Can buyer sue for false representations and warranties after closing despite advance knowledge?

Can a Buyer Close on the Purchase of a Business Knowing that the Seller's Representations and Warranties are False and Still Sue for Breach of Those Warranties?

A buyer signs an agreement to purchase ABC Corporation or its assets.  The lengthy purchase agreement contains numerous representations and warranties, or “reps and warranties” as they have come to be known.  After signing the purchase and sale agreement, while conducting due diligence, the buyer discovers facts which render the representations and warranties false.  Will the buyer waive all rights by closing with the knowledge that some or all the representations and warranties are false?

One could certainly justify arguing that the buyer should not be able to recover damages where the buyer knowingly decides to close with knowledge of the breach prior to closing.  But the reality of commercial transactions involving the sale of businesses is rarely that clear.  In large and complex business transactions, sellers are often required to make express written representations and warranties in lengthy purchase and sale agreements dealing with many issues.[1]  The representations and warranties can range over a number of matters, but often relate to the nature of the assets to be sold and the accuracy of financial records provided to the purchaser for valuation of the company or assets to be purchased.  Even when the buyer questions the accuracy of the seller’s representations and warranties, it is not always obvious from the onset that they are inaccurate.  This is especially true where the seller has owned the assets or business to be sold for some time and, therefore, has superior knowledge.  Thus concluding that by closing the buyer waives all rights to allege a breach of representation and warranty where the buyer suspected that the representations and warranties were false may be short sighted.

Although Florida’s Supreme Court has not yet ruled on whether proof of reliance on a written warranty of a purchase agreement is necessary to prevail on a claim for breach of express representation and warranty, other jurisdictions have allowed such claims despite the buyer’s knowledge of the breach prior to closing.  Therefore, with some safeguards, a buyer who discovered facts that made the warranties untrue may still be able to maintain claims against the seller despite choosing to close on the transaction with this knowledge, so long as the buyer discovered the breach after executing the purchase and sale agreement and takes some steps to preserve its rights under the agreement.  Because Florida’s Supreme Court has not yet ruled on this issue, this article will explore the approaches taken by other jurisdictions as well as Florida’s Federal Courts.

Knowledge of Facts Constituting a Breach of Warranty Prior to Closing Will Foreclose a Tort-Based Claim Sounding in Fraud

            Reliance on representations and warranties is likely to be a key issue in any case alleging a breach of the warranty provisions of a purchase and sale agreement.  For example, the seller being sued because the warranted financial statements provided to his buyer overstated income will likely defend on the basis that the purchaser knew the financial statements were exaggerated, or understood the true method used to record the questionable income, and that the buyer failed to rely on the misrepresentation when closing on the transaction.  This type of defense is based upon the well known tort law principle that one cannot justifiably rely on a representation known to be false and, therefore, cannot maintain a claim for fraud.[2]  This may very well be a valid and successful defense for tort claims such as fraud or negligent misrepresentation.  However, this principle does not necessarily mean that the buyer is without any remedy or that the seller is without liability. 

Other Jurisdictions Have Reasoned that Reliance Should Not Be Made An Element of a Claim for Breach of Express Written Warranty

Perhaps the most influential and often cited case supporting the proposition that reliance is not a necessary element of a breach of express written warranty claim is New York’s Court of Appeals’ opinion in CBS, Inc. v. Ziff-Davis Publishing Co.[3]  In that case, CBS contracted to purchase certain businesses owned by Ziff-Davis based upon financial information Ziff-Davis supplied.  Ziff-Davis warranted the truthfulness of the previously supplied financial information in the purchase and sale agreement.  Specifically, Ziff-Davis warranted that the audited income and expense reports of the businesses had “been prepared in accordance with generally accepted accounting principles,” and that an expense report fairly presented the items set forth therein.[4]  The purchase agreement further provided that “all representations and warranties of seller to buyer shall be true and correct as of the time of closing,” and that “all representations and warranties shall survive the closing, notwithstanding any investigation made by or on behalf of the other party.”[5] 

During due diligence and before closing, CBS uncovered information from documentation provided by Ziff-Davis leading CBS to conclude that Ziff-Davis had misrepresented the financial condition of the businesses CBS was to purchase.  When CBS notified Ziff-Davis of its concerns, Ziff-Davis contended that there was no misrepresentation and indicated its intent to hold CBS to the agreed-upon closing date.  Accordingly, CBS notified Ziff-Davis of its decision to close, but that the closing should not constitute a waiver of any of its rights under the purchase agreement.  CBS documented in a written notice to Ziff-Davis that a clear dispute existed between the parties.  CBS’s notice further stated that it had decided to proceed with the deal because it had spent considerable time, effort and money in complying with its obligations and recognized that Ziff-Davis had considerably more information available.  Following the closing, CBS filed suit for breach of warranties. 

Ziff-Davis defended the lawsuit by arguing that CBS’s manifested disbelief in or reliance on the truth of the warranted information prior to the closing relieved Ziff-Davis of its obligations under the warranties. In other words, Ziff-Davis argued that no claim for breach of representation and warranty could stand in light of CBS’s pre-closing expression of disbelief in the truth of the facts warranted resulting from CBS’s due diligence investigation after signing the purchase and sale agreement.  The New York Court of Appeals disagreed and held:

The critical question is not whether the buyer believed in the truth of the warranted information, as Ziff-Davis would have it, but whether it believed it was purchasing the seller’s promise as to its truth.  The view of ”reliance – i.e., as requiring no more than reliance on the express warranty as being part of the bargain between the parties – reflects the prevailing perception of an action for breach of express warranty as one that is no longer grounded in tort, but essential in contract.  The express warranty is as much a part of the contract as any other term.  Once the express warranty is shown to have been relied upon as part of the contract, the right to be indemnified in damages for its breach does not depend on proof that the buyer thereafter believed that the assurances of fact made in the warranty would be fulfilled.  The right to indemnification depends only on establishing that the warranty was breached.” [6]

New York’s Court of Appeals adopted the “basis of the bargain” approach.  Under this analysis, the critical inquiry is whether the purchaser believed he was buying the seller’s promise as to the warranted information as “part of the bargain when he signed the contract.”[7]  The CBS Court concluded that CBS had purchased Ziff-Davis’s promise as to the existence of the warranted facts and that Ziff-Davis should not be relieved of responsibility simply because, after agreeing to make the purchase and after executing the contract, CBS formed doubts during its due diligence as to the existence of those facts.[8] 

The CBS court’s analysis is based on the belief that a contrary holding would have the effect of depriving the express warranties of their only value to the buyer – i.e., to indemnify the buyer if the warranted facts prove to be untrue.[9]  It would also encourage parties not to engage in extensive due diligence because without the due diligence, there would be no reason for the buyer to disbelieve the seller prior to closing. 

Moreover, as noted by the CBS court, a contrary holding might also put a purchaser in a catch-22 position.  If the buyer decides not to close on the transaction, it may be liable to the seller if it later turns out that the buyer was wrong and the warranties were accurate.  Since the seller is likely to have more information about the representations and warranties, this is a real risk many buyers may not be willing or able to take.  On the other hand, if the buyer closes and confirms that the representations and warranties were false, the buyer may suffer unrecoverable damages if the law were to require the buyer to demonstrate reliance on the accuracy of the information provided.  Putting buyers in such a precarious position would not be commercially reasonable. 

The representations and warranties in complex purchase transactions are designed to specifically and predictably define and apportion the risks between the parties, a prediction necessary for many commercial transactions.[10]  To meet this predictability, to the extent there is a “reliance element,” it should be limited to the buyer’s reliance upon the existence of the seller’s promise to indemnify the buyer for any false representation or warranty, not reliance on the information actually supplied. The buyer’s “reliance” on the seller’s promise should be established if the warranty is part of the parties’ contract.  If the warranty is part of the written contract, it is fair to assume that its inclusion was at the buyer’s insistence to protect the buyer and that the buyer relied on the provision when committing to pay the purchase price.[11]

The CBS rationale has been adopted by a number of courts from different jurisdictions.  See e.g., International Paper Co. v. Androscoggin Energy LLC, 2002 WL 31507176 (N.D. IL 2002) (applying Maine law); Wikoff v. Vanderveld, 897 F.2d 232 (7th Cir. 1990) (applying Illinois law); SpinCycle, Inc. v. Kalender, 186 F. Supp. 2d 585 (D. Md. 2002) (applying Maryland law); Shambaugh v. Lindsay, 445 N.E. 2d 124 (Ind. Ct. App. 1983) (applying Indiana law); C.R. Anthony Co. v. Losetto Mall Partners, 817 P.2d 238 (N.M. 1991) (applying New Mexico law).  According to these cases, because tort law principles are markedly different from contract law principles, requiring plaintiff to prove justifiable reliance in a claim for breach of an express warranty would dissolve the distinction between the tort of misrepresentation and a breach of contract.[12]  In the context of what is often referred to as “reps and warranties” of purchase and sale agreements, it is often recognized that a written warranty should be treated no differently than any other written and voluntarily undertaken contractual commitment.[13]  According to this line of cases, because justifiable reliance has never been an element of a breach of contract claim, it should not become an element in claims for breach of written warranties.[14]  Therefore, even where a purchaser relies on its own due diligence, as opposed to the representations and warranties of the seller, the purchaser’s ability to assert a claim for breach of express written representation and warranty may remain unaffected.[15]  

Even Under the CBS Approach Safeguards Should Be Taken Before Closing.

            The foregoing notwithstanding, buyers and practitioners advising buyers should be careful when deciding to close on a transaction after learning of facts challenging the accuracy of representations or warranties.  Some courts purporting to follow the CBS approach have somewhat limited its holding, finding that the court’s decision was based upon the facts that CBS expressly conditioned its closing by preserving its rights under the warranties prior to closing and that CBS learned of the false representations and warranties from information supplied by Ziff-Davis.  These cases view the “reliance” issue as a question of waiver, not a question of whether express warranties exist or have been breached.  It is a pro-seller approach that allows sellers an opportunity to escape liability.  Under this approach, what the buyer knew and the source of the buyer’s knowledge are critical questions to be resolved in any lawsuit claiming breach of representations and warranties.  If the buyer decides to proceed with closing with knowledge and acceptance of facts disclosed by the seller which would otherwise constitute a breach of warranty, the buyer may be deemed to have waived its rights under the warranties unless the buyer expressly preserved such rights.[16]  

If, on the other hand, the information is common knowledge, or the seller is not the source of the information, the buyer may prevail on a claim for breach of warranty without the need to preserve any rights.  In such situations, “it is not unrealistic to assume that the buyer purchased the seller’s warranty as insurance against any future claims, and that is why [the buyer] insisted on the inclusion of the warranties in the bill of sale.”[17]  Under this theory, because the source of the information or knowledge of the buyer is important, a waiver is triggered only where the seller disclosed the facts which would constitute the breach prior to closing, not if the information was obtained from a third party or is common knowledge.[18] 

            Following CBS, as later modified by opinions interpreting its holding, other courts have similarly based their rulings on whether the buyer expressly preserved its rights when closing on a transaction with knowledge of facts questioning the accuracy of the seller’s representations and warranties.  For example, in Pegasus Management Co., Inc. v. Lyssa, Inc.,[19] the Court held that there was no waiver of any claims for breach of representation and warranty under Connecticut law because of a contractual provision that all representations and warranties, and all of the buyer’s rights under the warranties, would be effective regardless of any pre-closing due diligence and/or knowledge by the purchaser.  The court in Giuffrida v. American Family Brands, Inc.,[20] reached a similar conclusion under Pennsylvania law.  However, the Giuffrida Court found there was no waiver of any rights or obligations arising under the contractual representations and warranties on far less specific contractual language than that found in Pegasus.  Specifically, the court found no waiver, without any express provision relating to the buyer’s specific knowledge, based upon provisions that all representations and warranties survived closing by two years and that no rights were waived unless done in writing.   

Following these cases, buyers and practitioners might consider including one or more of the following provisions that have been held sufficient by some courts to preserve the rights of the buyer despite pre-closing knowledge of a breach of warranty:

• Every representation, warranty, covenant and agreement of the sellers set forth in this agreement and every one of the rights and remedies of purchaser for any one or more breaches of this agreement by the seller shall survive and not be deemed waived by the closing and shall be effective regardless of any inspection or investigation that may have been made at any time by or on behalf of the purchaser or by its directors, officers, employees, or agents, or any prior knowledge by or on the part of the purchaser or its directors, officers, employees, or agents;[21]

• All of the representations, warranties, covenants and agreements made by the parties to this agreement shall survive the execution and delivery of this agreement and the consummation of the transactions contemplated hereunder for a period of two (2) years after the closing date;[22]

• No waiver of the provisions hereof shall be effective unless in writing and signed by the party to be charged with such waiver or

• Any term of this agreement may be waived only with the written consent of the company and the purchaser.[23]

Of course the buyer will be better protected if the provision retaining the buyer’s rights, despite knowledge of pre-closing breaches, is more specific.

Florida Courts Appear Ready to Adopt the CBS Approach

The Florida Supreme Court has not yet ruled on whether reliance is an element of a claim for breach of express written warranties in the context of purchase and sale agreements.  In cases involving breaches of express oral warranties or warranties in connection with the sale of goods, however, Florida courts have held that to create an express warranty there must be an affirmation of fact to the buyer that becomes part of the basis of the bargain. [24]  An oral affirmation becomes part of the basis of the bargain and, thus, an express warranty, only if the buyer justifiably relies on the affirmation.[25]  This is essentially a reliance requirement that is inextricably intertwined with the determination as to whether an oral affirmation becomes part of the bargain and, thus, becomes an express warranty.[26]  Under these Florida cases, the buyer’s knowledge or absence of reliance on the oral representation will negate the existence of an express warranty.[27]  These cases, however, can and should be limited to express oral warranties or warranties in connection with the sale of goods subject to the provisions of the Uniform Commercial Code.  In the context of written purchase and sale agreements, the existence of an express warranty should not be seriously disputed because the warranty will be expressly contained in the agreement itself, foreclosing any doubts as to its existence.[28] 

At least one foreign court endeavored to predict that Florida’s Supreme Court would not require proof of reliance on a warranty in the context of written purchase and sale agreements.  In Lennar Homes, Inc. v. Masonite Corp.,[29] a builder sued its supplier for breach of a written warranty.[30]  The court recognized that a written warranty is nothing more than a contract between a buyer and seller and that reliance is not an element of a breach of contract claim.[31]  The court held that where the existence of the express warranty is established, requiring proof of reliance thereon would dissolve Florida’s distinction between the tort of misrepresentation and a claim for breach of contract.[32]  Therefore, the Lennar court reasoned, what matters most to purchasers is the fact that they have purchased the seller’s promise as part of the bargain to indemnify them if things go wrong.[33]  Injecting reliance into that analysis would defeat the very purpose for which warranties are included in agreements.[34]

The Middle District of Florida has similarly concluded that Florida’s Supreme Court would adopt the CBS court’s view that express warranties are bargained-for terms of contracts, a breach of which are actionable notwithstanding proof that the purchaser did not rely on them at the time of closing on the contract.  In Southern Broadcast Group, LLC. v. Gem Broadcasting, Inc.,[35] the buyer of two radio stations sued the seller for breach of warranty in connection with structural defects in some of the radio towers sold and for overstating revenues.  The buyer closed with knowledge of the deficiencies and immediately resold the purchased assets to a third party, but resold them at a discount because of the deficiencies.  When the original buyer sued the original seller for breach of representations and warranties, the seller argued that the claims were barred because the buyer could not establish reliance on the deficiencies or, in the alternative, the buyer waived its rights by closing with knowledge of the breach and deficiencies.

After thoroughly reviewing how other jurisdictions have dealt with this issue, the Middle District of Florida adopted the approach taken in the CBS. opinion.  The Southern Broadcast court held that the required proof of reliance, if any, was reliance on the warranty at the time the contract was formed, not later at some time prior to closing the deal.[36]  Therefore, the court held that so long as the buyer did not know of the deficiencies at the time it signed the purchase and sale agreement, the buyer could sue for breach of warranty despite having knowledge of the deficiencies prior to closing on the transaction.  The buyer did not need to prove reliance on the warranties at the time of closing to sue for breach of warranty.  Otherwise, the court concluded, the “seller could breach its warranties with impunity by simply disclosing its breach prior to closing and thus deny the buyer the benefit of its bargain.”[37]  

The Southern Broadcast court also rejected the seller’s defense that the buyer waived its rights to sue for breach of warranty by closing, because the buyer had expressly preserved all its rights in the purchase and sale agreement.  The agreement contained a provision stating that “all representations, warranties, and covenants made by the parties in this Agreement . . . shall survive the closing and remain operative and in full force for one (1) year” and that “no provision, condition or covenant of this Agreement shall be waived by either party except by a written instrument . . . signed by the party . . . to be charged with such waiver.”[38]  Therefore, the court held that the buyer did not waive its claims for breach of warranty despite having knowledge of the breach prior to closing. 

At first glance, the Southern Broadcast opinion appears to contradict an earlier opinion of the Eleventh Federal Circuit Court of Appeals.  In Hobco, Inc. v. Tallahassee Associate’s[39] the Court affirmed the trial court’s holding that a breach of warranty claim was without merit because there was no evidence that the buyer relied on the seller’s representations and warranties.  A careful reading of Hobco reflects, however, that the reliance element related to the very existence of the warranty, not whether reliance was an element of a claim for breach of an express warranty.  In Hobco, prior to the purchase of a building, the seller orally informed the buyer that the building could be filled with private tenants who would “feed-off” federal agencies that already occupied half the building.[40]  The seller later learned that this plan would fail, but did not disclose what he learned to the buyer, despite a warranty that the seller had not withheld any information from the buyer.  After closing, the buyer sued for breach of warranty.  The court held that the oral statement relating to the “feed-off” plan could not have become an express warranty and a basis of the bargain when the buyer signed the purchase contract.  The court found that the buyer’s extensive prior experience and expertise dealing with government tenants foreclosed any evidence that the buyer relied upon the seller’s representations at the time the contract was signed.  Since the seller’s oral representation relating to the “feed-off” plan never materialized to become an express warranty,[41] the purchaser was not successful on his claim.  The court did not, however, expressly rule on whether reliance must be proved to recover for breach of express written warranty once the existence of the warranty has been established.  

Conclusion

            The Florida Supreme Court has not ruled on whether a buyer can successfully sue for breach of an express written warranty in a purchase and sale agreement despite having knowledge of the breach prior to closing.  Other jurisdictions adopting the approach expressed by the CBS court have held that the buyer’s knowledge is irrelevant because reliance is not an element of a breach of contractual warranty claim.  However, in order to avoid an argument that the buyer waived his rights by closing despite knowledge of the breach prior to closing and to preserve their remedies in accordance with some courts’ modification of the CBS court’s rationale, buyers and practitioners advising buyers should ensure that the purchase and sale agreements contain express provisions protecting the buyers against the waiver of any rights and providing that all representations and warranties survive the closing. 

ENDNOTES

[1]            A “warranty” has been defined as “an assurance by one party to a contract of the existence of a fact upon which the other party may rely.”  Metropolitan Coal Co. v. Howard, 155 F.2d 780, 784 (2d Cir. 1946).

[2]            Hillcrest Pacific Corp. v. Yamamura, 727 So. 2d 1053, 1057 (Fla. 4th DCA 1999) (without justifiable reliance, there can be no claim for fraud). 

[3]            75 N.Y.2d 496; 553 N.E.2d 997; 554 N.Y.S.2d 449 (1990).

[4]            Id. at 500; 553 N.E.2d at 998; 554 N.Y.S.2d at 450.

[5]            Id.

[6]            Id. at 502; 553 N.E.2d at 1000-01; 554 N.Y.S.2d at 453 (italics added).

[7]            Id.

[8]            Id. at 504; 553 N.E.2d at 1001; 554 N.Y.S.2d at 453.

[9]            Id. at 506; 553 N.E.2d at 1002; 554 N.Y.S.2d at 454.

[10]          Giuffrida v. American Family Brands, Inc., 1998 WL 196402 *4 (E.D. Pa. 1998).

[11]          NSA Investments II LLC v. Seranova, Inc., 227 F. Supp. 2d 200, 204 (D. Ma. 2002) (“proof of reliance amounts to proof of the existence of an express warranty”); Metromedia Co. v. Fugazy, 983 F.2d 350, 360 (2d Cir. 1992); CBS v. Ziff Davis Publishing Co., 75 N.Y.S.2d at 506 n.5.

[12]           Southern Broadcast Group, LLC  v. Gem Broadcasting, Inc., 145 F. Supp. 2d 1316, 1323 (M.D. Fla. 2001). 

[13]           CBS, Inc., 75 N.Y.2d at 502; Council Bros. Inc. v. Ray Burner Co., 473 F.2d 400, 406 (5th Cir. 1973).

[14]           Mettler, Inc. v Ellen Tracy, Inc., 648 So. 2d 253, 255 (Fla. 2d DCA 1994) (elements of action for breach of contract are offer, acceptance, consideration, contract, breach and damages).

[15]          Wikoff v. Vanderveld, 897 F.2d 232 (7th Cir. 1990).

[16]          Galli v. Metz, 973 F.2d 145 (2d Cir. 1992); Rogath v. Seibenmann, 129 F.3d 261, 265 (2d Cir. 1997). 

[17]           Rogath, 129 F.3d at 265; Galli, 973 F.2d at 151.  The Middle District Court of Florida has questioned whether the source of the information should truly matter at all times.  Southern Broadcast Group, LLC, 145 F. Supp. 2d 1316 (M.D. Fla. 2001).  According to the Middle District of Florida, if the buyer learned of the breach from third parties prior to executing the contract, then inclusion of the warranty can be assumed to have been the insurance for the purchaser.  If the purchaser learned of the breach after executing the contract, the Middle District believes the source of the information is irrelevant because knowledge of the breach of that point should not foreclose a lawsuit.

[18]          Galli, 973 F.2d at 145; NSA Investments II LLC, 227 F. Supp. 2d at 205.

[19]          995 F. Supp. 29 (D. Ma. 1998).

[20]          1998 WL 196402 (E.D. Pa. 1998).

[21]         Pegasus Management Company, Inc., 995 F. Supp. at 33.

[22]          Southern Broadcast Group, LLC, 145 F. Supp. 2d at 1324 – 25; Giuffrida, 1998 WL 196402 *2.

[23]          NSA Investments II LLC, 227 F. Supp. 2d at 205.

[24]        Thursby v. Reynolds Metal Co., 466 So. 2d 245 (Fla. 1st DCA 1985).

[25]         Id.

[26]          Hobco, Inc. v. Tallahassee Assoc., 807 F.2d 1529, 1533 (11th Cir. 1987); Royal Typewriter Co. v. Xerographic Supplies Corp., 719 F.2d 1092, 1100-01 (11th Cir. 1983); Fla. Stat. § 672.313.

[27]         Royal Typewriter Co., 719 F.2d at 1101.

[28]         Lennar Homes, Inc. v. Masonite Corp., 32 F. Supp. 2d 396, 399 (E.D. La. 1998). 

[29]          Id.

[30]         The Court distinguished other Florida cases that did not deal with written warranties.

[31]         Id. at 399-400.

[32]         Id. at 399. 

[33]         Id. at 400. 

[34]         Id.

[35]         145 F. Supp. 2d 1316 (M.D. Fla. 2001)

[36]         Id. at 1324.

[37]         Id. at 1324.

[38]         Id. at 1324.

[39]         807 F.2d 1529 (11th Cir. 1987).

[40]         Id. at 1531.

[41]        Royal Typewriter Co., 719 F.2d at 1100 – 01; Fla. Stat. § 672.313.