The importance of drafting agreements with the utmost care and accuracy is unquestioned. However, following a decision by the United States Court of Appeals for the Ninth Circuit, it is clear that one can never overstate the significance of precise drafting. In many real estate and other business agreements, it is common practice to include a detailed representations and warranties section together with a limitation on the survival period for such representations and warranties. Some parties intend for the survival provision to shorten the amount of time one party has to file an action against the other for breach of warranty, while others interpret the provision to limit the time period during which an actionable breach could occur or be discovered.
In
Western Filter Corporation v. Argan, Inc. (9th Cir. August 25, 2008), the United States Court of Appeals for the Ninth Circuit addressed a disagreement about whether a survival provision on a warranty clause was intended to limit the amount of time one party may have to file an action against the other for breach of warranty, or whether the survival provision only limits the time period during which an actionable breach could occur or be discovered. Applying California law, in what the court described as "an issue of first impression", the Ninth Circuit held that a survival provision permitting the representations and warranties in a stock purchase agreement ("SPA") to survive the closing for a certain period of time did
not limit the period of time within which an action could be brought for breach of warranty. Instead, according to the court, the survival clause simply set forth the period of time during which the actionable breach of warranty could occur. The Ninth Circuit's holding highlights the importance of accurate drafting, not only for stock purchase agreements, but – we believe – for a wide range of real estate and general corporate documents, including sale and purchase agreements, governed by California law.
Background
On October 30, 2003, Western Filter Corporation ("Western") and Argan, Inc. ("Argan") entered into a SPA whereby Western agreed to purchase Purflow, Inc. ("Purflow"), Argan's wholly owned subsidiary. Both Western and Argan made several representations and warranties in the SPA. The portion of the SPA at issue in the decision provided that "[t]he representations and warranties of [Western] and [Argan] in this Agreement shall survive the Closing for a period of one year, except the representations and warranties contained in Section 3.1(a), (b), (c), and (f) and 3.2 (a) and (b) shall survive indefinitely." The representations which "survive indefinitely" were not at issue in this case. After the closing, Western became convinced that Purflow's inventory was worth significantly less than what Argan represented in the SPA, which, if true, would be a breach of a representation by Argan in the SPA. However, while on September 17, 2004 (11 months following the closing) Western sent written notice to Argan claiming that "the management of Purflow and Argan grossly misrepresented the financial condition of Purfolow", Western did not actually file legal action against Argan for the breach until approximately eighteen months after the closing.
The trial court granted Argan's motion for summary judgment, concluding that Western's claims were barred by the survival clause's one year time limit. Despite the fact that Western put Argan on notice of Western's belief of Argan's breach within the one year time limit, the trial court ruled that the plain meaning of the survival clause was that, in the event Argan breached certain representations and warranties, any claim by Western on account of such breach must be filed within one year after the closing.
Ninth Circuit Decision
On appeal, Western argued that the survival clause served only to set forth the time period for which a breach may occur or be discovered, whereas Argan maintained that the purpose of the clause was to limit the time period within which a breach of warranty claim could be brought, i.e., thereby creating a contractual limitation on the applicable statute of limitation. As the court stated in its decision, in California, the statute of limitation for a contract claim is four years, three years for a fraud or intentional misrepresentation claim, and two years for a negligent misrepresentation claim. Both Western and Argan agreed that, absent the survival clause, the representations and warranties contained in the PSA would have terminated at the time of the closing.
The Ninth Circuit acknowledged that Argan's position has some basis in case law out of the Ninth Circuit. Specifically, the Court cited
State Street Bank & Trust Co. v. Denman Tire Corp., (1st Cir. 2001), where the First Circuit held that a clause in an agreement stating that the representations and warranties "shall expire on the second (2nd) anniversary of the Closing" was sufficient to create a contractual agreement to shorten the applicable statute of limitation. The First Circuit ruled that to "say that something ‘shall survive' for a period of time, … is very much like saying ‘shall expire after a period of time." As such, the First Circuit determined that although the clause did not include specific language stating that a claim must be filed prior to the expiration of the limitation period, the language could only be reasonably understood to mean that any claim based on representations or warranties contained in the agreement must be brought within the period specified in the agreement.
However, as both parties acknowledged that there is no controlling authority in the Ninth Circuit on the interpretation of California law relating to this issue, the court looked to California appellate court decisions that have dealt with the issue. In
Lewis v. Hopper (Cal. Ct. App. 1956), the court stated that " a provision specifying the life of a warranty has no bearing on the time period for filing suit after the warranty has been breached". In addition to the Lewis decision, the Ninth Circuit stated that the overwhelming view of the California appellate courts has been that parties must be more explicit than the language at issue in Argan.
Accordingly, the Ninth Circuit found that since the survival clause did not explicitly state that it was shortening the statute of limitations, the survival provision's one year limitation merely set forth the time period during which a breach could occur or be discovered by Western. After that year, the Ninth Circuit determined that an action could be commenced by Western at any time during the applicable statue of limitations. According to the Ninth Circuit, if the parties had intended to curtail the applicable statute of limitations, they should have expressly done so in the agreement. As a related matter, the Ninth Circuit also provided guidance for drafting contractual provisions shortening the statute of limitations, noting that California law requires that any shorter period agreed to by the parties may not be so unreasonable as to "show imposition or undue advantage in some way" and that because a shorter period is in "derogation of the statutory limitation", it must be construed with strictness against the party invoking it. For any contractual limitation to be upheld under California law, it must be stated in a "clear and explicit" manner.
Lessons Learned
If the survival language in an agreement is not drafted precisely, the intent of the parties at the time of execution of such agreement may not be upheld by a court applying California law. Regardless of the parties' intent, whether it is to limit the amount of time in which a breach of warranty may occur or be discovered, or to set forth a limit on the time during which legal action relating to the breach of warranty must be commenced, the survival clause needs to be drafted in as clear and explicit manner as possible to reflect the parties' intent.
The Ninth Circuit made it clear that, in order for the parties to override the statute of limitations applicable to claims for breach of representations and warranties contained in an agreement, the survival provision must explicitly state such intent. For parties intending to contractually limit the period of time within which legal action must be commenced for breach of warranty (so that such claims must be filed sooner than the applicable statute of limitations under California law), the language of the agreement should state that (a) the parties intend to limit the period of time within which such legal action may be commenced, (b) the representations and warranties will terminate at the end of such survival period, and (c) legal action based on breach of warranty must be commenced by the end of the survival period.
Nossaman attorneys are available to advise concerning the interpretation of various types of contract provisions, including those addressed in the opinion discussed above, and to assist in drafting such provisions.
Yuliya Oryol is Assistant Chair of the firm's Corporate Practice Group. Ms. Oryol represents public pension funds, multi-national corporations and privately held companies in a broad range of transactional and advisory matters. She can be reached at yoryol@nossaman.com.