Representations and Warranties

In a business acquisition or commercial agreement, representations and warranties are factual statements made by one party (usually the seller) to another (usually the buyer) about the subject matter of the transaction. Although the terms are often used interchangeably, they have distinct legal meanings:

Representation: A statement of fact made to induce the other party to enter into the contract. A false representation can give rise to a claim for misrepresentation under common law or statute — allowing the innocent party to rescind the contract or claim damages regardless of whether the misrepresentation was incorporated into the contract as a term.

Warranty: A contractual term — a promise that a particular state of affairs exists. A breach of warranty gives rise to a claim for damages in contract law. Unlike a misrepresentation claim, the innocent party cannot rescind the contract for a breach of warranty — their remedy is damages.

In practice, modern Ontario business purchase agreements combine both concepts in a single section of 'representations and warranties,' and the remedies for breach are governed by the indemnification provisions of the agreement rather than pure common law principles.

Representations and warranties are the seller's formal disclosure of the condition of the business. They require the seller to make positive statements about the business — and to disclose in attached schedules any exceptions to those statements. The process of reviewing and negotiating these provisions is a critical part of any business purchase.

In an Ontario business purchase agreement, the seller's representations and warranties typically cover:

Corporate organization and authority: - The corporation is validly incorporated and in good standing under the OBCA - The corporation has the power to carry on its business and to enter into the purchase agreement - The execution of the agreement has been properly authorized

Share ownership and capitalization: - The seller owns the shares being sold, free and clear of encumbrances - All issued shares are validly issued and fully paid - The share register is accurate and complete

Financial statements: - The financial statements fairly present the financial position and results of operations of the business - There are no undisclosed liabilities

Tax matters: - All tax returns have been filed and all taxes paid - There are no outstanding CRA assessments or audits - No tax elections have been made that would adversely affect the business after closing

Material contracts: - Identified material contracts are valid, binding, and enforceable - No material contracts are in breach or subject to termination

Employees and labour: - All employment contracts and HR practices comply with the Ontario Employment Standards Act, 2000 - All WSIB premiums are current - No pending employment claims

Litigation: - No pending, threatened, or anticipated litigation, arbitration, or regulatory proceedings

Intellectual property: - The corporation owns or is licensed to use all intellectual property used in the business - No intellectual property of third parties is being infringed

Environmental matters: - No environmental orders, investigations, or contamination issues - Business operations comply with applicable environmental laws

Real property: - All real property is held with valid title, free of undisclosed encumbrances - No outstanding work orders or violations under municipal or building code

A seller rarely can make every representation and warranty without qualification. The mechanism for qualification is the disclosure schedule — a set of attachments to the purchase agreement in which the seller lists known exceptions to each representation.

For example, if the seller represents that there is no pending litigation, but there is a small claims court action outstanding, the seller discloses it in the litigation schedule. The buyer accepts the disclosed exception; only undisclosed exceptions are actionable as breaches.

The preparation of disclosure schedules is one of the most important tasks for the seller and their counsel in a transaction. Key principles:

Completeness: Incomplete or misleading schedules expose the seller to indemnification claims post-closing. The seller should err on the side of over-disclosure.

Materiality qualifiers: Many representations include a 'materiality' qualifier — the seller represents that 'there is no litigation that could reasonably be expected to have a material adverse effect.' Buyers often resist broad materiality qualifiers because they lower the bar for disclosure.

Knowledge qualifiers: Some representations are qualified by the seller's knowledge — 'to the knowledge of the seller, there are no environmental orders.' Knowledge is typically defined as actual knowledge of specified individuals (the selling shareholders or key officers), sometimes extended to include 'constructive knowledge' (what they would have known had they made reasonable inquiry).

Bring-down: Representations and warranties typically survive closing and are 'brought down' at closing — the seller must confirm they remain accurate as of the closing date.

Representations and warranties do not survive indefinitely — the purchase agreement specifies how long after closing a buyer can make an indemnification claim based on a breach:

General survival period: Most representations survive for 12 to 24 months after closing — long enough for the buyer to discover issues in the normal course of operating the business.

Extended survival for specific representations: Certain high-risk representations survive longer: - Tax representations: typically survive until the expiry of the applicable limitation period under the Income Tax Act (generally 3 years after the tax year in which the liability arose, or 6 years in cases of negligence or fraud) - Environmental representations: sometimes indefinite or until a specified long-stop date - Fundamental representations (title to shares, corporate authority, capitalization): often survive indefinitely or for an extended period of 5-7 years

Caps on indemnification: Sellers typically negotiate a cap on their total indemnification liability — commonly equal to 10-15% of the purchase price for general representations, with carve-outs for fundamental representations and fraud (often capped at 100% of the purchase price or unlimited).

Deductibles and baskets: Buyers must often meet a minimum claim threshold (a 'deductible' or 'basket') before claims can be made. Thresholds of 0.5-1.5% of the purchase price are common, protecting sellers from small, nuisance claims.

Tipping baskets vs. deductibles: A 'tipping basket' means that once the threshold is met, the seller is liable for the full amount of all claims (not just the excess). A 'deductible' means the seller is only liable for the excess above the threshold. Tipping baskets favor buyers; deductibles favor sellers.

Representations and warranties insurance (R&W insurance) has become increasingly common in Ontario business transactions, particularly those valued above $10 million. R&W insurance transfers the risk of a breach of representation from the indemnifying party (usually the seller) to an insurance company.

Buy-side R&W insurance: Purchased by the buyer, it covers the buyer for losses resulting from a breach of the seller's representations and warranties. This is the most common structure in Canada. The seller's liability (through the purchase agreement's indemnification provisions) may be reduced to a minimal amount or even nil, with the insurance covering buyer losses.

Benefits for sellers: Sellers receive a cleaner exit — their holdback or escrow obligations can be reduced or eliminated. Proceeds from the sale are available immediately rather than being held pending a claim period.

Benefits for buyers: Buyers have deeper-pocketed recourse (the insurer) than the seller, and the claims process is more predictable. Insurance enables deals to close where the seller lacks the financial capacity to backstop full indemnification obligations.

Cost: R&W insurance premiums typically range from 2-4% of the policy limit. The policy limit is usually equal to 10-20% of the transaction value.

For Ontario SME transactions (under $10 million), R&W insurance is rarely used because the cost is disproportionate to the transaction size. Traditional holdback and escrow arrangements remain the standard for smaller deals.

A Toronto buyer purchased the shares of an Ontario IT services company for $3.5 million. The seller represented and warranted that all tax returns had been filed and all taxes paid as of the closing date.

Nineteen months after closing, the Canada Revenue Agency assessed the corporation for $290,000 in unpaid corporate income tax relating to a pre-closing taxation year. The seller had not filed the tax return for that year before closing and had not disclosed the outstanding obligation in the tax disclosure schedule.

The purchase agreement had a 24-month survival period for tax representations, a general cap of 15% of the purchase price ($525,000), and a basket of $35,000. The buyer's total claim was $290,000, which exceeded the basket threshold.

The buyer made a formal indemnification claim against the seller. After mediation under the dispute resolution clause of the purchase agreement, the parties settled for $255,000 — the full $290,000 liability minus the $35,000 basket amount, with the seller paying net of their own tax credit for the payment.

The seller's failure to disclose the outstanding tax return cost them $255,000 — money they received at closing but had to repay. Proper disclosure in the tax schedule would have reduced the purchase price by a similar amount at closing, but at least the seller would have known their exposure in advance.