Those pesky warranties

One of the most contentious issues in the negotiation of any real estate sale contract arises in connection with the seller’s warranties.

It is the old tug of war. If the purchaser’s lawyer drafts the contract, he or she will probably insert warranties which go from A to Z and beyond. Conversely, if buyer’s lawyer drafts the contract, it may include a few innocuous warranties, such as the authority of the seller and buyer (which become moot anyway when the parties acquire title insurance).

Most troubling are condition warranties, those which cover the physical condition of the property. While it is possible that the transaction is to be a quick sale in which the buyer is not afforded an opportunity to perform a due diligence inspection of the property or the books and records of the seller, that situation is rare, and sellers customarily feel that, if the buyer has ample opportunity to do its due diligence, the property should be sold as-is, with no condition warranties at all.

On the other hand, the buyer may be concerned that its due diligence inspection may not turn up adverse conditions, which could result in costly future repairs. What if, for example, there is a foundation leak, which is not visible because of drywall, or it is not possible to determine how the air conditioning really works because the due diligence is conducted during the winter.

A frequent compromise is for the parties to agree that the seller will warrant that it has no knowledge of a particular adverse condition. A seller might warrant, for example, that it knows of no roof leak or that it knows of no hazardous substances on the property. It is a way for the buyer to get some comfort, but frankly, it is very little. There are a number of problems with that solution.

First, what type of knowledge is intended? Is it best of knowledge, actual knowledge or just plain knowledge? What do those words or phrases imply? Are they different? What degree of investigation is required for “best of knowledge”?

If the seller is an individual, the buyer knows whose knowledge it is getting. If the seller is an entity, is it bound by the actual knowledge of, say, a janitor, who saw hazardous materials being dumped 25 years earlier? If that seller which is an entity limits the knowledge warranty to specific persons, how does the buyer know it is getting someone who has access to the information?

Most important, it is easier to prove that there was a building code violation, for example, than it is to prove that the person referred to in the contract had knowledge of the situation.

The reader can readily see that there are more question marks than periods in the paragraph about knowledge warranties. Add an “as-is, where-is” section to the contract, in which the buyer concedes that it is relying on it own due diligence, and what happens to the knowledge warranties, even if that section begins, “Except as expressly warranted in this contract?”

What happens if there is a time limit on enforcing warranties? And why should such a time limit apply when a knowledge warranty is really a warranty that someone is not lying?

The knowledge warranty quandary is not limited to condition warranties. A seller might warrant that it knows of no defaults by its tenants, or that, to its knowledge, the books and records are accurate, or that the rent roll is true and correct. Sellers sometimes hide behind “knowledge” to limit liability as to matters which they really should know, and which cannot be relied upon without some assurance that what is shown during due diligence is not some cooked-up information.

There are no easy answers to the warranty questions. Each situation is different, and in each one, the parties have differing strengths and weaknesses. It is important to have advisers and counselors who understand the risks, the relative bargaining positions of the parties and the importance of the various warranties at issue, to advise the parties and help them to reach a solution which, while it never ideal, at least assists in reaching some resolution of the difficult issues involved.

Sidney G. Saltz is a partner in the business, tax and real estate department of the Chicago law firm of Barnes & Thornburg LLP. He can be reached at [email protected].