to a much shorter period, often six months or a year. Finding a time period that is reasonable for both parties is critical.Indemnification:
Reps and warranties are often coupled with indemnification provisions, which specify how the parties will handle claims related to false reps and warranties after the closing. The buyer will typically want broad indemnification provisions that require the seller to pay for any damages resulting from a breach of the reps and warranties, while the seller may want to limit the indemnification such that there is both (i) a minimum amount of damages before a claim can be made, and (ii) a cap on the total damages that can be claimed.
Best Practices and Strategies for a Successful Negotiation
Negotiating reps and warranties in a commercial real estate contract can be challenging, but there are several best practices that can help ensure a successful outcome:
Understand the Other Party:
It's important to approach negotiations with a willingness to understand the other party's position and concerns, as well as your own. Institutional sellers, for example, may be driven by reporting requirements or timing issues that drive negotiations, and understanding those sensitivities can help reach a creative solution that satisfies buyer and seller.Be Prepared:
Before entering into negotiations, make sure you have a thorough understanding of the property (to the extent possible prior to formal due diligence) and any potential issues that may arise. This will help you make informed decisions and negotiate effectively by identifying potential problems early on and allocating responsibility for those risks accordingly in the purchase and sale agreement.Focus on the Big Picture:
It's important to keep the overall goals of the transaction in mind and not get bogged down in minor details. Keep in mind that reps and warranties are just one aspect of the contract, and not all transactions warrant extensive reps and warranties. If you plan to demo a building for a new project, fighting for reps about the current condition of the building may not make a ton of sense. Being practical is often far more effective than looking to win every point.Seek Legal Advice:
Negotiating reps and warranties can be complex and may require legal expertise. Consider working with an experienced real estate attorney who can help you navigate the negotiation process and provide guidance on where buyers and sellers typically end up on specific reps and warranties and related remedies.Be Flexible:
Negotiations often involve compromise and give-and-take. Be open to creative solutions and be willing to adjust your position as needed to reach a mutually beneficial outcome.
Conclusion
Negotiating reps and warranties is a critical aspect of any commercial real estate transaction. By understanding the different types of reps and warranties that may be included, the key negotiation points, and best practices for successful negotiation, you can help ensure that the final contract provides adequate protection for both parties and sets the stage for a successful transaction. Remember to approach negotiations with a willingness to understand the other party's position, be prepared, and seek legal advice if needed.
