Representations and Warranties in Real Estate Sales Contracts

The most common and frequently used mechanisms for contractual risk allocation in a variety of business transactions are representations and warranties coupled with indemnification against loss or liability resulting from breaches thereof. In particular, contract drafters use representations and warranties to allocate and shift financial risk in asset purchase agreements, mergers and acquisitions, and, of course, real estate transactions. Indemnification provides protection against loss or liability arising out of the untruth or inaccuracy of any representation and the resulting breach of the accompanying warranty.

Beyond the basic terms of a real estate purchase and sale agreement (PSA), which identify the parties, describe the property, and specify the purchase price, some of the most important and vigorously negotiated provisions are the representations and warranties of the seller and the related indemnities. Tension normally exists between buyers and sellers regarding the scope of representations and warranties to be provided by the sellers and the extent to which the buyers should be able to rely on those representations and warranties. Also, the buyer under a PSA wants indemnification against the consequences of a breach of the seller’s representations and warranties.

On the other hand, the seller wants to give as little as possible in the way of representations and warranties and indemnity (i.e., the traditional caveat emptor mentality). The practical and reasonable resolution of this conflict is for the seller to tell the buyer what it knows about the property (using the “best knowledge” qualifier as an antecedent to the representations and warranties) and not actively conceal or withhold material information, and for the buyer to rely primarily on its own due diligence investigation (i.e., “trust but verify”). To the extent that the scope of the seller’s representations and warranties is limited or qualified, the seller’s liability under any supporting indemnity should be mitigated accordingly.

Case law defines a representation as a statement of a past or present fact made by a party as of a moment in time to induce reliance by the other party. It is not a statement of something that will happen or is to be done in the future. That would be a covenant. Nor can there be actionable fraud for misrepresentation of an intent or state of mind. See Sachs v. Blewett, 185 N.E. 856 (Ind. 1933) (holding that there is no such thing as promissory fraud). A representation states a past or present fact, i.e., something that objectively and presently exists or that previously existed or happened. Its essential purpose is to induce reliance in the recipient.

A warranty is a promise that the representation is true. So when the representation is coupled with a warranty, it provides the recipient with assurance of the truth of the representation and remedies if it is not. These remedies include damages, restitution, and avoidance of the contract. If damages are claimed, they may include out-of-pocket costs, benefit of the bargain, and, in the case of intentional misrepresentation, punitive damages.

It is possible to have a representation without a warranty. In that case, however, if the representation is untrue or inaccurate, the recipient must prove justifiable reliance on its part and either fraudulent intent or negligent misrepresentation on the part of the maker of the false statement in order to recover damages or seek avoidance of the contract. In other words, the recipient of a naked representation must prove the elements of common law fraud.

If the representation is coupled with a warranty of its truth, then the recipient’s burden of proof is significantly reduced and simplified. There is no need to prove either fraudulent intent of the maker or reliance of the recipient. All that must be shown is that the statement was in fact false or inaccurate. It is a claim for breach of warranty, rather than misrepresentation, sounding in contract rather than tort.

As indicated, representations and warranties are a contractual risk-shifting device. The degree to which risk may be shifted depends upon the specific language of the representations and warranties. For example, if the seller of an improved property (i.e., a building) makes an absolute and unqualified representation and warranty that the property is free of defects, this wholly negates the doctrine of caveat emptor and shifts the entire risk of the possible existence of defects to the seller. And it affords the buyer the right to sue the seller or to rescind the contract if there is any defect in the property. The dynamic changes significantly if the seller qualifies the representation and warranty with a knowledge qualifier. Some of the risk is shifted back to the buyer if the seller represents and warrants that “to its knowledge” the property is free of defects. In that case, the seller is liable for breach of the warranty only if it had knowledge of a defect but concealed it. And the buyer’s burden of proof is increased because it must prove that the seller had knowledge of the defect but failed to disclose it.

Some additional parsing of the language can further reduce the seller’s liability. For example, the seller might say “to the best of my knowledge, but without investigation or inquiry.” This additional qualifying language most likely would deprive the buyer of a claim for negligent misrepresentation. And the seller’s liability can be limited even further if he says only that he has no knowledge of any material defects. This materiality qualifier shifts the risk of minor defects back to the buyer.

Understand, though, that even if the buyer is successful in negotiating and obtaining some representations and warranties from the seller concerning the condition of the property, this is never a substitute for the buyer’s own due diligence investigation. It is simply a matter of “trust but verify.” Notwithstanding that the buyer may trust the seller, the buyer still must verify the truth and accuracy of the facts and matters represented and warranted by the seller. This can be accomplished only by conducting a thorough due diligence investigation of the property before closing.

To aid the buyer’s due diligence investigation of the property, the seller should also be obligated to deliver to the buyer those historical records and documents concerning the property that the seller has in his possession, such as old environmental reports, geotechnical data, surveys in the case of raw land, and maintenance and repair records and operating reports in the case of existing buildings, and the buyer should have all of this information verified and updated in the course of his due diligence investigation. A prudent seller, however, may disclaim any responsibility for the accuracy or reliability of any of the information furnished because most of it is the work product of others. In that event, the buyer should request (and be prepared to pay for) a reliance letter from each professional who has provided any such report or data to the seller.

Also note that the scope and subject matter of the representations and warranties in a PSA are fact-sensitive and governed by the type of transaction. There is no “one-size-fits-all” when it comes to contractual representations and warranties.

For example, in a transaction involving the sale and purchase of improved property, the representations and warranties will focus heavily on the physical condition of the improvements and their various components, e.g., roof, structural elements, and HVAC system; on compliance of the improvements with applicable laws, ordinances, and codes; and on absence of environmental defects and violations.

If the transaction involves the sale and purchase of investment property, e.g., an office building or a shopping center, the representations and warranties also will focus on the financial performance of the asset. This includes such things as the revenue stream (i.e., rents and other charges), operating costs, debt service, the quality of the leases and tenants (i.e., the rent roll), and the absence of litigation affecting the property.

If the transaction involves the sale and purchase of raw land for development, the representations and warranties will focus on the “buildability” of the site. This includes confirmation that the property is properly zoned for the buyer’s intended development, all necessary utilities (i.e., electricity, water, gas, telephone, fiber optic cable, and storm and sanitary sewers) are available at the site, soil and drainage are suitable for development of the property, and the site has adequate access for development (i.e., abutting public streets, curb cuts, and median cuts).

Also, the majority of the seller’s representations and warranties will be effective as of the moment the PSA is signed, unless otherwise specified. Circumstances may change after that time and before the closing. So, the buyer’s obligation to close and purchase the property should be conditioned upon the continued truth and accuracy of the seller’s representations and warranties until the moment of closing.

The PSA also should provide for the seller’s affirmation of the representations and warranties as of the closing date. This is the so-called bring-down provision. Also, it is customary to provide that the representations and warranties and the accompanying indemnity will survive the closing of the transaction for a specified period. This is subject to negotiation; however, it is usually a period of at least one year following the closing of the transaction. In the absence of a provision to the contrary in the PSA, the seller’s representations and warranties and any supporting indemnity are merged into the conveyance and do not survive the closing. See Warner v. Estate of Allen, 776 N.E.2d 422 (Ind. App. 2002).

Of course, for an “as is” sale of property, the seller makes no representations and warranties regarding the condition or suitability of the property. In that case, the conditions precedent to the buyer’s obligation to close are crucial. The buyer will condition its offer to purchase on the suitability of the property for the buyer’s intended use or development and the absence of defects or deficiencies. Here again, “suitability” includes such things as proper zoning, availability and capacity of public utilities, suitability of the soil and drainage, and convenience of access. And, of course, the suitability condition must be coupled with a contractual provision that allows the buyer ample time to conduct a thorough due diligence investigation of all of these matters and to terminate the PSA and receive a refund of the earnest money if it is not satisfied with the results of its due diligence investigation.

Note, however, that even if the sale of property will be “as is,” without any representations and warranties regarding the condition of the property or its suitability for a particular purpose, the buyer should still require the seller to represent and warrant certain basic facts regarding the property before the buyer undertakes a costly and time-consuming due diligence investigation of the property. These basic facts include the following:

• The seller owns marketable title to the property in fee simple and the property is free of any easements or restrictions that could prevent the buyer’s intended use or development of the property.
• The seller has no knowledge of any contamination, hazardous substances, USTs, or other environmental defects on the property or of any other conditions that could prevent the buyer’s intended use or development of the property.
• There are no condemnation proceedings pending or, to sellers’ knowledge, threatened against the property.
• There are no suits, judgments, or other legal proceedings pending or, to the seller’s knowledge, threatened against the seller or the property that could prevent the seller from entering into and performing this agreement.
• The seller is not obligated to sell, lease, or mortgage the property to any other person or entity, and there are no other agreements by which the seller is bound that could prevent the seller from entering into and performing this agreement.
• There are no mortgages or other liens against the property that cannot be discharged out of the proceeds at closing and no leases or tenancies that could deprive the buyer of possession of the property.

In other words, the buyer should not undertake a costly and time-consuming due diligence investigation without some minimal assurance that the seller owns the property and that there is no insurmountable impediment to the transaction. But also note the use of the knowledge qualifier that limits the seller’s liability with respect to several of these representations and warranties.

The scope of the representations and warranties in any given transaction depends on the relative leverage and negotiating skills of the parties to the transaction. No buyer always gets all of the representations and warranties it wants. Sometimes the seller may refuse to provide any representations and warranties regarding the condition of the property or assets being sold, leaving the buyer to rely solely on its due diligence investigation. In that situation, matters that otherwise would have been represented and warranted by the seller must be conditions precedent to the buyer’s obligation to close the transaction. And, of course, if there are representations and warranties, their continued truth and accuracy should be a condition precedent to closing

These are some of the fundamental issues that must be addressed in the negotiation and drafting of representations and warranties for the sale and purchase of commercial real estate. What follows are a couple of examples of representations and warranties from some real-world contracts.

Excerpt from Short-Form Purchase and Sale Agreement

Seller’s Representations and Warranties: Seller represents and warrants the following facts and matters:

a) Title: Seller owns marketable title to the Land in fee simple and the Land is free of any easements or restrictions that could prevent development of the Project on the Land.

b) Environmental: Seller has no knowledge of any contamination, USTs, or other environmental defects on the Land or of any other conditions that could prevent development of the Land.

c) Condemnation: There are no condemnation proceedings pending or, to Sellers’ knowledge, threatened against the Land.

d) No Litigation: There are no suits, judgments, or other legal proceedings pending or, to Seller’s knowledge, threatened against Seller or the Land that could prevent Seller from entering into and performing this Agreement.

e) No Obligations: Seller is not obligated to sell, lease, or mortgage the Land to any other person or entity and there are no other agreements by which Seller is bound that could prevent Seller from entering into and performing this Agreement.

f) No Liens or Leases: There are no mortgages or other liens against the Land that cannot be discharged out of the proceeds at Closing and no leases or tenancies that could deprive Buyer of possession of the Land.

The foregoing representations and warranties must be true and correct at the time of Closing and will survive the Closing.

Excerpt from Long-Form Shopping Center Purchase and Sale Agreement

Representations and Warranties of Seller: To induce Buyer to execute this Agreement, Seller represents and warrants to Buyer as follows:

A. Organization: Seller is a ________________ duly organized and validly existing under the laws of the State of its organization.

B. Authority: Seller has the full right, title, power, and authority to enter into this Agreement and to consummate a sale of the Property, and all persons whose signatures are necessary to sell the Property are duly authorized to execute and have duly executed this Agreement.

C. No Litigation: No action, suit, claim, arbitration, litigation, or other proceeding is pending or threatened against the Property or any part thereof.

D. No Condemnation: Seller has not received any notification from any governmental agency or authority, or any public utility, of any pending or threatened condemnation of or assessment against the Property or any part thereof or any proposed taking of any portion of the Property, any proposed assessment for public improvements, or any proposed increase in the cost of utility services.

E. Binding Effect: This Agreement and all documents executed pursuant hereto by Seller are valid and binding upon and enforceable against Seller in accordance with their respective terms, and the transaction contemplated hereby will not result in a breach of or constitute a default or permit acceleration of maturity under any mortgage, deed of trust, loan agreement, or other agreement to which Seller or the Property is subject or by which Seller or the Property is bound.

F. Contracts: Exhibit B is a true, correct, and complete list of all service and maintenance contracts and amendments and modifications thereof. To Seller’s knowledge, there are no defaults under any of the contracts, all of the contracts are in full force and effect, and all of the contracts are terminable without cost to Buyer on or before the Closing Date.

G. Permits: Exhibit C is a true, correct, and complete list and is an accurate description of each of the permits and licenses, as amended and in effect. Each of the permits and licenses is in full force and effect. Neither Seller nor any employee of Seller has received notice of any intention on the part of the issuing authority to cancel, suspend, or modify any of the permits or licenses or to take any action or institute any proceedings by any governmental agency for the use or occupancy of the Property or to effect such a cancellation, suspension, or modification.

H. Leases: Exhibit D is a true, correct, and complete list of all of the tenants leasing any part of the Property under all Leases.

I. Title: Seller has good and marketable fee simple title to the Real Estate and to all personal property and each item thereof, all free and clear of all liens, security interests, encumbrances, leases, and restrictions of every kind and description, except the permitted title exceptions, approved Leases and liens, and encumbrances to be released on the Closing Date.

J. No Liens: The interest of Seller in the Leases and the contracts and the licenses is free and clear of all liens and encumbrances and has not been assigned to any other person, except as reflected in the permitted title exceptions and liens and encumbrances to be released on the Closing Date.

K. Possession: Except for tenants under the approved Leases, there are no persons in possession or occupancy of the Property or any part thereof, nor are there any persons who have possessory or other rights or claims with respect to the Property or any part thereof.

L. Access: Seller has obtained all licenses, permits, easements, and rightsofway, including proof of dedication, required from all governmental authorities having jurisdiction over the Property or from private parties to make use of utilities serving the Property and to insure access and ingress and egress to and from the Property.

M. Zozing: The zoning classification of the Real Estate pursuant to the ____________________ Zoning Ordinances permits the operation of the Property for its current uses. The Improvements on the Property have been constructed and are presently used and operated in compliance with all licenses and all legal requirements, and with all covenants, easements, and restrictions affecting the Property, and all obligations of Seller with regard to the legal requirements, covenants, easements, and restrictions have been and are being performed in a proper and timely manner. Seller’s use of the Real Estate does not constitute a nonconforming use under applicable zoning laws and ordinances.

N. Utilities: All water, sewer, gas, electric, telephone, cable, and drainage facilities and all other utilities and public or quasipublic improvements upon or adjacent to the Property required by law or for the normal operation of the Property are installed, are connected under valid permits, are in good working order, are adequate to service the Property, and are fully paid for.

O. Improvements: All of the Improvements on the Real Estate are in good condition and have been properly maintained without deferring any appropriate maintenance for similar buildings since Seller’s ownership of the Property.

P. Environmental: No Hazardous Material (as defined below) has been used, generated, manufactured, stored, treated, released, or disposed of at, in, on, or under the Property in violation of any Environmental Law (as defined below); nor is the Property in violation of any Environmental Law.

As used in this Agreement, the term “Hazardous Material” means any substance or material that is or becomes regulated, defined, or designated by any federal, state, or local governmental authority as hazardous, extremely hazardous, imminently hazardous, dangerous, or toxic, or as a pollutant, contaminant, or waste, and shall include, without limitation, PCBs, asbestos, asbestos-containing materials, oil, and petroleum products and byproducts. As used in this Agreement, the term, “Environmental Law” means all current and future federal, state, and local statutes, regulations, ordinances, and rules relating to (i) the emission, discharge, release, or threatened release of any Hazardous Material into the air, surface water, groundwater, or land; (ii) the manufacturing, processing, use, generation, treatment, storage, disposal, transportation, handling, removal, remediation, or investigation of any Hazardous Material; or (iii) the protection of human health, safety, or the indoor or outdoor environment, including without limitation, the Clean Air Act; the Federal Water Pollution Control Act; the Resource Conservation and Recovery Act; the Comprehensive Environmental Response, Compensation and Liability Act; the Occupational Safety and Health Act; the Endangered Species Act; all amendments thereto; all regulations promulgated thereunder; and their state statutory and regulatory counterparts.

Q. Employees: With the exception of the management agreement, if any, there are no employment, employee benefit, or collective bargaining contracts affecting the Property. There are no employees of Seller engaged in the operation of the Property.

R. Compliance: Seller’s operation of the Property is in full compliance with all applicable laws, ordinances, codes, and orders and there are no governmental or private actions, proceedings, or notices pending or threatened against Seller for violation of any such laws, ordinances, codes, or orders.

S. Financial Reports: The Financial Reports fully, fairly, and accurately reflect and represent the financial results of the operation of the Property during the periods covered thereby.

T. Brokers: There are no brokerage fees or commissions due or which hereafter may become due in connection with any of the Leases (including any renewals or extensions thereof) that could result in a lien against the Property or any part thereof under I.C. 32-28-12.5-1 et seq.

U. Non-Foreign Investment: Neither the Seller nor any of the members, partners, shareholders (whether or not a controlling interest), officers, or directors of the Seller: (i) is listed on the SDN List (as defined below) maintained by OFAC (as defined below) or any other similar list maintained by the United States Department of State, Department of Commerce, or any other government authority or pursuant to any Executive order of the President; (ii) have been determined to be subject to the prohibitions contained in Presidential Executive Order No. 13224; or (iii) have been previously indicted for or convicted of any USA Patriot Act offense.

All such representations and warranties shall be reaffirmed as being true and correct on the Closing Date. Seller shall indemnify, defend, and hold Buyer harmless from and against any and all loss, cost, damage, and expense suffered, sustained, or incurred by Buyer as a result of any breach or untruth of any such representations and warranties. Such representations and warranties and Seller’s indemnity with respect thereto shall survive the Closing.

Representations and Warranties of Buyer. To induce Seller to execute this Agreement, Buyer represents and warrants to Seller as follows:

A. True and Correct: All representations and warranties of Buyer appearing in other Sections of this Agreement are true and correct.

B. Authority: Buyer has full capacity, right, power, and authority to execute, deliver and perform this Agreement and all documents to be executed by Buyer pursuant hereto, and all required action and approvals therefor have been duly taken and obtained. The individuals signing this Agreement and all other documents executed or to be executed pursuant hereto on behalf of Buyer are and shall be duly authorized to sign the same on Buyer’s behalf and to bind Buyer thereto. This Agreement and all documents to be executed pursuant hereto by Buyer are and shall be binding upon and enforceable against Buyer in accordance with their respective terms.

C. No Money Laundering: None of the funds to be used for payment by Buyer of the Purchase Price will be subject to 18 U.S.C. §§ 1956–1957 (Laundering of Money Instruments); 18 U.S.C. §§ 981–986 (Federal Asset Forfeiture); 18 U.S.C. § 881 (Drug Property Seizure); Executive Order Number 13224 on Terrorism Financing, effective September 24, 2001; or the United and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, H.R. 3162, Public Law 107-56 (the “USA Patriot Act”).

D. Non-Foreign Investment: Buyer is not, and will not become, a person or entity whom U.S. persons are restricted from doing business with under the regulations of the Office of Foreign Asset Control (OFAC) of the Department of Treasury, including those named on OFAC’s Specially Designated Nationals and Blocked Persons list (SDN List), or under any statute, executive order, including the September 24, 2001, Executive Order Blocking Property and Prohibiting Transactions with Persons Who Commit, Threaten to Commit, or Support Terrorism, the USA Patriot Act, or other governmental action.