ForensicEyes: Cannabis M&A: Common Representations and Warranties

In my last post in this series, I ran through a detailed list of some of the more common conditions to closing you’ll see in the run-of-the-mill cannabis business purchase. Today, I want to do something similar, but instead with representations and warranties.

In M&A contracts, the parties make various legal promises. Promises to do something in the future — like a seller’s promise to operate the business in the ordinary course prior to closing — are usually referred to as “covenants”. Promises about things that have occurred in the past or the state of the business or assets being sold at the time of signing or closing are called “representations and warranties”. Sometimes the lines can get blurred between covenants and reps and warranties, but for the purpose of this post, we won’t get into that.

One big footnote here is that reps and warranties do in fact apply to future conduct or status in some cases. Most cannabis M&A transactions have a gap of time between signing and closing. A buyer will want to be sure that the reps and warranties made at the time of signing — like the company having paid all taxes — are still true at closing. So reps and warranties will often specify that they are accurate both at the time of signing and closing.

In some cases, parties will even draft reps and warranties so that the thing promised is true at closing even if it’s not true at signing. This essentially has the effect of being a closing condition (which I got into in detail in my last post), as accuracy of reps and warranties will always be a condition for closing. For example, if there was an outstanding tax liability on signing, the buyer may make the sellers rep and warrant that as of the closing, there would be no outstanding tax debt. This would give them time to get it taken care of.

Additionally, many purchase agreements will require the sellers or the officers or managers of the sellers to certify at the time of closing, in writing, that the reps and warranties contained in the purchase agreement are accurate. This obviously helps strengthen the case against a seller if it turns out the rep and warranty was false.

Finally, survival of reps and warranties is also a hugely important concept that can be highly negotiated. Most purchase agreements will state that the reps and warranties survive for some specific period after closing. After the survival period, it if turns out that a rep and warranty was false or inaccurate, there’s nothing the other party can do. Sellers, who usually make way more reps and warranties, will negotiate for a shorter time. Buyers, who need the sellers’ assurances that the target business is in the state they promised it would be, will often ask for longer.

Anyway, below is the list. Reps and warranties are usually all stacked within specific sections of a purchase agreement that can, in some cases, be a dozen pages long. I can’t possibly address the entire universe of reps and warranties that could be in a purchase agreement, but I’ll try to highlight some of the big ones:

Organization, Authority, Binding Obligations, No Conflicts

There are always a series of reps and warranties early on in the reps and warranties section. They promise that maker of the rep and warranty is a valid company (if an entity), that the person signing has authority to sign and that the transaction has been approved, that the obligation is binding, and that the transaction won’t conflict with any internal or external agreements or laws. These can be fairly boilerplate but you’ll see them in every deal.

Purchased Assets/Inventory

Sellers will make representations concerning the status and quality of inventory being purchased (if allowed under state law) and assets being purchased or that are owned or leased by the target company. For example, sellers will represent that there are no liens or security interests on the purchased assets, that they are in good working condition, that they are marketable, etc. The buyer wants to know that it is buying assets or a company with assets that work, and inventory that it can sell.

Lease and Property Ownership

Similarly, a buyer will want to know that property owned and leased by the target business is in fact owned or leased (and that the company isn’t in default under a lease), that the property has no mortgages, that the property has been used for legal and legitimate purposes. They will also often ask sellers to represent that all environmental laws have been complied with at the property. In some cases, sellers will be asked to make reps and warranties about specific features of a property, such the amount of specific utilities.

Compliance with Laws

One of the most important representations and warranties from a buyer’s point of view is compliance. Buyers will want to know that the target company or assets, and the sellers themselves, complied with all applicable laws at all times while owning the property. Why this rep and warranty is so important speaks for itself.

Litigation and Legal Proceedings

Another rep and warranty that you’ll be certain to see concerns litigation involving the sellers or target assets. Buyers don’t want to jump into a company that’s embroiled in expensive litigation. But even more than that, an ongoing dispute between the sellers of the business and someone else claiming they actually have an ownership interest in the company is a recipe for disaster and can even lead to claims of fraudulent transfer (believe it or not, we’ve seen stuff like this happen over the years). So it’s good for buyers to be promised that there are not only no active claims, but also that sellers are not aware even of potential claims.

Taxes and Indebtedness

These are probably the most important reps and warranties of all for cannabis businesses. Buyers will want sellers to rep and warrant that the target company has filed all tax returns on time, paid all applicable taxes, and doesn’t have debt to any third party (as of the effective date or closing). Tax liabilities and third-party debt can be massive in this industry and so buyers can end up worse than where they started if they aren’t careful.

Brokers

Often times one or both sides to a deal is represented by a broker. Both sides will usually represent that either (1) they did not have a broker, or (2) they used only a specific broker. Nobody wants someone popping up and claiming they are entitled to a broker fee, and so if reps are crafted strategically they can shift the onus onto a different party to cover undisclosed broker fees.

Licenses

Okay, I may have lied a little when I said that tax reps are the most important. When it comes to M&A deals with licensed companies, as opposed to ancillary entities, the licenses are usually the most valuable assets owned by the target company. So the buyer will want the seller to promise that it has done everything required to maintain the licenses in good standing, that it has not done anything to jeopardize any license, that it is not aware of any circumstance that would jeopardize the license, and that it has provided truthful and complete information and documents to a licensing authority. If it turns out any of that didn’t happen, that’s likely to lead to big trouble.

Material Contracts & Vendors

Buyers will want to have information about all of the target company’s contracts, vendors, and in some cases customers (especially for B2B businesses). Much of that will be disclosed in diligence, but a buyer will still want the seller to rep that a list of specific contracts or vendors is accurate. There can be disagreement as to how to define what a “material contract” is, because sellers will get annoyed having to put together a list of small or short term contracts, so you’ll often see different definitions take shape.

Intellectual Property

IP is another key asset of a cannabis business that will usually come along with the purchase for the buyer. Like with licenses, the buyer will want to know that the seller has taken all steps to register IP, maintain the secrecy of trade secrets, preserve any rights its had in IP, enter into written work for hire agreements or assignments, etc.

Due Diligence Materials

Buyers will also want (though a lot of sellers don’t want to give) written assurances that everything they were told or given in diligence was both true and complete. Sellers can be hesitant to give this even where they don’t believe they have anything to hide, as they can be worried that buyers can claim fraud if it turns out they forgot to hand over a document. This too can often be a source of real debate.

Buyer Reps

Most of the reps and warranties we’ve talked about today are seller reps. But there are some other reps we’ll see in purchase agreements from time to time that buyers make. I won’t spend a ton of time on them since seller reps are usually way more robust. Buyers will often rep that they are qualified to own a cannabis business, i.e., they are 21+, have no disqualifying convictions, live in the state at issue if there’s a residency requirement, etc. There are also some securities law reps that buyers may make.

Sellers will always want buyers to rep that they have not relied on anything the sellers said except what’s in the written reps and warranties (to counteract the due diligence issue noted above) and/or that they have investigated facts on their own and made their own judgment without relying on what the sellers told them. There can be some push and pull here, but the bulk of the negotiations tend to be on the seller reps.

All of the above raises two points that I think bear mentioning. First, I have seen a lot of cases where sellers try to cut a rep and warranty out of a purchase agreement that I’ve drafted altogether because they say it’s not 100% accurate. It’s understandable to want to not make a promise that you know isn’t true. But the better way to handle this from the buyer’s point of view is through a disclosure schedule.

A disclosure schedule basically will allow the sellers to carve things out from a rep and warranty. For example, they could represent something like “Except as disclosed on Schedule X, Company has paid all taxes.” (This is a gross oversimplification, but just for example’s sake.) Then, they would list the unpaid taxes on the schedule. The beauty of a disclosure schedule is that the buyer can still get the rep it wants and the seller can get a carveout to ensure it’s true.

Second, you may ask what happens if a rep and warranty is not true. The bargain of a contract is that we have to take people at their word. And sometimes, people make inaccurate or even false reps and warranties (unfortunately, I’ve seen it a lot). When this happens, the other party will have claims for breach of contract and possibly even fraud, may be able to invoke indemnification provisions in the purchase agreement, and in extreme cases may even be able to rescind the purchase agreement.

This post ended up being a monster, but we’ve got tons more to read on cannabis M&A. Here’s a good place to start:

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ForensicEyes

Thursday, 16 September 2021

Cannabis M&A: Common Representations and Warranties