When a Representation is More Than a Representation – The Litigation Risk of the Contractual Warranty

Agreements of all stripes contain “representations and warranties” – statements of fact one party “represents,” “warrants,” or (confusingly) “represents and warrants” to be true. Such statements are so common that one would be excused from thinking that these contractual terms are simply different ways of saying the same thing – as lawyers are fond of saying, a distinction without difference.

Although representations and warranties share attributes (the affirmation that certain facts are true), the legal consequence for breach can be quite different. Although a breach of a representation can give rise to a cause of action for fraud, a breach of warranty can potentially void an entire agreement, providing the defendant in a breach of contract action with a potent shield from liability.[1]

This was the result in a recent case before the Washington Court of Appeals – a case that highlights the risks associated with what might at first glance appear to be a boilerplate representation of fact.

In Martin v. Smith, the parties entered into a licensing agreement providing for payment by Smith to Martin for the licensing of Martin’s technology.[2] In the agreement, the parties mutually represented:

Each party (the “Warranting Party”) warrants and represents to the other Party that … the Warranting Party is not presently the subject of, nor the proponent of, any claim that would have a material adverse [e]ffect on the other Party.[3]

During negotiation of the agreement, Martin disclosed to Smith that he had been contacted regarding a Securities and Exchange Commission investigation into a Ponzi scheme involving another company; apparently, the SEC believed that Martin had been paid funds that were proceeds from that scheme.[4] Martin also disclosed to Smith that the SEC was considering adding them as “relief defendants” in a pending lawsuit relating to the Ponzi scheme.[5] Smith was provided with copies of the correspondence from the SEC.[6]

The parties’ agreement was dated April 11, 2007. On April 9, 2007, the SEC filed an amended complaint naming Martin and others as “relief defendants.”[7] Martin was served with the complaint in May 2007, and Smith learned of the suit at around the same time.[8] Smith breached the agreement, and Martin sued. Smith counterclaimed for breach of warranty.[9]

After the trial court found in favor of Martin, Smith appealed, arguing that the contract was void because Martin was in fact the “subject of” a claim at the time of the entry of the agreement. The Court of Appeals agreed and reversed the trial court’s judgment. According to the Court of Appeals, it was immaterial that Smith knew of the SEC investigation before executing the agreement, just as it was immaterial that no evidence showed that Martin knew of the SEC’s complaint when the agreement was executed: “the falsity of a statement which is made a warranty will avoid the contract without regard to whether it can be considered as material in any way to the risk or the loss.”[10]

This result seems exceedingly harsh, when it appears that both parties were aware of the possibility that the SEC might sue Martin, and neither party knew that suit had been filed when the agreement was executed. In other words, the fact that the warranty was false was unknown by the warranting party and apparently immaterial to the non-warranting party’s decision to enter into the agreement.

Contracting parties would be wise to confine warranties to those facts that truly are within their control. Parties finding themselves called to defend in court should scrutinize those warranties made by their counterparty, because even an unknowing, immaterial warranty may provide an absolute defense to breach.

–Matthew H. Rice