What are Representation and Warranty Clauses in Investment Agreements?

Investment contracts often include Representations and Warranties clauses. In corporate legal affairs, particularly in the case of M&A, such clauses may be stipulated in business transfer agreements or share transfer agreements. Furthermore, these clauses can also become an issue in copyright transfer agreements and license agreements. Despite the potential issues arising from these clauses in various contracts, it seems that there is not always a sufficient understanding of what these clauses are and what they legally mean. Therefore, in this article, we will explain the general concept of Representations and Warranties clauses and discuss their role in investment contracts.

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What is a Representation and Warranty Clause?

A representation and warranty clause is a provision in a contract where one party, at a certain point such as at the time of contract conclusion, makes a statement to the other party about certain facts related to the contracting party, the contract content, facts related to the contract, or facts about business activities, and guarantees the content of those statements. The representation and warranty clause originates from Anglo-American law and is sometimes referred to as “Reps and Warranties”.

The Significance of Representation and Warranty Clauses

As the representation and warranty clause originates from Anglo-American law, we will first explain its significance in Anglo-American law, and then in Japanese law.

The Significance of Representation and Warranty Clauses in Anglo-American Law

The origin of the representation and warranty clause in Anglo-American law is thought to be the theory of ‘misrepresentation’, a false statement that misleads the other party to the contract. Misrepresentation can also be made about facts that are not directly related to the contract (such as facts inducing the contract), so it is not always the case that misrepresentation is made about the contract content. Therefore, the theory of misrepresentation was developed to seek remedies in tort law, not as a breach of contract, but as a type of fraud or error, regardless of the intent or negligence of the person who made the misrepresentation, with the aim of protecting the other party. Under such circumstances, the theory of incorporating misrepresentation into contract clauses and imposing warranty liability on the party who made the misrepresentation has developed in practice, and it is believed that the theory of representation and warranty clauses has evolved.

The Significance of Representation and Warranty Clauses in Japanese Law

As the above theory of Anglo-American law has been adopted in Japanese contract practice, there are many cases where representation and warranty clauses are stipulated in M&A, financial transactions, investment contracts, etc. The significance of representation and warranty clauses in Japanese law can basically be considered in the same way as in Anglo-American law. That is, it is considered to have the significance that one party to a certain contract represents and warrants the truthfulness and accuracy of certain premise facts related to the contract to the other party at a specific point in time.

Function of Representation and Warranty Clauses

Despite the stipulation of representation and warranty clauses in a contract, if it becomes clear that there has been a violation of these representations and warranties, the party who committed the violation is obligated to compensate the other party for any damages incurred, regardless of whether the violation was intentional or due to negligence.

Furthermore, if there is a violation of the representations and warranties, the following penalties may be considered:

• It could be a reason for contract termination
• The other party may refuse to fulfill their contractual obligations on the grounds that the preconditions are different
• In the case of a share transfer agreement, it could be a reason for adjusting the transfer price of the shares
• In the case of a loan for consumption, it could be a reason for loss of the benefit of the term

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Representations and Warranties in Investment Agreements

We have previously discussed representations and warranties. However, in the case of investment agreements, it is necessary to stipulate representations and warranties in accordance with the nature of the agreement. Therefore, we will explain the representations and warranties in investment agreements below.

Contents of Representations and Warranties in Investment Agreements

The contents of the representations and warranties in investment agreements are made based on the prerequisite conditions necessary for the investor to make the investment.

Specifically, the company will make the following representations and warranties:

• The financial statements disclosed to the investor have been prepared based on fair accounting standards
• There are no hidden liabilities not listed in the financial statements, and the company is not being sued by other companies
• The procedures within the company related to the issuance of shares have been carried out legally and effectively
• The information contained in the articles of incorporation, shareholder register, business plan, certificate of registered information (copy of the registry), and other documents related to the company’s business operations, finances, and personnel that have been disclosed to the investor accurately reflect the latest content and are appropriate and sufficient for important points
• There are no facts other than those disclosed to the investor that could have a significant impact on the investor, and there is no possibility of such facts occurring in the future
• The company has no substantial relationship with antisocial forces, etc.

Functions of Representations and Warranties in Investment Agreements

The functions of the representations and warranties in investment agreements are as follows:

Function to Supplement Due Diligence (DD)

Investors, especially when they are venture capital (VC), usually conduct DD on the companies they invest in. However, there are limits to the scope of what can be investigated in DD, and there are also issues of time and cost. Therefore, it is conceivable that the company will make representations and warranties about matters that the investor could not fully investigate in the DD.

Due Diligence (due diligence)

This refers to a series of detailed investigations conducted in advance for the purpose of properly evaluating the value of the investment target, etc., when an investor makes an investment or a financial institution undertakes underwriting, etc. It is often conducted in cases of corporate acquisitions and restructuring. By conducting due diligence, investors can understand the situation of the investment destination in advance, and for example, in the case of corporate acquisitions, negotiations on the purchase price and acquisition conditions are conducted based on the facts revealed there.

Kazuyuki Takahashi et al., “Small Dictionary of Law” p. 963 (Yuhikaku, 5th edition, 2016)

Function to Trigger Penalties for Breach of Representations and Warranties

This is essentially the same as the function of the representations and warranties mentioned above. However, there is a view that the legal nature of a breach of representations and warranties is not a problem of non-performance of obligations, as representations and warranties are not obligations that the company has under the contract.

Therefore, if there is a breach of the representations and warranties, it is necessary to specifically state in the investment agreement what kind of penalty the violator will incur.

Examples of Representations and Warranties in Investment Agreements

Examples of representations and warranties in investment agreements can include the following clauses:

Article 5 (Representations and Warranties)
The issuing company and the management shareholders jointly represent and warrant to the investor that the following facts are true:
(1) The issuing company has been legally established and is validly existing.
(2) The issuing company has the necessary capacity and authority to enter into and perform this agreement and to issue the shares under this agreement, has completed all necessary internal procedures for the issuance of the shares, and the conclusion and performance of this agreement and the issuance of the shares do not violate any laws, ordinances, rules, directives, the articles of incorporation of the issuing company or any other rules or contracts to which it is a party, and if any procedures such as approvals, notifications, etc. are required for the conclusion and performance of this agreement and the issuance of the shares, such procedures have been completed.
(3) The business operations of the issuing company are being conducted legally and properly, and if licenses, permissions, approvals, registrations, and notifications are required for the business operations, they have been properly implemented.
(4) The contents of the shares [and stock acquisition rights] to be issued by the issuing company are as stated in the documents submitted by the issuing company to the investor.
(5) There are currently no legal proceedings, labor disputes or other administrative or tax procedures pending against the issuing company, nor is there any risk of such.
(6) The descriptions and information in the business plan, financial statements, shareholder status including potential shares, and other documents related to the business operations, finance, personnel, etc. of the issuing company, which were presented and delivered by the issuing company to the investor, are true and accurate.
(7) The issuing company has legally prepared and submitted tax returns to date, and there are no facts of non-payment or delinquency of taxes to be paid in the past or present.
(8) Neither the related parties of the issuing company (as defined in Article 112, Paragraph 4 of the Company Accounting Rules) nor its shareholders are so-called antisocial forces or similar entities (hereinafter referred to as “antisocial forces, etc.”), and they are not cooperating or involved in the maintenance and operation of antisocial forces, etc. through the provision of funds or similar acts to antisocial forces, etc., nor do they have any interaction with antisocial forces, etc.

General Incorporated Association Computer Software Association, “Investment Agreement Seed Round (No Non-Competition Obligation)”, https://www.csaj.jp/documents/activity/project/startup/Contractsample_3-1.pdf, (September 6, 2019)

Summary

In conclusion, we have explained the representation and warranty clauses in investment contracts. The prerequisites for making an investment are important for companies receiving the investment and for investors making the investment. Therefore, it is necessary to carefully consider the contents of the representations and warranties when concluding an investment contract. Furthermore, the contents of the representation and warranty clauses in an investment contract vary depending on the information already disclosed by the company, the contents of the due diligence conducted by the investor, and the contents of the investment contract. The contents of the representations and warranties are not standardized, so please make sure to have them drafted by a legal expert or undergo a legal check by a lawyer.