Due diligence vs. warranties

By M. Henry Heines, Townsend and Townsend and Crew LLP -- Electronic Business, 5/16/2007

Editor's note: Excerpted from Patents For Business: A Manager's Guide to Scope, Strategy, and Due Diligence, by M. Henry Heines, partner, Townsend and Townsend and Crew LLP.

Every transaction involving the transfer or acquisition of assets or rights will contain warranties, and one may well wonder whether these warranties render due diligence reviews redundant. Certainly in intellectual property due diligence, all of the concerns listed above can be covered by warranties or indemnities. Why then should one invest in the expense of a due diligence review when the warranties or indemnities in the contract can be specifically worded to cover the same issues?

Warranties and indemnities are indeed useful for a variety of matters, but they are generally of limited duration and often of limited amount. For this reason, warranties and indemnities are inappropriate for many intellectual property matters. Furthermore, a warranty or indemnity clause typically contains cumbersome requirements for the party seeking to invoke the clause. The clause may, for example, require advance notice to the warrantor that a claim will be made, or may apply only when the misrepresentation or loss is "material," a standard that is often difficult to define and to show as having been met. In some cases, the clause applies only when the warrantor had "reasonable knowledge" of the problem that caused the loss, which likewise can be difficult to define and to show as having been met. Even if all requirements for a claim under a warranty are met, the warranty may not fully compensate the injured party, particularly if the loss that was suffered is not one that can be adequately compensated for by money. And even if money were sufficient, the warrantor might not have sufficient assets to meet the claim.

Certain warranties and indemnities will necessarily be included in the transaction regardless of whether a due diligence review precedes the closing, since there will be various matters that are unreasonable or uneconomical for the investigator to check. For example, the contract will typically contain a warranty by the target that the information the target supplies to the investigator is complete and accurate. Nevertheless, for the bulk of the intellectual property issues that will determine the risks and the value of transaction, it is far more expedient, efficient, and effective to investigate these issues in a due diligence review and identify them before they become losses.

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