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C H A P T E R T H R E E Translating the Business Deal into Contrac t Concepts: Par t 1 (Representation and Warranties & Covenants and R ights) 3.1 3.2.1 3.2 11 INTRODUCTION Before deal lawyers begin to draft, they learn the terms of the business deal. Those terms are the deal lawyer’s facts. The lawyer must then fi nd the contract concepts that best refl ect the business deal and use those concepts as the basis of drafting the con- tract provisions. This skill is known as translating the business deal into contract concepts. It is the foundation of a deal lawyer’s professional expertise and ability to problem solve. Without it, negotiating and drafting are abstractions. By learning this skill fi rst, you will be able to layer knowledge of how to draft on top of a framework that has taught you what you are drafting. This chapter and the next discuss the contract concepts in depth and demon- strate how they are used in a contract. This chapter deals with representations and warranties, then covenants and rights. Chapter 4 deals with conditions, discretionary authority, and declarations. As part of this discussion, you will learn not only the legal aspects of each contract concept, but also its business purpose. Chapter 4 ends with a chart that summarizes the material in these two chapters. REPRESENTATIONS AND WARRANTIES DEFINITIONS Imagine that Sally Seller has listed her house for sale and that Bob Buyer is interested in purchasing it. But before Bob agrees to buy the house, he wants to learn more information about it. All that he knows now is that the house is a two-story Cape Cod painted brown. He asks Sally the following questions during a telephone call as he is out of town on business: � When was the house built? � How old is the roof? � Do all the appliances work? � Is the house wired for cable television and is the wiring functioning properly? � Is there a swimming pool? � Is there a swimming pool water heater? Does it use propane gas for fuel? 12 Chapter 3 Translating the Business Deal into Contract Concepts: Part 1 � How much propane gas is in the tank? � What color are the living room walls, and when were they last painted? � How big is the lot on which the house was built? Sally responds to Bob by telling him the following: � The house was built in 1953 along with other houses in the neighborhood. � The roof is four years old. � All the appliances are in excellent condition. � The house is wired for cable television, and it is functioning properly. � Yes, there is a swimming pool. � Yes, there is a swimming pool water heater, and it uses propane gas for fuel. � The tank is exactly one-half full with propane gas. � The living room’s walls are painted eggshell white and were painted one year ago. Sally mentions that she has been thinking of painting them a pale blue to coordinate with her furniture. � The house was built on a one-acre lot. After hearing Sally’s responses, Bob decides that the house is perfect for him. He and Sally agree on a $200,000 purchase price. Bob then calls his lawyer and asks her to draw up the contract and to include within it the information that Sally has just told him. He tells his lawyer that the answers were an important factor in his decision to buy the house. How does the lawyer include the information in the contract? The answer is that she will use representations and warranties. A representation � is a statement of fact � as of a moment in time � intended to induce reliance.1 Assume that Sally and Bob sign a contract today for the sale of the house and that in the contract Sally tells Bob the following: � The roof is four years old. Sally’s statement is a representation. She made that statement (a statement) today (a moment in time). (Had she made the statement a year ago, the roof would have been three years old, and if she were to make the statement in a year, it would be fi ve years old.) In addition, she made the statement to convince Bob to purchase the house (to induce reliance). The representation that the roof is four years old is a statement about a present fact. Sally also made representations with respect to facts concerning the past: The house was built in 1953 along with other houses in the neighborhood. Although a party can make representations with respect to present and past facts, they gener- ally cannot do so with respect to future facts. Those are mere statements of opinion. Chapter 9 discusses this issue in more depth. For Bob to have a cause of action for misrepresentation, he must actually have relied on Sally’s statement, and that reliance must have been justifi able.2 That is, Bob 1. See Harold Cohn & Co, Inc., v. Harco Intl., LLC, 804 A.2d 218, 223-224 (Conn. App. Ct. 2002). 2. See S. Broad. Group, LLC v. Gem Broad., Inc., 145 F. Supp. 2d 1316, 1329-1330 (M.D. Fla. 2001), aff’d, 49 Fed. Appx. 288 (11th Cir. 2002) (table). must not have known that Sally’s statement was false. So, for example, if Bob pur- chases the house after his contractor tells him that the roof is much older than four years, Bob’s reliance on Sally’s representation that the roof is four years old is not justifi able. Accordingly, Bob would not have a cause of action with respect to a misrep- resentation as to the roof’s age. He would have a cause of action, however, for breach of a warranty of that same statement.3 A warranty differs from a representation. A warranty is a promise by the maker of a statement that the statement is true.4 This promise will result in the maker of the statement paying damages to the statement’s recipient if the statement was false and the recipient damaged. The war- ranty acts as an indemnity. It does not matter whether the recipient knew the state- ment was false.5 The salient factor is the recipient’s reliance on the promise of damages if the statement is false. Therefore, while Bob would not have a cause of action for a misrepresentation with respect to the roof’s age, he would be able to sue for a breach of warranty postclosing—so long as he told Sally when they were closing that he was reserving his right to make a claim.6 Deal lawyers almost always negotiate for both representations and warranties. For example, in the house purchase agreement between Sally and Bob, the represen- tations and warranties article would be introduced with the following language: The Seller represents and warrants to the Buyer as follows: By virtue of this one line, every statement in the sections that followed would be both a representation and a warranty.7 In the purchase agreement between Sally and Bob, Sally’s representations and warranties would resemble the following: Seller’s Representations and Warranties. The Seller represents and warrants to the Buyer as follows: (a) The house was built in 1953, along with the other houses in the neighborhood. (b) The roof is four years old. (c) All the appliances are in excellent condition. (d) The house is wired for cable television, and it is functioning properly. (e) There is a swimming pool. (f) There is a swimming pool water heater, and it uses propane gas for fuel. 3. Id. at 1321-1324. See also Shambaugh v. Lindsay, 445 N.E.2d 124, 125-127 (Ind. Ct. App. 1983). 4. See CBS Inc. v. Ziff-Davis Publg. Co., 554 N.Y.S.2d 449, 452-453 (1990). 5. See id. Since CBS, a majority of states have followed the New York rule. See, e.g., Wikoff v. Vanderveld, 897 F.2d 232 (7th Cir. 1990) (applying Illinois law). But see Hendricks v. Callahan, 972 F.2d 190 (8th Cir. 1992) (applying Minnesota law). 6. See Galli v. Metz, 973 F.2d 145, 150-151 (2d. Cir. 1992) (holding that where a buyer closes with full knowledge that the facts disclosed by seller are not as warranted, the buyer may not sue on the breach of warranty, unless it expressly preserves the right to do so). 7. In unusual circumstances, a practitioner might recommend to a client that it make only a warranty. See §9.4. 133.2 Representations and WarrantiesChapter 3 14 Chapter 3 Translating the Business Deal into Contract Concepts: Part 1 (g) The tank is exactly one-half full with propane gas. (h) The living room’s walls are painted eggshell white and were painted one year ago. (i) The house was built on a one-acre lot. Finally, when determining whether a party made a misrepresentation and breached a warranty, a statement’s truthfulness is always determined by comparing the state- ment to reality as of the moment in time when the statement was made, not when the determination of truthfulness is made.8 Therefore, Sally’s representation and war- ranty are truthful so long as the living room walls were painted eggshell white when she stated that they were that color. It would be irrelevant with respect to claims for misrepresentation and breach of warranty that she painted the walls pale blue after she made the representation in the contract for sale but before she sold the house to Bob. Of course, the painting of the walls would not be irrelevant to Bob. However, to obtain a remedy, he would need to rely on a cause of action other than misrepresenta- tion and breach of warranty. He would need a covenant.9 REMEDIES Representations and warranties are common law concepts. As such, they carry with them common law remedies. The differences in these remedies can directly affect which cause of action is the most favorable for a plaintiff to plead. A party can make three types of misrepresentations: innocent,10 negligent,11 and fraudulent.12 A litigation alleging any of these misrepresentations is a suit in tort. Typically, innocent and negligent misrepresentations must be material to support a remedy.13 The law with respect to fraudulent misrepresentations depends upon the jurisdiction. In some jurisdictions, a misrepresentation need not be material for it to constitute a fraudulent misrepresentation,14 while in others it must.15 If a misrepresentation is innocent or negligent, the usual remedies are avoid- ance and restitutionary recovery.16 Avoidance permits the injured party to unwind the contract.17 Both lawyers and courts often refer to it as rescission. Restitutionary 3.2.2 8. See Union Bank v. Jones, 411 A.2d 1338, 1342 (Vt. 1980). 9. See §3.3. 10. See Bortz v. Noon, 729 A.2d 555, 563-564 (Pa. 1999); Restatement (Second) of Torts §552C (1977) (misrepresentations in sales, rental, or exchange transactions). 11. See Liberty Mut. Ins. Co. v. Decking & Steel, Inc., 301 F. Supp. 2d 830, 834 (N.D. Ill. 2004); Restate- ment (Second) of Torts §552 (1977) (information negligently supplied for the guidance of others). 12. See Skurnowicz v. Lucci, 798 A.2d 788, 793 (Pa. Super. Ct. 2002). 13. See Restatement (Second) of Contracts §164 (1981). 14. See Sarvis v. Vt. State Colleges, 772 A.2d 494, 498 (Vt. 2001). Compare Restatement (Second) of Contracts §164 (1981) (providing that a fraudulent misrepresentation need not be material to make it voidable) with Restatement (Second) of Torts §538 (1977) (providing that reliance upon a fraudulent rep- resentation is not justifi able unless the matter misrepresented is material). 15. See Skurnowicz v. Lucci, 798 A.2d 788, 793 (Pa. Super. 2002). 16. See Norton v. Poplos, 443 A.2d 1, 4-5 (Del. 1981) (innocent misrepresentation); Patch v. Arsenault, 653 A.2d 1079, 1081-1083 (N.H. 1995) (negligent misrepresentation). Damages have been awarded in cases of innocent and negligent misrepresentation. See Restatement (Second) of Torts §552B and §552C (1977). See generally Dan B. Dobbs, Dobbs Law of Remedies, vol. 2, §9.2(2), 554-556 (2d ed., West 1993). 17. See Kavarco v. T.J.E., Inc., 478 A.2d 257, 261 (Conn. App. Ct. 1984). See generally E. Allan Farn- sworth, Farnsworth on Contracts, vol. 1, 495-496 (3d ed., Aspen 2004). recovery requires each party to return to the other what it received, either in kind, or if necessary, in money.18 A misrepresentation may also be fraudulent—a misstatement made with knowl- edge of its falsity (scienter).19 In this case, an injured party has a choice of rem- edies. First, it may void the contract and seek restitution,20 just as with innocent and negligent misrepresentations. Alternatively, it may affi rm the contract, retain its benefi ts, and sue for damages based on a claim of fraudulent misrepresentation,21 sometimes referred to as the tort of deceit. The injured party’s damages claim could also include punitive damages,22 which, of course, can be signifi cantly larger than general damages. If an injured party decides to affi rm the contract by suing for fraudulent misrep- resentation, the measure of damages depends upon which state’s law governs the contract. Most states use the benefi t of the bargain measure of damages,23 with the minority using the out-of-pocket measure of damages.24 The benefi t of the bargain measure of damages results in a higher damages award and is the measure of damages that a party generally receives upon a contract breach. It is equal to the value that the property was represented to be minus the actual value. So, if the property was represented to be worth $10,000 but was actually only worth $3,000, the damages would be $7,000. Value if as represented $10,000 Actual value -3,000 Damages $7,000 Out-of-pocket damages are equal to the amount the plaintiff paid for the property minus the actual value. Thus, if the plaintiff paid $5,000 for property that was only worth $3,000, it could recover only $2,000 in damages. Amount Paid $5,000 Actual value -3,000 Damages $2,000 The difference in recovery between the benefi t of the bargain damages and out-of- pocket damages can be important when a plaintiff decides whether to sue for fraudu- lent misrepresentation or breach of warranty. Specifi cally, if an injured party asserts a claim for breach of warranty, a contract claim, the remedy for that breach is full ben- efi t of the bargain damages.25 Therefore, in a state that follows the out-of-pocket rule of damages for fraudulent misrepresentations, a plaintiff would probably be better off pursuing a breach of warranty claim, as its benefi t of the bargain damages would be 18. See E. Allan Farnsworth, Farnsworth on Contracts, vol. 1, 499 (2d ed., Aspen 2004). Some cases hold that the injured party is also entitled to reliance damages. See In re Letterman, 799 F.2d 967, 974 (5th Cir. 1986). 19. See Bortz v. Noon, 729 A.2d 555, 560 (Pa. 1999). 20. See Smith v. Brown, 778 N.E.2d 490, 497 (Ind. Ct. App. 2002). 21. See Stebins v. Wells, 766 A.2d 369, 372 (R.I. 2001). 22. See generally Dan B. Dobbs, Dobbs Law of Remedies, vol. 2, §9.2(5), 565-568 (2d ed., West 1993). 23. See, e.g., Lightning Litho, Inc. v. Danka Indus., Inc., 776 N.E.2d 1238, 1241-1242 (Ind. Ct. App. 2002). 24. See Reno v. Bull, 124 N.E. 144, 146 (N.Y. 1919). Some states follow neither rule exclusively, but instead have a more fl exible approach that varies the damage award based upon specifi c factors. See, e.g., Selman v. Shirley, 85 P.2d 384, 393-394 (Or. 1938). 25. See Nunn v. Chem. Waste Mgt., Inc., 856 F.2d 1464, 1470 (10th Cir. 1988). 153.2 Representations and WarrantiesChapter 3 16 Chapter 3 Translating the Business Deal into Contract Concepts: Part 1 greater.26 A claim for fraud might become the preferable claim, however, if a plaintiff could successfully argue for punitive damages. The following chart summarizes the remedies associated with representations and warranties. INNOCENT AND NEGLIGENT FRAUDULENT MISREPRESENTATIONS MISREPRESENTATIONS WARRANTIES Avoidance and Avoidance and Benefi t of the restitutionary recovery restitutionary recovery bargain damages or Damages: • Out-of-pocket damages or • Benefi t of the bargain damages • Punitive damages In this discussion, false representations have been referred to as misrepresenta- tions. Although some lawyers colloquially speak of breaches of representations, that terminology is incorrect. A breach is a violation of a promise. Because representations are not promises, they cannot be breached. Instead, a party makes misrepresenta- tions. It is correct, however, to speak of breaches of warranties, as warranties are promises. WHY A PARTY SHOULD RECEIVE BOTH REPRESENTATIONS AND WARRANTIES As the preceding sections have made clear, multiple benefi ts accrue to a party who receives both representations and warranties. To summarize, they are the following: � First, a party will have the option to void the contract and receive restitution only if that party receives representations. � Second, a party may sue for punitive damages only by claiming a fraudulent misrepresentation. � Third, if a party cannot prove justifi able reliance on a representation, that party can still sue for breach of warranty. � Fourth, if a state follows the out-of-pocket rule for damages for fraudulent misrepresentations, a party can still recover the greater benefi t of the bargain damages by suing for breach of warranty. � Fifth, a breach of warranty claim may be easier to prove than a fraudulent mis- representation claim. As noted earlier, to prove fraudulent misrepresentation, a plaintiff must demonstrate scienter, that the defendant knowingly made a false representation. As proving a party’s state of mind can be diffi cult, a breach of warranty claim, which has no such requirement, may be the easier claim to win.27 3.2.3 26. See Ainger v. Mich. Gen. Corp., 476 F. Supp. 1209, 1233-1234 (S.D.N.Y. 1979). 27. See W. Page Keeton, Dan B. Dobbs, Robert E. Keeton & David G. Owen, Prosser and Keeton on Torts §107, 741 (5th ed., West 1984). RISK ALLOCATION Each representation and warranty establishes a standard of liability. If a statement is false—if the statement does not refl ect reality—then the standard has not been met and the party making the statement is subject to liability. By establishing standards of liability, representations and warranties serve an important business purpose. They are a risk allocation mechanism. This means that the degree of risk that each party assumes with respect to a statement varies depend- ing upon how broadly or narrowly the statement is drafted. Recall that Sally told Bob that the propane gas tank was exactly one-half full. That is a precise statement. It is posited as an absolute, without any kind of wiggle room. It is a fl at representation. It is a high-risk statement for Sally because if she is even a little wrong, Bob has a cause of action for misrepresentation and breach of warranty. Sally could have reduced her risk by making a less precise statement. She could have made a qualifi ed representation. For example, she could have said that the tank was approximately half-fi lled. Then if the propane gas tank was less than one-half its capacity, Sally might still be able to contend that her statement was true. Her risk of having made a false statement is reduced. Bob, however, has now assumed a greater risk with respect to Sally’s statement about the amount of fuel in the tank. Originally, Bob would have had a cause of action if the tank was even a little less than half full. Now, in order to prove a misrepresentation and breach of warranty, Bob must argue what approximately means. The risk allocation has shifted more of the risk to Bob.28 To see how risk allocation works in a more sophisticated context, imagine that you are general counsel of a $100 million company that is selling all of its shares in a wholly owned subsidiary (the Target). Your current task is to negotiate the no litiga- tion representation and warranty that appears in the stock purchase agreement.29 You know the statement needs to be qualifi ed. But how? Immediately following this paragraph are fi ve versions of a no litigation repre- sentation and warranty. The fi rst version is the language in the agreement. The subse- quent versions represen