Sameer Sah
Khaitan & Co, Mumbai
sameer.sah@khaitanco.com

Niyanta Munyal
Khaitan & Co, Mumbai
niyanta.munyal@khaitanco.com

What are material contract warranties?

Material contracts are those agreements that are essential to a company’s business operations and overall value. This can include a broad spectrum of agreements, such as customer contracts, supplier agreements, intellectual property licences and financing arrangements. While a buyer may focus on certain aspects in diligence while framing their investment and value hypothesis, the warranties are meant to be more overarching and tend to be related to these contracts, typically covering:

• validity and enforceability: the assurance that the contracts are legally sound and enforceable against the counterparty;
• no breach or default: the confirmation that the target company is not in breach of any material contract and has not received any notice of breach or default from the counterparty;
• accuracy of disclosures: the warranty that the target company has accurately disclosed all material contracts along with copies, etc, and any related disputes or potential liabilities;
• no approval or other consequence based on the transaction: a representation that the company does not require approval, or waiver, or no-objection from a counterparty as a result of this transaction, for instance, any change in control, or non-compete, or other such restriction;
• stamp duty: under Indian law, if stamp duty is not properly paid on contracts, those written documents cannot be admitted as evidence before a court of law.

The stakes of the game: implications of breach

A breach of material contract warranties can have a cascading effect on an M&A transaction, potentially leading to:

• price adjustment: the buyer may seek a reduction in the purchase price to reflect the diminished value of the target company due to the breach. This would typically only work for truly blockbuster contracts; else the seller is likely to negotiate it back;
• indemnification: the buyer may seek indemnification from the seller for any losses or damages incurred as a result of the breach. It will be important to assess how ‘loss’ is computed and what elements of ‘loss’ are covered within that definition. This is also typically heavily negotiated; or
• termination of the deal: in some cases, a material breach may give the buyer the right to terminate the transaction altogether. Again, if the contract is truly material, and has a significant impact on the business, it may also by itself constitute a ‘material adverse effect’ (MAE) or ‘material adverse change’ (MAC); however, again, the likelihood of that is slim.

Manoeuvring around the battlefield: key considerations for buyers and sellers

Buyers

• due diligence: It is paramount for buyers to conduct exhaustive due diligence to review all material contracts and assess their validity, enforceability and compliance with applicable laws and regulations. Also, to the extent possible, the buyer should also test the compliance with operational conditions within the contract – for instance, are there any insurance requirements?
• specific warranties: buyers should negotiate specific warranties that address the key risks associated with the target company’s material contracts, such as customer concentration, long-term commitments and potential regulatory changes;
• disclosure schedules: a meticulous review of disclosure schedules is essential to identify any exceptions to the warranties and assess their potential impact on the transaction. Buyers should also be careful while accepting documents forming part of the disclosure schedules to ensure that nothing has been missed during diligence. Sometimes, buyers may also require a listing of all ‘material contracts’ in the disclosure; and^[1]
• remedies for breach: buyers should negotiate clear remedies for breach, including price adjustment, indemnification and termination rights. Each of these would be a consequence of the commercial dynamics of the transaction and the negotiating positions and leverage of the parties. If there is truly some contract that constitutes a material enough aspect, and there are some activities to be undertaken in the future, buyers may also consider tranching the investments, and/or creating escrows and holdbacks. However, sellers will probably fiercely resist this.

Sellers

• accurate disclosures: sellers must ensure that all material contracts are accurately disclosed in the disclosure schedules, including any related disputes or potential liabilities;
• limitations on liability: sellers should negotiate limitations on liability for breach of warranties, such as caps on damages, time limits for claims and exclusions for certain types of losses;
• knowledge qualifiers: sellers should consider including knowledge qualifiers in the warranties to limit liability to matters within their actual knowledge. To the extent sellers are seeking data room or diligence disclosures, this will tend to be heavily negotiated based on the parties’ negotiating position and the pace of the sale process being run by the seller;
• post-closing cooperation: sellers may agree to cooperate with the buyer in addressing any specifically and clearly identified post-closing issues related to material contracts; and
• MAE definitions: sellers should be careful around the interplay between an MAE/MAC definition and specific contracts.

Lessons from the trenches: insights from legal battles

• in a case involving HSBC and Avitel, the Court emphasised the importance of accurate disclosures and the potential consequences of misrepresentation. HSBC invested in Avitel based on representations about a lucrative contract with the BBC, which turned out to be non-existent. The Court upheld an arbitral award in favour of HSBC, emphasising the seller’s duty to provide truthful information.^[2]  
• in another case involving Prodapt and Synophic Systems, the Court underscored the need for buyers to conduct thorough due diligence and assess the potential risks associated with material contracts. Prodapt acquired Synophic Systems but later discovered undisclosed breaches of ethics policies with a major client, Cisco. The Court upheld an order requiring the seller to provide security for potential damages, emphasising the buyer's right to protect its interests.^[3]  
• in a case between GWL Properties and James Mackintosh & Company, the Court highlighted the importance of clear and unambiguous language in the warranties and the need for sellers to stand by their representations. GWL sold its subsidiary, GWLL, to James Mackintosh & Company, but later disputes arose regarding the accuracy of the financial statements and the recoverability of certain debts. The Court upheld an arbitral award in favour of the buyer, emphasising the seller’s obligation to provide accurate information and the buyer’s right to rely on the warranties.^[4]  

Which contract is material, and which isn’t?

Determining whether a contract is ‘material’ in an M&A context often involves a qualitative and quantitative analysis of its impact on the target company. For instance, in the HSBC-Avitel case, the undisclosed BBC contract was deemed material as it was projected to generate substantial revenue, influencing HSBC’s investment decision.^[5] Similarly, in the Prodapt-Synophic case, the contract with Cisco, representing a significant portion of Synophic’s business, was considered material due to its impact on the company’s valuation and the buyer’s due diligence process. ^[6]    

Another approach to determining materiality is to assess the contract’s importance in relation to the overall business operations of the target company. In the GWL Properties-James Mackintosh case, the recoverability of GWLL’s receivables, representing a significant portion of its assets, was deemed material as it directly impacted the company’s financial health and the buyer’s valuation. ^[7] The Court emphasised the importance of accurate representation of these receivables in the financial statements, as they played a crucial role in the acquisition decision.  

Finally, materiality can be assessed based on the specific terms and conditions of the contract, such as its duration, exclusivity or termination clauses. For example, a long-term exclusive supply agreement with a key customer could be considered material as it would significantly impact the target company’s future revenue and profitability. Similarly, a contract with unfavourable termination clauses could pose a substantial risk to the buyer, making it a material consideration in the deal.

A well-informed and well-advised buyer will carefully consider what attributes, based on the target’s industry and business, distinguish key contracts and include those attributes in the definition of ‘material contracts’.^[8] A well-advised seller on the other hand will try to push for an objective threshold (such as revenue, expenditure, etc) or specific covenant elements (such as non-compete covenants, exclusivity covenants, intellectual property licences, etc). Ultimately, the determination of ‘materiality’ depends on the specific facts and circumstances of each transaction and requires careful consideration of both the qualitative and the quantitative aspects of the contract in question.

Business perspective on ‘material contracts’

While the earlier parts of this article explore the legal perspective of ‘material contracts’, the business perspective far transcends that. In the author’s view, the emphasis has to be on ‘material contacts’ as well – so that there is clarity that the relationships underlying these contracts are not compromised. If there are ‘key customers’ and ‘key suppliers’, should the buyer insist on meeting them, whether before or after signing? Has there been operational diligence to assess the level of internal controls that the target maintains in order to manage and administer contracts? Are all risks being quantified, tabulated and discussed or are they simply being neglected and allowed to fester? A financial review of contracts and their pricing, and payment terms, may provide hints to buyers about what efficiencies or value creation they can introduce post-closing. Also, particularly for strategic buyers, the question arises whether one can rely on their existing relationships with the same counterparties. There is also the question of whether the buyer is in fact a competitor or part of the competitor group of some of the counterparties. A classic example would be a buyer looking to forward-integrate in value-added services, being cognisant that the target at the same time is servicing, availing or cross-selling services from competitors of the buyer. Some or most of these are even incapable of quantification monetarily, but each and every one of these questions is a clear value determinant.

R&W insurance and ‘material contracts’

Representation and warranty (R&W) insurance is becoming a very significant dealmaking tool, helping to bridge the risk fjord for buyers and sellers. Such R&W insurance tends to be a significant function of the extent of due diligence – vendor, acquirer or both. The insurer is however highly likely to pressure-test the methodology of the diligence and the basis for identifying ‘material’ so far as the diligence is concerned. If the method is arbitrary or subjective, as opposed to methodical and objective, there is a greater chance to enter negotiations with the insurer around what qualifiers or underwriting they prefer to provide for contract related warranties.

Lack of written (long form) agreements

In today’s day and age of GST, it is near impossible for a company not to have written contracts. At the very least, targets will have tax invoices, and these invoices will have written terms and conditions behind them. Most targets will also have purchase orders or supply orders which either they will raise, or the counterparty will have raised on them. It is, however, fairly common in India not to have long form agreements where the relationship tends to be the basis of continued dealings. In these scenarios, one should at least consider capturing the ‘material suppliers’ and ‘material customers’ – howsoever one defines them – in some set of warranties (financial statements, operations, disputes, receivables, etc). Also, buyers may tend to push for long form agreements, but one would expect sellers to push back for reasons best understood by them. Again, the conclusion would be left to the parties’ commercial positions and negotiation strategies – there are no rights or wrongs on this.

Conclusion

Material contract warranties are a critical component of M&A transactions, providing buyers with assurance and protecting sellers from future liabilities. By conducting comprehensive due diligence, negotiating specific warranties and ensuring accurate disclosures, both parties can mitigate the risks associated with material contracts and pave the way for a successful M&A deal. The legal cases discussed above serve as valuable reminders of the potential pitfalls and underscore the importance of careful attention to detail in this complex area of law.