What is a representation?
A representation is a statement of present or past fact intended to induce another party to take (or not take) some action.[i] It is different from the other components of a contract because it is not a promise. There is no agreement to do or not do something; a representation merely states “this is what is.” Unlike promises, which are breached when a party violates the promise, representations can be misrepresented. Unless dealt with explicitly in a contract, this has the potential to give rise to certain remedies that may not otherwise be available (more on this below).
What is a warranty?
Warranties are promises made regarding a fact (which may also be a representation).[ii] These promises can be made about past, present, and future facts, such as a warranty that a product will work for a specified amount of time. Since warranties are promises (like a covenant), when they are violated they are breached, giving rise to typical contract damages.
How are they used to mitigate risk?
Risks arise when a party has imperfect information. In mathematical terms, risk has a direct, positive relationship with uncertainty, which should come as no surprise. Mitigating risk, therefore, becomes an effort in reducing uncertainty, which in the setting of a contract is done, in part, with reps and warranties.
Reps and warranties have an inverse relationship to risk, meaning the more one can get from the other party, the more asset risk is accounted for and transformed into deal risk by creating opportunities to exercise a remedy. Effectively, deal risk can be shifted between parties until an equilibrium is reached. Given the realities of doing business, “equilibrium” does not necessarily mean a 50/50 split in deal risk. Instead it is the point at which both parties are within their acceptable range for deal risk and are ready to proceed with contract execution.
While reps and warranties obviously directly reveal information about the respective parties position, they also indirectly reveal information. For example, if one asks for a representation about a certain fact and the other party refuses to make that representation, that refusal can be just as revealing regarding their position going into the contract.[iii]
[i] Richard K. Neumann, Jr., Transactional Lawyering Skills (2013).
[ii] See Neumann.
[iii] See Neumann.