Almost every purchase and sale agreement (a “PSA”) contains a short (or, more frequently, long) list of seller representations, which, as a condition precedent to the purchaser’s obligation to close, must be true and correct in “all material respects“ as of closing (or, sometimes, as of the date PSA was initially signed). What does that mean? What does a representation mean, for example, that, “There are no service contracts affecting the property other than as shown on Exhibit C” is true and correct “in all material respects”? On one level, it means that, if the parties disagree, it will be up to a court to decide.
With 1031 transactions, expiring rate locks and loan commitments, and “time of the essence” closing dates, nobody wants uncertainty in a PSA; it serves the interests of all parties to provide a mechanism that can manage expectations and provide assurance that the contemplated transaction will close without incident.
An easy way to avoid such uncertainty, would be to quantify what would constitute “materiality” (i.e., address it from a purely monetary perspective). The PSA can provide that all of the (or particular) representations of the seller shall be “deemed to be true and correct in all material respects” as long as any subsequently discovered untruths or inaccuracies do not have a “material adverse effect” (a “MAE”) on the subject property or on the purchaser, as the successor owner thereof. Defining what would constitute a “MAE” would be the subject of negotiation, but it would, at least, provide for the management of expectations, and parameters within which the seller would be assured that it will have a buyer at the closing table. Likewise, the buyer would be protected in that its potential exposure to misrepresentations or deviations of fact would be limited to an agreed-upon threshold, beyond which it would have the option to elect not to proceed.
Setting a MAE can be accomplished by agreeing to a dollar amount which would be required to cure the misrepresentation, or reflect the diminished value of the property as a result thereof (this may be a little more subjective), each of which can be determined more expeditiously by agreed-upon third parties, as opposed to enduring years of litigation and its attendant expense.
In practical terms, the mechanism would be that the trigger amount of costs and/or diminution in value would be agreed to in advance and, to the extent that there is a breach of any of seller’s representations (whether inadvertent or deliberate), the purchaser would be required to agree that it would accept a “negative deductible” on the purchaser price for the property (i.e. it would have to agree to absorb the costs associated with misrepresentations which may occur up to the amount of the MAE). The parties could additionally negotiate so that, beyond the MAE threshold amount, but up to a second “cap” threshold amount, the seller would have the right to keep the purchaser committed under the PSA by simply crediting purchaser with the agreed compensatory costs. The purchaser, however, would need to be sensitive to any financing which it might be seeking, and the tolerance of a lender to factual inaccuracies in the seller’s representations.
Of course, the concept of a MAE will not fit for all representations, because some (e.g., the legal authority of the seller to consummate the contemplated transaction) simply must be true, without qualification. It may be that a purchaser would agree that the MAE qualification would apply only to specifically enumerated representations.
The bottom line is that managed expectations are always desirable for all parties, and such expectations are often the subject of negotiation; quantifying the extent of excess/unanticipated costs which a purchaser may be compelled to incur under a PSA is very helpful in providing a certain level of assurance to a seller that a transaction will close. It should also be noted that building such wiggle room into the requirement that representations be true as of the closing date, often allays fears and anxieties of a seller in determining the representations themselves and the seller’s willingness to provide them at the outset (which is typically where the brunt of the PSA negotiation occurs). Agreeing to manage each other’s expectations by applying a MAE qualifier to representations can lead to minimizing some of the battles to get a PSA over the finish line and executed by the parties, saving all parties avoidable frustration and expense.
Lawrence T. Shepps is a partner in the Firm’s Transactional Department.
He can be reached at lshepps@bbgllp.com
