Seller representations are often the most carefully negotiated provisions in a real estate purchase and sale agreement.
Seller representations serve two related functions; first, they fill in gaps on the buyer’s legal and physical due diligence since there are certain items the buyer is either unable to independently verify (i.e., that the seller has not received specific notices relating to the property) or is not contractually permitted to independently verify (i.e., certain matters that would involve prohibited contact with a tenant). Second, the risk of a failure of such seller representations are allocated such that a buyer can look to the seller for recovery in the event of a failure.
While these types of representations are heavily negotiated, it is alarmingly common for purchaser’s attorneys to neglect to include any “teeth” by way of appropriate credit support for seller’s surviving liabilities. Since real estate assets are commonly held in special purpose bankruptcy remote entities, it is highly likely the seller will have little to no net worth after closing, effectively hampering any potential recovery efforts.
There are three essential pieces any purchase agreement needs to include to provide some financial backstop to the accuracy of seller representations:
Together, these three elements can accomplish the ultimate goal of seller representations: allocation of risks related to the property as between buyer and seller.
The “merger doctrine” of property law states that the provisions of the contract of sale “merge” into the deed of conveyance. Therefore, any obligations in the contract that are not also either reflected in the deed or expressly stated to survive are extinguished upon recording the deed. All real estate purchase agreements should therefore include an express statement of survival.
Once the parties have agreed the seller will remain liable for certain of its representations after closing, it becomes necessary to define a scope of exposure. Market standard has settled on defining the scope of the seller’s liability by including a “maximum liability cap” as well as a survival period where any claims made after such period are uncovered. These are, of course, heavily negotiated and leverage-dependent; however, a reasonable rule of thumb is that the maximum liability cap should be between 2–5% of the purchase price and the survival period should be between six and 15 months after closing.
Purchasers cannot lose sight of the fact that during the battle around representations, the war is won or lost on the economic substance that will bolster these contractual obligations. The risk allocation achieved by a comprehensive list of seller representations is useless without accessible cash to backstop any resulting liability.
It is instructive to understand what would happen in the instance where there were no post-closing credit provision in the PSA. This is optimal for sellers, as it would allow the entire proceeds of the sale to be distributed to investors immediately without any delay or holdback. In addition, since many properties are owned via special purpose entities, it would allow the seller to almost immediately liquidate the entity and “close the books” on the transaction. Not so for a purchaser: in order to pursue funds that have already been distributed up through a corporate structure, a purchaser would have to “pierce the corporate veil” and trace the proceeds of the sale to their ultimate recipients. Unless the liability involved were inordinately high, the expense of pursuing this course will almost surely be higher than the disputed amount under the PSA.
Noted below are brief descriptions of the most common credit enhancement options and some of their relative benefits and drawbacks.
Having confirmation and assurance from the seller that it will maintain a net worth of a minimum amount confirms to the buyer that the seller will be able to satisfy a judgment. This can be appealing to the seller because it eliminates the need to set aside any proceeds of the sale, allowing for immediate distribution and use of funds.
However, from a buyer’s perspective, having a net worth covenant does not truly guarantee their ability to recover. If the seller breaches its representations and warranties, what is stopping them from breaching their net worth covenant as well? Additionally, to enforce the obligation, the buyer would have to commence proceedings in court, which can be costly and introduce a further element of uncertainty. It may be burdensome to continuously monitor the net worth of the seller—the only practical way to verify the seller is in compliance with the net worth covenant is to require periodic bank statements or other documents to prove the minimum net worth is being maintained. This also may present the buyer with confidential information about the seller, which may be problematic for both parties.
A guaranty or joinder from an affiliate of the seller can be a very flexible way to please both parties. The scope of the guaranty can be tailored to fit the specifications of the transaction and not create excessive risk for buyer or seller. Funds are not required to be set aside in advance under a guaranty or joinder, and as such, the seller can immediately make use of the sale funds or distribute to investors.
However, a guaranty is only as good as the party issuing it. There is a risk the guarantor will liquidate its assets before the end of the survival period, making the chance of recovery difficult for the buyer upon a seller default. Additionally, if the affiliate guarantor and the seller go into bankruptcy concurrently (not uncommon for interrelated companies), the secured creditors of both the guarantor and the seller will come before the unsecured creditor that only has a parent guarantee. This can become an issue when the guarantor has given many guarantees for affiliates such as the seller; while the guarantor appears to have deep pockets, if a group company defaults across more than one purchase and sale agreement, the affiliate’s numerous outstanding guarantees may diminish its net worth, possibly leaving nothing for the buyer to recover from. Proper due diligence must be conducted to determine not only the creditworthiness of the guarantor, but also its outstanding commitments and liabilities to effectively evaluate the viability of the guaranty.
A letter of credit is a letter issued by a bank that serves as a guarantee of payment, with disposition governed by a separate agreement. The bank is independent of the parties and its obligation to honor the letter of credit is independent of the obligations of the parties—the bank issues the credit simply based on whether the terms and conditions under the letter of credit are met. Letters of credit are highly customizable and can be as elaborate or simple as the parties agree upon to trigger payment. Ultimately, it transfers creditworthiness from the seller to the bank—banks are generally creditworthy and stable and protect against seller bankruptcy risk.
However, letters of credit do not come without their risks. Letters of credit carry currency risks in the purchase face value and respective currency fluctuations. Letters of credit also require a fee to implement, which can be as much as 1% annually of the face amount. Additionally, a letter of credit requires the seller to deposit the face amount with the bank during the term of the letter of credit, meaning that the proceeds from the sale cannot be distributed until post-survival period.
An escrow holdback occurs when part of the closing funds are set aside in escrow (kept by a third party and taking effect only when specific conditions are satisfied) until the end of the survival period. An escrow holdback allows for both liquidity and a specifically targeted risk allocation and certainty with respect to the amount that can be recovered in case of a breach. The party holding the escrow holdback can be an independent third party (typically a title insurance company), and the funds typically are released if/when the conditions under the agreement are met.
From a seller’s perspective, this may not be a very desirable option. As with a letter of credit, the seller’s investors do not receive some of the proceeds until post-survival period. It requires a further escrow agreement between the parties to govern its disposition, which requires more time and cost to negotiate. There may also be escrow holdback fees. Lastly, the recent low-interest rate environment makes funds in holdback and escrow accounts relatively stagnant.
In real estate transactions, the “black swan” risks are relatively limited—the essential items that could materially affect the continuing viability of the investment are structural integrity of the asset, environmental issues, issues with leases and a failure of title. These risks can be allocated away from the buyer by, respectively, an engineering report, a Phase I environmental site assessment (and related adjustment to the purchase terms, if necessary), legal analysis of the leases and title insurance. For these reasons, buyers of real estate tend to get comfortable with the credit of their seller and do not generally pursue the risk-shifting that RWI offers.
RWI may provide some competitive advantage to real estate purchasers in a bid context. Frequently, the seller of a desirable asset will solicit bid packages that include marked up versions of a form PSA provided to all potential buyers. In this context, some aggressive bidders may pursue RWI as opposed to a seller liability concept because their PSA will look better both optically and financially to the seller.
RWI becomes an important element of a real estate deal when the asset being acquired is a REIT. In that case, purchasers frequently buy RWI to protect against a failure of REIT status of the target. Such a failure could result in the acquirer being saddled with a large tax bill, and RWI can effectively manage that risk.
RWI can come at a significant cost. In addition, the insurer will need to conduct its own due diligence on the transaction and the parties involved to set the insurance premium, requiring insurer to be brought in early in the deal to confer with buyer and seller’s counsel.
A personal guaranty acts as another assurance to the buyer about the seller’s commitment to ensure recovery in case of a breach. It allows business operations to carry on and sale funds to be distributed without any sort of holdback, making it a desirable option for a seller. However, as with a guaranty or joinder from an affiliate of the seller, the guaranty is only as good as the person delivering it—there is always a risk of personal bankruptcy or barriers to recovery from the guarantor.
Including some form of post-closing credit enhancement is an important practice point for all real estate purchase agreements. Too often, this essential financial protection is not given the appropriate focus it deserves in preserving the buyer’s route to recovery for any post-closing breaches of representations. There are a number of good options to achieve this goal, so attorneys and business people should enter any transaction negotiation with a full quiver of arrows with respect to this issue.