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E-MailSteven L. Schwarcz is the Stanley A. Star Distinguished Professor of Law & Business at Duke University School of Law and Senior Fellow of the Centre for International Governance Innovation. This post is based on his recent paper.
In Representations & Warranties, Fraud, and Risk Shifting: An Analytical Framework, I attempt to build a systematic framework for analyzing breaches of representations and warranties (“R&W”s). Many contracts include R&Ws in order to reduce information asymmetry and to reallocate risk between the parties. When used in asset-sale agreements, R&Ws are assertions by a seller to the buyer about the quality of the assets being sold. When used in financing agreements, R&Ws are assertions by a borrower to the lender about the borrower’s financial condition, its ability to repay the financing, and the quality of the collateral. Whichever the context, I refer to the parties providing these assertions as “warrantors.”
To provide real world grounding, the Article takes into account actual R&Ws used in business and finance, starting with those used in securitization transactions. Securitizations exemplify the current controversy over the meaning of R&Ws and also broadly represent the problems because they incorporate the same types of R&Ws found in both asset sales and financings.
A warrantor that breaches a R&W normally would be liable for contract-breach damages, which are calculated as expectation damages. Expectation damages can be an inefficient remedy for R&W breach, however, because they cannot always be calculated and awarded costlessly. Parties therefore have examined alternative breach remedies. In securitizations, they’ve settled on a “cure-or-repurchase” remedy: requiring the warrantors either to correct, or “cure,” the breach or to repurchase the breaching loan—the type of underlying asset that generates cash to repay securitization investors.
Warrantors contend that this “sole remedy” should adequately shift risk. Litigating investors now counter, however, that it insufficiently shifts risk if the breaches are extensive. They also contend that extensive R&W breaches should constitute fraud and that, in the presence of fraud, their remedies should not be limited.
These disputes are prevalent. In many securitizations that pre-dated the 2008 financial crisis, more than half of the underlying loans are estimated to have breached one or more R&Ws. In response, investors, government agencies, and insurers have filed hundreds of securitization-related lawsuits claiming fraudulent inducement, breach of contract, and other violations. Some settlements to date have exceeded $15 billion, with the banking industry alone incurring $200 billion in aggregate fines, settlements, and related legal costs. Many lawsuits remain ongoing, and new cases are still being filed based on long-standing tolling agreements.
The outcome of billions of dollars of litigation thus turns on whether R&W breaches merely contractually shift risk or could also constitute fraud. In building a systematic framework for analyzing R&W breaches, this Article also seeks to resolve that issue.
The Article builds its framework by examining the historical boundary between risk shifting and fraud for R&W breaches and then analyzing, more normatively, what that boundary should be. Historically, that boundary is murky; warranty law initially developed from tort law and was recognized as an action in deceit, but over time courts began to view warranty law as more grounded in contract than tort law.
This muddling persists, with some suggesting there may be a distinction between “representations” and “warranties” with the former being viewed as a statement of fact whose breach is deceitful and the latter being viewed as a “contractual term” that only gives rise to an indemnity claim. Because contracts do not normally differentiate representations from warranties, the muddling creates uncertainty and provides an opening for parties to assert extra-contractual fraud claims for R&W breach.
The Article helps to reduce that uncertainty by analyzing what should be the boundary between R&W breaches that support a fraud/tort-based deceit claim and those that merely shift risk contractually. The analysis starts by asking why courts should not simply respect freedom of contract and enforce R&W agreements in accordance with their terms. In principle, voluntary bargaining should lead to an economically efficient outcome for the contracting parties.
Freedom of contract, however, should be subject to three limitations: paternalism, externalities, and public policy. To the extent R&W breaches are fraudulent, freedom of contract should be constrained by the public policy against fraudulent conduct. On that basis, the Article proposes a normative rule: R&W breaches should shift risk in accordance with the contract, including any cure-or-repurchase or other sole remedy provision; however, intentional breaches should also justify extra-contractual fraud claims. The Article shows that this normative rule would make sense from the standpoints of correcting market failures and maximizing efficiency. It also explains why other possible versions of a normative rule for R&W breach—such as requiring lawyers to clearly distinguish what is a “representation” and what is a “warranty” in future contracts, thereby triggering different remedies depending which is breached—might be theoretically possible but not pragmatic.
The Article also examines whether the existence of unintentional, but extensive, R&W breaches should override sole remedy provisions. The argument for such overriding is that extensive breaches could make a cure-or-repurchase sole remedy prohibitively expensive, if not impossible, to enforce. However, the scholarship making that argument is flawed.
Some scholars claim, for example, that the verification costs necessary to establish the existence of extensive breaches can be prohibitively expensive if the inquiry occurs years after the alleged breaches occurred, as was common during the 2008 financial crisis. This claim centers on the cost of reconstructing the appraised value of collateral at the time of the alleged breaches. The Article explains, though, that R&Ws as to appraised value usually are assertions about the appraisal procedure, not about the accuracy of the appraisal itself. Scholars also argue that enforcing a cure-or-repurchase remedy would be prohibitively expensive because it would require proof of causation. The Article shows, however, that enforcing the cure-or-repurchase remedy does not necessarily require proof of causation, merely proof that a loan breached a R&W at the time of its sale.
Finally, the Article asks whether unintentional but extensive R&W breaches should justify some type of constructive fraud or gross negligence rule. Because the use of constructive fraud or gross negligence to override contractual provisions is not the norm, it argues that any such use should require a compelling policy basis. Where the contract itself provides a negotiated remedy for R&W breaches, there does not appear to be such a compelling basis. Moreover, the cost of such a rule would not appear to justify its benefits; warrantors may feel compelled to engage in due diligence simply because they fear that investor-plaintiffs could allege, ex post, that they should have known that extensive R&W breaches could occur. Such a constructive fraud rule would compel costly due diligence to avoid litigation any time there is even a remote chance of extensive R&W breaches occurring.
