In negotiating agreements for the purchase and sale of real estate, and in merger and acquisition (“M&A”) agreements, much time is spent negotiating the representation and warranties sections of the agreements. What is to be made of an agreement’s focus on the survival of such negotiated representations and warranties? Survival provisions are commonplace enough in both agreements for the purchase and sale of real estate and in M&A agreements. It turns out that there are good reasons for survival provisions in both, but the reasons derive from different sources.
Under Texas law, an agreement for the purchase and sale of real estate contemplates a Closing (“Closing” will be used herein to denote the consummation of the transaction contemplated by a purchase and sale agreement). Under the common law “merger doctrine,” the proposition is that the purchase and sale agreement (and, correspondingly, all covenants, representations, and warranties contained therein) are merged into the deed upon Closing. This means the “deal” between the seller and the purchaser concerning the purchase and sale of the subject matter is expressed exclusively by the terms and provisions found in the deed – i.e., the terms and provisions of the purchase and sale agreement, including the representations and warranties, have been “merged” into the deed. Is this doctrine hard and fast? It appears not. In Texas, the doctrine can be overcome on equitable grounds – in other words, if fraud, duress, or undue influence are present, all bets are off. Moreover, if the purchase and sale agreement contains collateral agreements of the parties which are agreed to be performed post-Closing, and which have nothing to do with the conveyance, those too escape the application of the “merger doctrine.” Additionally, case law in other jurisdictions seems to be trending away from the “merger doctrine” reasoning that it is a hidebound rule of the common law, and that modern law compels the more intuitive approach such that if the contract provision in question has nothing to do with title, possession, quantity, or emblements of the real property, then that provision will survive the execution and delivery of the deed (for a more detailed treatment of the foregoing principles, see Thomas W. Whelan, Enforceability of Purchase and Sale Agreements, State Bar of Texas 43rd Annual Advanced Real Estate Law Course Ch. 3 (2021)). Nevertheless, there is enough residual fear of the “merger doctrine” that a prudent practitioner will hedge by baking a survival clause into a real estate purchase and sale agreement.
Other than the fear of the extinction of the seller’s representations and warranties concerning the subject matter of such a purchase and sale agreement, there are more logical reasons to include a survival clause (which is usually coupled with a corresponding seller’s indemnity provision) into a purchase and sale agreement. The function of the representations and warranties section of a purchase and sale agreement is: (i) to provide an opportunity for the seller to disclose relevant information about the property being sold; (ii) to allocate the risk concerning some flaw which is unknown to both parties at the time of contracting; (iii) to afford the buyer the opportunity to pull the plug on the purchase and sale if the buyer discovers, during the inspection period and prior to Closing, that the seller has breached one of the representations or warranties; and (iv) when coupled with survival and indemnity provisions, to provide the buyer with a remedy for the breach of a representation or warranty which the buyer discovers after Closing. The indemnity provisions are used to put post-Closing teeth into the representations and warranties by providing the buyer with the seller’s indemnity, and in most instances, to cap the seller’s liability by limiting the buyer’s remedy to a specified amount. The survival concept is that a defect might not “rear its head” until after Closing, and the survival of a representation or warranty respecting a certain aspect of the purchased property gives the buyer additional time to operate the property on a day-to-day basis, and thus, put the buyer in a better position to determine if there are defects which were impracticable to discover during the limited time of a pre-Closing inspection period. As previously mentioned, the indemnity provisions usually provide that the buyer’s exclusive remedy for a post-Closing breach will be the seller’s indemnity; and, that when the “survival period” ends, the seller’s liability with respect to the purchase and sale will likewise terminate (but more on this later). There is another purpose that the survival of representations and warranties serves – it reduces transaction costs. In an “as is, where is” deal, for the buyer to learn anything and everything about the property which is the subject of the purchase and sale agreement would require considerably more time than that which is normally allotted for an inspection period. In this context, having a representation about the property - and the seller’s warranty that such property measures up to a certain standard – survive the Closing provides a rational mechanism by which the deal flow of transactions, which would otherwise get bogged down in interminable inspection periods, is facilitated.
M&A agreements do not appear to be shackled by the inflexibility of the “merger doctrine,” and what’s more, they should not be! The “merger doctrine” is a common law holdover which is unique to a transaction involving the conveyance of real property. Indeed, the ABA’s Model Stock Purchase Agreement Comment affirms this proposition in stating that if a seller’s representation is intended to provide the basis for post-Closing liability, it is customary for the agreement to include a survival clause “to avoid the possibility that a court might import the real property law principle that obligations merge in the delivery of a deed and hold that representations merge with the sale of the shares…“ (emphases added) (American Bar Association, Model Stock Purchase Agreement §10.1 Comment (1995)). But alas, the Comment goes on to resign itself to the irrational fear that the doctrine might sneak up on the parties by adding that “Although no such case is known, the custom of explicitly providing for the survival of representations in business acquisitions is sufficiently well established [in the M&A discipline] that it is unlikely to be abandoned.” (Id.) But there is a more cogent reason for invoking a survival mechanism for representation and warranties in M&A agreements. As in real estate transactions, it is a way of limiting the costs of the buyer’s due diligence and allocating risk between the parties, but in M&A transactions, where there is far more complexity in the dynamic of a going concern, survival of representations and warranties becomes even more critical. The likelihood is that the buyer will learn much more about the intricacies of the business being purchased by operating the business for a substantial amount of time after the Closing than the time afforded by a, say, 120-day inspection period. The seller knows much more about its business than the buyer; to relieve the buyer from an interminable and costly due diligence period, the survival of representations and warranties (and corresponding indemnities) is the go-to mechanism.
But as in most things, there’s a catch!
The rub, as they say, is not in the concept – it’s in the application! If the buyer, having operated the property or the business for some time after Closing, discovers that there is a breach of a warranty or representation, what then are the consequences, and what then is the process?
The typical survival clause reads something like “the representations and warranties of seller in this agreement shall survive the Closing for a period of one year, except the fundamental representations and warranties which shall survive indefinitely.” (The indefinite survival of the fundamental representations and warranties, and how that process differs are beyond the scope of this paper – the focus in this paper is those representations and warranties which survive the Closing for a limited period.) What does this survival provision mean? Does it mean a breach of a representation or warranty must occur within one year from the date of Closing? Does it mean the buyer has one year to discover the breach of the warranty or representation? Does it mean once discovered, the buyer must give notice of the breach within one year of discovery? Does it mean the buyer must file suit within one year of Closing? If so, does this mean that this provision is, in essence, a contractual limitations provision? Does a contractual limitations provision trump the pertinent statute of limitations? If not, what is the limitations period which applies? With respect to any limitations period, contractual or statutory, when does the cause of action accrue?
The foregoing questions arising from a simple survival clause adds credence to the caveat: there’s nothing simple anymore.
The sample survival provision recited above means the parties have agreed that any breach of a representation or warranty must occur within one year of Closing. But presumably, that’s all it means. As previously suggested, this “typical” bare-bones survival provision leaves many questions unanswered. Under Texas law, the time within which one must file an action for breach of contract is four years (Tex. Civ. Prac. & Rem. Code 16.004 – Texas law has evolved such that an action for “debt” includes contract actions). Without more, the occurrence of a breach merely triggers the accrual of a cause of action for breach of the representation or warranty, and the buyer has four years within which to file suit. The danger here is that seller’s counsel might take a cursory look at the purchase and sale agreement, focus on such a simple survival provision, and conclude that the buyer must file suit within one year or its cause of action will be time-barred. Wrong! This sample provision states that the representation or warranty will survive for one year, so that if the buyer discovers the breach within that one-year period, as previously pointed out, the buyer has four years within which to file its lawsuit. While the sample provision does not provide that the buyer must give notice of the breach as a prerequisite to filing its suit, common sense would dictate that the buyer should give written notice to the seller to “preserve the error,” so to speak (or, if there’s enough time remaining in the one-year period, to negotiate a settlement with the seller short of litigation).
There is another twist to contractual limitations. Even if one interprets the language in the sample survival provision to mean that the seller and the buyer had agreed to shorten the time within which to file suit to one year, this agreement would be deemed void by a Texas court. Texas law provides that parties may not agree to a limitations period “shorter” than two years (Tex. Civ. Prac. & Rem. Code § 16.070(a) - see, Spicewood Summit Office Condos Ass’n, Inc. v. Am. First Lloyd’s Ins. Co., 287 S.W.3d 461 [Tex. App. – Austin 2009, pet. Denied]). Texas law does give some relief from that provision to the M&A space – if a transaction involves the sale of a business where the consideration is $500,000 or more, then Tex. Civ. Prac. & Rem. Code § 16.070(a) does not apply (Tex. Civ. Prac. & Rem. Code § 16.070(b)).
Because accrual of a cause of action marks the running of the limitations period, whether statutory or contractual, it is a critical inquiry in determining when a lawsuit must be filed. A word about when a cause of action might accrue in the context of the breach of a representation or warranty contained within a purchase and sale agreement; under Texas case law, the “discovery rule” (i.e., the “discovery rule” as that term is used in the area of limitations of actions jurisprudence) rarely applies in contract cases because contracting parties are expected to exercise due diligence in enforcing their contract rights (but Texas case law does make some exceptions when the injury is ”inherently undiscoverable”). With that as a backdrop, the question arises - when is a representation or warranty breached, because such breach would trigger the accrual of the cause of action? In most cases (excluding sign-and-close transactions), the purchase and sale agreement is signed prior to Closing. Logic would dictate then that the seller’s representations and warranties contained in the purchase and sale agreement are made at the time of signing. However, most purchase and sale agreements contain a provision providing that all representations and warranties shall be “brought down” to the date of Closing. Does a bring-down certificate mean that the seller’s representations and warranties made at the time of signing would get a “refresh date” such that the warranty would be breached as of the Closing date? For example, if the seller’s inventory was overstated by $1,000,000 on the date of signing, does the seller’s bring-down certificate “boost” the breach date to the Closing date? If there’s no bring-down clause, then arguably, the limitations period does begin to run upon signing. However, if the “discovery rule” obtains, then the breach of the representation or warranty would occur after the Closing – specifically, the limitations period would begin to run upon the buyer’s discovery that the inventory had been understated by $1,000,000. The Delaware Chancery Court seems to be of the mind that in the M&A space, the breach occurs on the Closing date, even though the buyer discovered the breach after the Closing date. Depending upon the buyer’s post-Closing attentiveness, this difference could be consequential! For a more detailed treatment of the foregoing, see Will Pugh, Getting What You Bargained for: Avoiding Legal Uncertainty in Survival Clauses for a Seller’s Representations and Warranties in M&A Purchase Agreements, 12 J. Bus. Entrepreneurship & L. 1 (2019) Available at: https://digitalcommons.pepperdine.edu/jbel/vol12/iss1/1.
In the context of M&A agreements (and in some cases, agreements for the purchase and sale of real property), interesting questions about the law applicable to survival provisions, the accrual of causes of action, and contractual limitations arise. The judicial exercise is to determine the “applicable law” by, in turn, determining the law of the jurisdiction where the “contract arises,” the law of the jurisdiction of the forum (whether or not selected), and the law of the jurisdiction chosen by the parties under choice-of-law principles. The Delaware Chancery Court has held that in the foregoing sample survival clause, such language alone is sufficient to indicate the parties have contracted for a limitations period of one year – but this presumes that the court has determined that the law of the State of Delaware controls with respect to the issue of limitations. Other jurisdictions will require more extensive “magic” language (Id. at 18). A couple of teasers - the Erie doctrine comes into play, and the question arises as to whether or not statutes of limitation are substantive or procedural in nature. However, those issues are beyond the scope of this paper, but they certainly deserve separate treatment!
What is the takeaway? My view is that it boils down to a free-form drafting exercise. Texas law favors freedom of contract (with the contractual limitations exception previously mentioned, and so long as the contract subject matter is not against public policy), therefore the parties should be free to nail down all the variables concerning the seller’s representations and warranties, the survival of those representations and warranties, when a cause of action for breach thereof accrues, and the process by which the buyer enforces its remedies in respect of any breach. But nail-down it must be – leaving any of these details unattended can have significant consequences! (See Western Filter v. Argan, 540 Fed. 3d 947 (9th Cir. 2008)).
The bottom line? The survival section of a purchase and sale agreement deserves more (indeed, demands more) than a passing glance!