Wisconsin Lawyer
Vol. 75, No. 7, July 2002

Buyer's Pre-Closing Knowledge of Seller's Breach of Warranty

by Robert J. Johannes & Thomas A. Simonis

t is standard practice for attorneys to include representations and warranties regarding various matters in contracts, including agreements for the sale of businesses. Attorneys in all practice areas include these representations and warranties to allocate economic risks between the parties.

Frequently, one of the parties to the contract will learn, before the sale closes, that a representation or warranty made by the other (for example, the seller) is untrue. A buyer who knows of a material breach often will complete the transaction without the parties amending the contract or agreeing on the consequences of the breach, because the buyer assumes that the contract terms will be enforced, and that the seller will be responsible for any damages resulting from the breach. In fact, many purchase agreements for business transactions contain a specific provision providing that the buyer's knowledge of the breach is not a bar to the buyer's recovery. Many business attorneys, relying upon such a provision, counsel their clients accordingly. If a court or arbitrator held that the buyer's pre-closing knowledge of a breach of a warranty precluded a cause of action arising from that breach, the client's reasonable expectations would be frustrated.

This article surveys the national trend as to the requirement of reliance to maintain a claim for a breach of an express warranty; examines the currently unsettled Wisconsin law on this issue; and notes the relevant differences, under Wisconsin law, between a tort claim for misrepresentation and a contract claim for breach of warranty. The article concludes that, at least in negotiated transactions, reliance should not be a required element for breach of express warranty or, at least, that the type of reliance required is simply reliance on the enforceability of the warranty rather than on the underlying truth of the warranty.

The National Trend

The majority of jurisdictions that have considered whether reliance is a required element of a cause of action for a breach of an express warranty in a sale of a business have concluded that reliance is not required.

Currently, the law in New York best represents the modern view of this issue. In CBS v. Ziff-Davis, the New York Court of Appeals held that reliance on the underlying truth of a warranted fact in a contract for the sale of a business was not required in order to maintain an action for a breach of an express warranty.¹ Ziff-Davis involved a contract for the sale of a privately held corporation to a corporate buyer. The contract of sale contained express warranties by Ziff-Davis, the seller, as to the truthfulness of financial information previously supplied by it. After entering into the contract, the buyer, CBS, conducted its own investigation into the financial status of Ziff-Davis. This investigation led CBS to believe that the financial information submitted by Ziff-Davis was untrue, and CBS informed Ziff-Davis of its concerns. Ziff-Davis dismissed CBS's concerns and insisted that it proceed with closing. CBS agreed to close after the parties came to a mutual understanding that the closing would not waive any rights either party had under the purchase agreement. After the deal was concluded, CBS brought a suit for breach of warranty.

Ziff-Davis argued that reliance was a required element of a breach of warranty claim and because CBS did not believe the warranted financial statements, it could not have relied on them, rendering the warranty unenforceable. The court of appeals rejected this argument. In its decision, the court distinguished that an action for a breach of warranty is no longer grounded in tort, but rather in contract. By making this distinction, the court held that reliance on the underlying truth of the warranted assertion was not required. Rather, the only element of reliance needed to maintain the claim for breach of warranty was the buyer's belief that it was purchasing the seller's promise as to the warranted fact. In other words, the buyer was purchasing the economic risk allocation that the parties had bargained for.²

Another New York case that clearly demonstrates the lack of a reliance requirement is Ainger v. Michigan General Corp.³ In this case, the seller, a book publisher, placed a warranty into the sales contract that it was "not involved in litigation and has not been notified of any claims which could give rise to litigation."⁴ After the sales contract was formed, but before the deal closed, the buyer conducted its own investigation and became aware of a copyright dispute between the publisher and one of its authors. The buyer made its concerns known to the seller and received reassurances that the warranties were true. The parties closed the sale, and a dispute subsequently arose with the author regarding ownership of the copyrights, eventually resulting in a lawsuit between the seller and the buyer.

In a counterclaim to the lawsuit, the buyer alleged a breach of warranty. The seller defended by arguing that the warranty was unenforceable because the buyer knew of the potential litigation from the copyright dispute; therefore, the buyer could not have relied on the warranty. The court disagreed, holding that knowledge of the untruth of a warranted assertion was not a bar to recovery for a breach of warranty. "The problems of a reliance, and a right to rely, on the representations do not appear when the action is grounded in warranty. The warranty is as much a part of the contract as any other part, and the right to damages on the breach depends on nothing more than the breach of warranty."⁵

This view has been upheld in most jurisdictions that have considered the reliance question. In the Seventh Circuit, cases in Indiana and Illinois have held that reliance on the underlying truth of the warranted assertion is not required to maintain a breach of express warranty claim.⁶ These cases have held that an express warranty is a contract term, and that an action for a breach of an express warranty is a contract claim, not a tort claim. In Indeck, for example, the court held that "[t]he right to indemnification depends only on establishing that the warranty was breached."⁷

While no Florida cases have dealt explicitly with the requirement of reliance for a claim of breach of an express warranty, two federal courts have held that, if faced with the issue, the "Florida Supreme Court would embrace the modern view that express warranties are bargained-for terms of a contractual agreement, any breach of which is actionable notwithstanding proof of nonreliance at the time of closing on the contract."⁸

Under Pennsylvania law a showing of reliance is not necessary to maintain a breach of warranty action.⁹ In Giuffrida, the court held that the line of cases requiring reliance was "inconsistent with the commercial realities of these complex purchase agreements negotiated over several months by sophisticated parties."¹⁰ Further, the court held that requiring reliance would inject uncertainty into agreements because the enforceability of warranties would be subject to a fact finder's determination, and that it would discourage due diligence.¹¹

Reliance on the truth of the warranted assertion also is not required to maintain a breach of an express warranty claim in Connecticut,12 Montana,¹³ Massachusetts,¹⁴ and New Mexico.15

In only four states were cases found that still require reliance on the underlying truth of the warranted assertion to recover for a breach of an express warranty. These states are Kansas,¹⁶ Minnesota,¹⁷ Delaware,18 and California.¹⁹ These cases have been heavily criticized, and they represent the view of a minority of jurisdictions.

Some courts have made distinctions that depend on whether the buyer expressly reserved its right to claim a breach of warranty following the closing for an untruth the buyer knew of before the closing, or whether the buyer learned of the untruth from a source other than the seller.²⁰

These cases have held that the necessary reliance to establish a claim for breach of express warranty is the mere reliance on the warranty as a contract term, not reliance on the underlying truth of the warranted assertion. However, these cases also have held that if the seller discloses the untruth of a warranty, and the buyer closes with knowledge of that untruth, then the buyer is foreclosed from later asserting that breach because the buyer has waived its right to assert a breach of warranty claim. On the other hand, if the buyer expressly reserves its right to later claim a breach of warranty, then it may do so because no such waiver exists.

Finally, these cases also hold that if the buyer learns of the untruth other than from the seller, then the buyer's claim for breach of warranty is not precluded, because it is not unreasonable to assume that the buyer is purchasing the seller's warranty as insurance.²¹

In summary, while not every jurisdiction has considered the reliance requirement, most jurisdictions considering the issue have held that reliance on the underlying truth of the warranted assertion is not required.

Unsettled Wisconsin Law

As one would expect, reliance on the truth of the assertion is a required element of the tort of misrepresentation under Wisconsin law.²²

In Foss, the buyer entered into a contract for the purchase of a commercial property. The contract contained a provision that the "Seller warrants and represents to Buyer that Seller has no notice or knowledge of any ... underground storage tanks" on the property.²³ At closing, the buyer knew that there were two underground storage tanks on the property, and the seller presented the buyer with a letter stating that the property was sold "as is."²⁴

The buyer in Foss subsequently brought a claim against the seller for the tort of misrepresentation, attempting to recover the costs of removing the storage tanks and leaked fuel and lost rentals due to construction delays. Importantly, the buyer did not bring a contract claim for a breach of warranty. The court of appeals held that the buyer could not maintain his tort claim, stating that "[t]o succeed on such a tort claim ... [the buyer] must have believed the representation was true and relied on it to his damage."²⁵

The question still remains in Wisconsin whether reliance on the truth of the warranted assertion is a required element of a contractual action for breach of warranty.

Unlike the jurisdictions discussed above, Wisconsin courts have not yet directly answered the question of whether a buyer's nonreliance on the truth of a warranted assertion (specifically arising from its pre-closing knowledge of the assertion's untruth) precludes a contractual claim for breach of an express warranty. The cases concerning the effect of the buyer's pre-closing knowledge that a warranted fact is untrue reach varied and seemingly conflicting conclusions. Furthermore, the secondary sources addressing this issue reach different results.

In general, reliance is not required for a contract action. ²⁶ Thus, if an express warranty is a contract term, then a contract claim brought to enforce it should not require reliance. However, in Wisconsin this appears not to be the case. The Wisconsin Civil Jury Instruction on breach of an express warranty states that the buyer's reliance is a required element of an express warranty.²⁷ The jury instruction, however, does not explain whether the requirement is reliance on the truth of the warranted assertion or reliance on the bargained-for allocation of economic risk demonstrated by the warranty (that is, reliance on the express warranty as a term of the contract).

Almost a century ago, the Wisconsin Supreme Court considered the requirement of reliance in a warranty action in Smith v. Reed.²⁸ The sales contract in issue contained a representation (not characterized as a warranty) on which the jury found the buyer did not rely. On appeal, the court held that reliance was required to give a representation the effect of a warranty. The court did not elaborate on whether the reliance required was on the truth of the representation or on the enforceability of the representation as a contract term. However, the court did state that "if an express warranty had been given in express terms as a part of the contract of sale, no proof of reliance thereon would have been necessary."²⁹ With this statement, the court seems to be saying that incorporating the magic words of "express warranty" into a representation can eliminate the need to demonstrate reliance.

Again, it is not clear what the court means by saying no reliance is required. Does the court mean that the buyer is not required to demonstrate reliance on the truth of the assertion or, more broadly, that the buyer is not required to demonstrate reliance even on the enforceability of the warranty? How does one reconcile the court's "no reliance" statement with the current jury instruction? This question can be resolved by interpreting the jury instruction to require reliance on the enforceability of the express warranty as a contract term and the statement in Smith as discounting the need for reliance on the truth of the assertion.

Most Wisconsin cases addressing the requirement of reliance for a breach of express warranty claim have dealt with situations in which a buyer desired to treat a representation as an express warranty. Before enactment of the UCC, courts consistently had followed the Smith holding and required that reliance on the truth of the assertion be shown in order to turn a representation into a warranty.³⁰ Although the UCC applies only to sales of goods, its provisions often have been extended to other contracts of sale.³¹

The current version of the UCC requires only that a seller's affirmation of fact be "part of the basis of the bargain" for the affirmation to be treated as a warranty.³² The Wisconsin Supreme Court has held that "the buyer's reliance on the affirmation [is] not determinative as to whether the representation is a basis of the bargain."³³ Thus, the UCC appears to eliminate the requirement of reliance on the truth of an assertion for the assertion to be a warranty. As long as a warranty is part of the basis of the bargain (that is, a negotiated term of the contract), the warranty, and the bargained-for allocation of economic risk that it represents, should be enforced regardless of the buyer's pre-closing knowledge of the untruth of the warranted assertion (that is, the buyer's nonreliance).

It is possible that a court might now go even farther, and hold that the statement from Smith eliminating the need to show reliance for an express warranty means not only an elimination of reliance on the truth of the assertion made in the warranty, but also an elimination of all reliance (including the reliance requirement to turn a representation into a warranty). Given the national trend of eliminating the reliance requirement, this result would not be surprising. Furthermore, because of the economic loss doctrine in Wisconsin, attempting to analyze contract-based claims in terms of tort concepts, such as reliance, is both archaic and potentially destructive of the goal of bringing certainty to the expectations of parties to a contract. While historically a breach of warranty claim evolved from a tort claim, the economic loss doctrine instructs us that contract disputes should not be grounded at all in tort but in the privatized negotiations embodied in contract.34

In any event, Wisconsin law does not expressly answer the question of whether or what type of reliance is necessary to establish a breach of express warranty claim. Regrettably, a paucity of decisions on this issue exists, and the decisions that do exist often establish a forced distinction between whether a warranted assertion is a mere representation (requiring proof of reliance on the underlying truth of the assertion) or whether it is an express warranty (which may not require reliance on the underlying truth). The most likely result is that no reliance on the underlying truth is required if an express warranty is made.³⁵

Conclusion

As a matter of policy, courts should hold that when the written terms of a contract contain express warranties, the warranties represent the bargained-for economic risk allocation agreed on by the parties; the warranties are enforceable terms of the contract; and the buyer's pre-closing knowledge of the untruth of a warranted assertion, however such knowledge is obtained, does not preclude recovery for a breach of warranty claim. If any reliance is required, reliance on the enforceability of the contract and the warranties it contains should be sufficient. Such a rule would bring Wisconsin into conformity with the law of a majority of jurisdictions.

Lastly, when two sophisticated parties enter into a contract for the sale of a business, there are several material factors regarding the agreement that cannot be determined to an acceptable degree of precision. An example of this is when both parties know that the company being sold has or may have environmental damage on its property, but the parties cannot agree on the potential costs of cleanup. In situations similar to this, the parties often will negotiate a warranty, where the seller will warrant that there is no environmental damage on the property, even though both parties either know this is not true or are uncertain.³⁶ This warranty is purchased by the buyer in order to shift the cost of cleanup to the seller. If the warranty were not in the contract, then the buyer would reduce the amount it is willing to pay for the company by its estimate of the cleanup costs that it would be liable for. The warranty is a contract term for which the buyer has paid consideration to the seller.

If a court subsequently determines that the warranty is not enforceable because the buyer knew of its untruth or otherwise did not rely upon it, the court upsets the bargain of the parties to allocate the clean-up costs to the seller. This collides with the recognition, cited with approval in Mackenzie v. Miller Brewing Co.,³⁷ that contracts reflect the parties' bargain, and nonenforcement of the bargain would not only "chill the formation of contracts and reduce predictability," but also diminish the objective of protect[ing] justifiable expectations and the security of transactions.

Regardless of the unsettled state of Wisconsin law, the authors believe that the following language (written from a buyer's perspective), if included as an introduction to the representations and warranties article of the contract of sale, should be sufficient to ensure that all representations and warranties will be enforceable without regard to any proof of reliance or fear that a seller will successfully assert a waiver argument:

"In order to induce Buyer to enter into this Agreement, and to close upon all transactions contemplated by this Agreement, Seller makes the following representations and warranties to Buyer. Each Section of this Article is considered by the parties to this Agreement to be, will be treated as, and shall be effective and enforceable as an express warranty, whether or not Buyer has relied on the truth of the warranted fact. Buyer's knowledge of any inaccuracy or breach of any representation and warranty, regardless of when, how or from what source such knowledge is acquired, shall not be a waiver of such representation and warranty or any of Buyer's rights under this Agreement with respect to such breach. Buyer expressly reserves the right to assert any and all claims for, or arising from, the breach of any representation and warranty, regardless of any knowledge of such breach prior to closing. Buyer has no duty to disclose to Seller any knowledge of any breach of any representation and warranty, regardless of when, how or from what source such knowledge is acquired."

Endnotes

¹CBS Inc. v. Ziff-Davis Pub. Co., 75 N.Y.2d 496 (1990). (For the purposes of this article, an express warranty will be treated as a statement in a contract of sale made by the seller, upon which the parties to the contract expect the buyer to rely. This statement typically will be made to warrant the truth of an assertion regarding the business to be sold.)

²See Am. Bar Ass'n, Model Stock Purchase Agreement with Commentary 189 (1995).

³Ainger v. Michigan General Corp., 476 F. Supp. 1209 (S.D.N.Y. 1979), aff'd, 632 F.2d 1025 (2d Cir. 1980).

⁴Id. at 1214.

⁵Id. at 1223 (quoting Glacier Gen. Assurance Co. v. Casualty Indem. Exch., 435 F. Supp. 855, 860 (D. Mont. 1977)); see also Am. Bar Ass'n, supra note 2, at 189 (discussing buyer's knowledge of untruth of a warranted assertion before closing not being bar to recovery).

⁶Pension Benefit Guar. Corp. v. Ziffer, 1994 U.S. Dist. LEXIS 87 (N.D. Ill. 1994); Indeck N. Am. Power Fund, L.P. v. Norweb, P.L.C., 316 Ill. App. 3d 416 (2000); Shambaugh v. Lindsay, 445 N.E.2d 124 (Ind. Ct. App. 1983); Mowbray v. Waste Management Holdings Inc., 189 F.R.D. 194 (D. Mass. 1999).

⁷Indeck, 316 Ill. App. 3d at 428.

⁸Southern Broad. Group, LLC v. GEM Broad. Inc., 2001 U.S. Dist. LEXIS 7386, *17 (M.D. Fla. 2001); see Lennar Homes Inc. v. Masonite Corp., 32 F. Supp. 2d 396 (E.D. La. 1998).

⁹Giuffrida v. American Family Brands Inc., 1998 U.S. Dist. LEXIS 5588 (E.D. Penn. 1998).

¹⁰Id. at *15.

¹¹Id. at *16-17; see also Mackenzie v. Miller Brewing Co., 2001 WI 23, ¶28, 241 Wis. 2d 700, 623 N.W.2d 739 (holding that the law encourages contractual exchanges to foster predictable results).

¹²Pegasus Mgmt. Co. v. Lyssa Inc., 995 F. Supp. 29 (D. Mass. 1998).

¹³Glacier Gen. Assurance Co. v. Casualty Indem. Exch., 435 F. Supp. 855 (D. Mont. 1977).

¹⁴Wechsler v. Long Island Rehabilitation Ctr., 1996 Mass. Super. LEXIS 626 (1996); Richards v. Saveway Oil Co., 2 Mass. Ct. App. 514 (1974).

¹⁵C.R. Anthony Co. v. Loretto Mall Partners, 112 N.M. 504 (1991).

¹⁶Land v. Roper Corp., 531 F.2d 445 (10th Cir. 1976).

¹⁷Hendricks v. Callahan, 972 F.2d 190 (8th Cir. 1992).

¹⁸Middleby Corp. v. Hussmann Corp., 1992 U.S. Dist. LEXIS 13138 (N.D. Ill. 1992) (applying Delaware law).

¹⁹Kazerouni v. De Satnick, 228 Cal. App. 3d 871 (1991).

²⁰Rogath v. Werner, 129 F.3d 261 (2d Cir. 1997); Galli v. Metz, 973 F.2d 145 (2d Cir. 1992); Southern Broad. Group, LLC v. GEM Broad. Inc., 2001 U.S. Dist. LEXIS 7386 (M.D. Fla. 2001); Giuffrida v. American Family Brands Inc., 1998 U.S. Dist. LEXIS 5588 (E.D. Penn. 1998).

²¹In the opinion of the authors, this is a forced distinction. It is not clear why one circumstance is treated as a purchase of insurance while another is treated as a waiver of claims when the buyer's knowledge is the same and the only difference is the source of that knowledge. In each situation, one would expect the question to be decided by analyzing whether the elements necessary to establish a waiver - a knowing relinquishment of a right - exist. This distinction seems at odds with the treatment of express warranties as contract terms, where proof of reliance generally is not a required element for a cause of action for breach. Moreover, distinguishing between sources of knowledge introduces a degree of uncertainty into already complex transactions, making the source of knowledge subject to a finding of fact before a court.

²²See Anderson v. Tri-State Home Improvement Co., 268 Wis. 455, 461, 67 N.W.2d 853, 858 (1955); Foss v. Madison Twentieth Century Theaters Inc., 203 Wis. 2d 210, 218, 551 N.W.2d 862, 865 (Ct. App. 1996).

²³Foss, 203 Wis. 2d 210, 214, 551 N.W.2d at 864.

²⁴Id. at 216, 551 N.W.2d at 864.

²⁵Id. at 218, 551 N.W.2d at 865.

²⁶See Wis JI-Civil § 3010 Agreement (1998). (This jury instruction states that the three elements required for a contract to be binding are an offer, an acceptance, and consideration.)

²⁷Wis JI-Civil § 3220 Express Warranty: General (1998).

²⁸Smith v. Reed, 141 Wis. 483 (1910).

²⁹Id. at 487 (emphasis added).

³⁰See Borg v. Downing, 221 Wis. 463 (1936).

³¹See Dittmann v. Nagel, 43 Wis. 2d 155 (1969) (UCC express warranty principles extend to other areas of law).

³²Wis. Stat. § 402.313 (1999-2000).

³³Ewers v. Eisenzopf, 88 Wis. 2d 482 (1979).

³⁴See, e.g., Stoughton Trailers Inc. v. Henkel Corp., 965 F. Supp. 1227 (W.D. Wis. 1997).

³⁵While it is not clear what is necessary to make a contractual assertion an express warranty, it appears from Smith that the inclusion of the magic words "express warranty" in the contract provision are, even if not necessary, sufficient to make the provision an express warranty.

³⁶Alternatively, the parties could express their economic risk allocation in the form of either an express purchase price adjustment mechanism or an explicit indemnity. If either of these drafting methods were used, no issue of buyer's reliance would arise and both would be given effect. The authors believe that this same result is commonly intended, and should be given equivalent effect, if the parties choose to express their risk allocations via the drafting mechanism of representations and warranties.

³⁷2001 WI 23, ¶28, 241 Wis. 2d 700.

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