Reps and Warranties: El Convidado de Piedra or From Minor to Essential

Introduction

In Chile, the expression “el convidado de piedra” (“the stone guest”) is widely used. The phrase originates in The Trickster of Seville and the Stone Guest (El Burlador de Sevilla y el Invitado de Piedra), a play attributed to the Spanish dramatist Tirso de Molina. In the story, the protagonist, Don Juan, mockingly invites the stone statue of Don Gonzalo de Ulloa (a man he had previously murdered) to dine with him. To everyone’s astonishment, the statue comes to life and attends the dinner, becoming a “stone guest”, a guest who was at first irrelevant and ignored, yet ultimately drags Don Juan down to hell. In much the same way, “representations and warranties” have gone from being a relatively minor institution to one that can expose a contracting party to the largest damages award ever handed down in connection with an M&A transaction in Chile.

In share and business purchase agreements governed by Chilean law (a legal system rooted in the civil law tradition), representations and warranties clauses have become quite common, notwithstanding their common law origins, and are now regarded as essential and clearly significant features of M&A transactions. In this article we examine the scope of this institution, drawing primarily on the views of Chilean professors Enrique Barros, Nicolás Rojas, Enrique Alcalde, and Adrián Schopf.

Function of representations and warranties

The need to include representations and warranties stems from their role as a risk-allocation mechanism at the time of contracting, particularly in complex sale transactions where an information asymmetry typically exists between the parties.

The buyer is usually not in a position to have full knowledge of the conditions, characteristics, and contingencies of the company they intend to acquire. For this reason, the seller is required to make a series of statements, representations, or promises regarding the truthfulness of certain circumstances connected to the company, such as its financial, balance sheet or legal status, and even legal matters such as the ownership of specific rights or the company’s valid existence. These representations allow the buyer to rely on the conditions offered and to accept the economic terms of the transaction, given that the assumption of risk by either party is necessarily reflected in the purchase price.

These clauses also serve to facilitate negotiations between the parties. Indeed, the time that a buyer would need to exhaustively review and study every relevant characteristic of the target company could prove impractical, particularly since transactions of this kind must typically be completed within fixed timeframes. Even when the buyer conducts adequate due diligence, it remains exposed to various risks associated with inaccurate, incomplete, or unknown information. For this reason, the parties agree on representations and warranties to mitigate those risks.

The importance of these clauses is such that, in many cases, a representation or warranty that does not correspond to reality could have meant that the buyer would not have submitted an offer at all or would have submitted one at a price lower than that stated in the final offer.

This topic has become particularly significant in Chile today, as several major recent cases have involved precisely these issues: allegedly false or inaccurate representations or warranties and their effects on the sale of the respective company. In particular, a three-judge panel of the Arbitration and Mediation Centre (CAM) of the Santiago Chamber of Commerce recently ordered the largest damages award ever handed down in the context of a business sale, condemning a Chilean businessman (Isidoro Quiroga and family) to pay approximately USD300 million to the Chinese firm Joyvio for providing incomplete information in the sale of the salmon company Australis, considering that the representations and warranties were inaccurate.

Specifically, the award found that the sellers concealed the fact that the salmon farming operations were harvesting beyond the volumes permitted under applicable regulations, thereby compromising the sustainability of the business.

While the sellers' defence argued that the award in fact ordered a price adjustment not contemplated by the contract, what is relevant for the purposes of this article is that the tribunal characterised the breach of representations and warranties as a contractual default giving rise to a damages award.

Legal nature of representations and warranties

Regarding these representations, it is interesting to consider what happens when the buyer discovers that they are inaccurate or false ie, when a breach of the agreed representations and warranties occurs.

To determine the legal consequences faced by a party who made erroneous or false representations, it is first necessary to examine the legal natureof  such representations. This analysis will determine what remedies are available to the buyer when confronted with such a situation.

In this context, the question arises as to whether the breach of a representation and warranty amounts to the breach of a contractual obligation under the purchase agreement, given that such representations have been agreed upon within the contract itself. From a legal standpoint, an obligation may be defined as a legal bond between two specific persons – debtor and creditor – by virtue of which the former is legally required to give, do, or refrain from doing something in favour of the latter. In this sense, an obligation is identified with a specific performance, so that for the buyer to have a claim against the seller, there must be a failure to satisfy the performance owed.

However, when a representations and warranties clause is agreed upon, this is not entirely straightforward. The performance that flows from such a clause in the purchase agreement consists solely in declaring that a certain circumstance accords with reality. There is no obligation to give, do, or refrain from doing in the strict sense of Article 1438 of the Chilean Civil Code; there is only the assertion that something is true, which may subsequently prove not to be the case.

In this regard, Professors Enrique Barros and Nicolás Rojas argue that representations and warranties do constitute obligations under a modern conception of contract law, in which weight is given to the purpose pursued by the parties at the time of contracting and to the allocation of risks they have assumed. From this perspective, if the parties contracted on the basis that certain circumstances were in fact true, the falsity or inaccuracy of those representations must necessarily amount to a contractual breach.

Accordingly, we consider that there is no difficulty in characterising representations and warranties as obligations of result, since their function is not merely to deploy a certain course of conduct, but to ensure that what is declared is actually true. Therefore, if the representations prove to be false or inaccurate, there would be a contractual breach giving rise to liability on the part of the party who made them.

Professor Adrián Schopf, for his part, argues that representations and warranties correspond to true guarantee obligations, by virtue of which the debtor assumes all risks associated with the truthfulness of the declared circumstances, even in cases of fortuitous event or force majeure. Accordingly, the party who makes the representations guarantees a specific outcome, allowing the counterparty to rely on them without needing to exhaustively verify each of the stated circumstances and, therefore, always bears the consequences of that outcome not being achieved (Schopf, 2023). This promotes certainty and the smooth flow of commercial transactions, particularly in complex operations such as business sales, and aligns with the parties’ interests (Tapia Rodríguez, 2010).

On this basis, Professor Schopf contends that guarantee obligations constitute a separate and more rigorous category than obligations of result, since the debtor assumes all risks associated with the breach of the representations, with no practical possibility of being exonerated from liability. In this way, the seller is liable in all events for the frustration of the guaranteed outcome, and its liability flows precisely from the mere falsity of the representations made and from the objective allocation of the risks associated therewith (Schopf, 2023).

Remedies available to the buyer for false or inaccurate representations and warranties

Having established the legal nature of representations and warranties, it is appropriate to consider what remedies are available to the buyer when such representations prove to be false or inaccurate. In particular, it is important to determine the legal mechanisms recognised under Chilean law that allow the buyer to obtain compensation for the damages caused by such inaccurate statements incorporated into the agreement.

Representations and warranties and hidden defects

It is interesting to mention the traditional approach that has connected false or inaccurate representations and warranties with hidden defects (vicios redhibitorios). One of the seller's obligations is to deliver the sold assets in conditions that allow the buyer to enjoy it usefully and without disturbance, so that mere physical delivery is insufficient. That obligation is breached when the good has defects rendering it useless or substantially diminishing its utility. In such cases, the buyer may bring the redhibitory action set out in Article 1857 of the Chilean Civil Code, aimed at obtaining rescission of the sale or a proportionate reduction of the price on account of the hidden defects in the thing sold.

False representations and warranties as a defect of consent

Likewise, the falsity of representations and warranties could constitute a defect of consent within the meaning of Article 1458 of the Chilean Civil Code, which regulates wilful misconduct as a defect of consent and allows the rescission of the contract when such wilful misconduct is committed by one of the parties and was decisive for entering into the agreement, thereby constituting grounds for relative nullity. In this regard, Alcalde argues that the filing of a nullity action does not preclude a simultaneous claim for damages, since nullity also seeks to restore the parties to their pre-contractual position. In the author’s view, this solution finds support in the general spirit of the legislation and in various provisions of the Chilean Civil Code, including Articles 1353, 1455, 1458, and 1814 (Alcalde, 2008).

Contractual liability arising from false representations and warranties

If representations and warranties are understood to constitute actual contractual obligations – whether obligations of result or guarantee obligations, as Professors Barros and Rojas maintain and Schopf argues more strictly – the mere falsity or inaccuracy of such representations would be sufficient to constitute a contractual breach, even if there is no negligence or wilful misconduct. In that case, the seller would be liable for the damages caused to the buyer pursuant to Article 1489 of the Civil Code, without being able to excuse itself by claiming to have acted with due diligence, since compliance with these obligations does not depend on the effort exerted by the debtor, but on the actual truthfulness of what was warranted (Barros and Rojas, 2010).

Without prejudice to the foregoing, if representations and warranties were not regarded as obligations of result or guarantee obligations, but as best-efforts obligations (obligaciones de medios), it would be necessary to determine the applicable standard of diligence to the seller. In Professor Alcalde’s view, this cannot be resolved solely by reference to the general rule of Article 1547 of the Chilean Civil Code but must be analysed in light of the principle of good faith enshrined in Article 1546 of the same statute. Indeed, having regard to the information asymmetry between the parties and the fact that the party making the representations is in a privileged position to know the accuracy of what it is warranting, the applicable standard of diligence could extend even to slight negligence (Alcalde, 2008).

This approach was reflected in the judgment rendered in the Australis Seafood case, which, while finding no fraud on the part of the sellers, held that there had been a failure to disclose or a concealment of “suspicions” (which even the sellers’ own counsel characterised as suspicions of acts by third parties and of future regulatory changes) and, on that basis, found that the inefficacy of the representations and warranties gave rise to a damages award.

The foregoing leads to the conclusion that a buyer affected by false or inaccurate representations and warranties may bring nullity or termination actions, as appropriate, as well as the corresponding damages claim. This is because specific performance of these obligations is impossible, since the performance at issue consists precisely in the truthfulness of what was declared. Accordingly, the damages claim may be pursued autonomously, even when the buyer decides to keep the contract in force. In this regard, Professor Alcalde contends that the buyer’s ability to preserve the contract and still claim damages under Article 1814, third paragraph of the Chilean Civil Code demonstrates the autonomous character of the damages action relative to nullity, termination, or specific performance actions (Alcalde, 2008).

Similarly, the Supreme Court, in its judgment in Zorín v Compañía Siderúrgica Huachipato S.A., recognised that autonomy by holding that damages form part of the full performance of the obligation pursuant to Article 1591 of the Chilean Civil Code. In that case, a company purchased disused rolling mill rolls from another company with the intention of reselling them. However, since the chemical composition of the rolls did not correspond to what had been offered by the seller, which prevented their resale, the buyer brought a damages action. The trial court upheld the damages claim in its entirety, but the Court of Appeals limited recovery to actual damages and damages for loss of profit. This ruling was appealed by both parties, and the Supreme Court upheld the formal cassation (casación en la forma) appeal filed by the defendant. In its replacement judgment, the Supreme Court awarded compensation solely for loss of profits but reaffirmed the autonomous nature of the damages action.

Professor Alcalde argues that if the representations prove to be false or inaccurate despite the seller having acted with the required diligence, indemnification liability would arise, since neither wilful misconduct, fraud nor fault attributable to negligence take place. He also considers that a proportionate reduction of the price could still be sought, provided the claim does not pursue the non-existence, nullity, or termination of the contract (Alcalde, 2008). However, that solution would only be applicable if representations and warranties are regarded as best-efforts obligations rather than as obligations of result or guarantee obligations. We consider this last option to be less appropriate, as the obligation should be considered an obligation of result.

Indeed, given that these clauses are designed precisely to mitigate the information asymmetry between the parties, and that the duty to disclose information lies with whoever is in the best position to know the relevant details of the transaction, accepting the contrary would enable the seller to excuse itself by satisfying a certain standard of diligence. By contrast, where the obligations are ones of result or obligations of guarantee, the mere inaccuracy or falsity of what was declared suffices to constitute a breach and to give rise to the obligation to compensate the buyer for the resulting damages.

Conclusions

In conclusion, representations and warranties serve an essential function in business sales, since they allow the risks arising from information asymmetry between the parties to be allocated properly and provide certainty with respect to certain material circumstances of the transaction, which, had the buyer known them, might even have led it not to submit a purchase offer. For this reason, their falsity or inaccuracy – even in the absence of wilful misconduct or deliberate concealment by the seller – may constitute a true contractual breach, particularly when they are understood as obligations of result or guarantee obligations, under which the seller is responsible for the accuracy of what was warranted.

In addition, the buyer has a range of legal remedies available in relation to such breaches, including nullity actions, termination actions and damages claims, which may even be pursued autonomously when the buyer does not consider it in its best interest to seek a declaration that the purchase agreement must be terminated or resolved.