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Buyer beware! Disclosure in acquisitions – what it’s for, and who it benefits?

One of the most important features of any merger and acquisition (M&A), share sale or asset process is ‘disclosure’, along with its sister process, due diligence.

Disclosure and due diligence are significant because of the existence of ‘warranties’. Warranties are statements of fact about the business or assets being sold, and they are made by the seller in the contract for sale. A warranty that is later found to be untrue can result in a legal claim by the buyer against the seller for breach of contract.

Disclosure ‘qualifies’ the warranties to protect the seller against warranty claims. For example, the seller may be asked to give a warranty that the company being sold isn’t involved in any litigation. If there are outstanding legal disputes, the seller will ‘disclose’ the existence of these claims to the buyer pre-sale and provide further details to the buyer as part of the due diligence process.

On the face of it, disclosure seems to be of more benefit to the seller than the buyer, since it’s a bit like a ‘get-out’ clause. So, can a buyer take disclosure for granted, or at least leave it to their legal team to conduct the due diligence process on its behalf?

The short answer is no. Disclosure can be extremely helpful to a buyer in terms of providing information about the target company and business. In this guide, we explain what the disclosure exercise involves and why it’s so important, focussing primarily on the sale of a company’s shares.

What’s a warranty?

Warranties are the statements made by the seller about its company and the business being sold. The warranties are contained in the sale and purchase contract between the buyer and the seller. They are often heavily negotiated.

If the buyer discovers, following completion of the acquisition, that a warranty is untrue, it can bring a breach of contract claim against the seller. If it succeeds, the seller will have to pay damages so that the buyer is put (financially) in the position it would have been had the warranty been true.

You can find out more in our article Warranties and indemnities: what you need to know.

You can also watch our video on preventing warranty claims from arising:

What’s disclosure?

Warranties normally follow a standard format. One of the standard warranties a buyer will be asked to make is that the company is not involved in any current (or threatened) litigation. If there are outstanding legal disputes on the day the sales contract is exchanged, the seller won’t be able to make the warranty. Because of this, it will disclose to the buyer details of the dispute as part of its ‘disclosure’ during the due diligence phase.

This disclosure has the effect of ‘qualifying’ the warranties. The seller isn’t able to give the buyer the warranty as drafted, so the warranty will be amended to refer to the items disclosed to the buyer.

Since the buyer now knows about the dispute, they can’t bring a claim for a breach of the ‘no litigation’ warranty. Disclosure can also protect sellers from accusations of fraud or mis-selling under certain legislation.

What’s more, not only is the seller protected from breach of warranty claims but the disclosure and due diligence processes are very helpful to the buyer, who can discover a great deal about the business from information disclosed to them that might not otherwise be publicly available.

Disclosure and due diligence

Due diligence is the information-gathering exercise conducted by the buyer before they commits to purchase a company.

Once the seller has decided to sell its business, they will set up a ‘data room’ – either real or virtual – that will contain information and documents relevant to the business and that may be of interest to potential buyers. Buyers will conduct due diligence partly by trawling through the documents in the data room, and partly by researching publicly available information about the target business.

In effect, due diligence is a fact-finding mission conducted by the buyer so that they understand exactly what they are buying.

Why then does the seller also need to make disclosures to the buyer? If the buyer has conducted a thorough due diligence exercise, don’t they already know everything about the target company and business?

The answer is no. Inevitably, due diligence doesn’t cover everything. This may be because there hasn’t been enough time for the buyer to investigate everything, it may be too expensive to carry out full investigations (for example, if the company has operations abroad), or because mistakes have been made by the buyer’s staff when answering questions about the business.

While due diligence will ideally provide the buyer with a lot of information about the target company and business, the formal disclosure process often flushes out even more information, since the buyer will focus on the precise wording of the warranties to avoid liability down the line.

Disclosure letters

Formal disclosure is made in a disclosure letter that’s given by the seller to the buyer. It’s drafted by the seller’s legal team following input from the seller and its staff.

The first section usually includes fairly standard wording (although it may be subject to negotiation between the legal teams), followed by ‘general disclosures’ and then ‘specific disclosures’.

What’s the disclosure bundle

The disclosure ‘bundle’ is the set of documents and evidence referred to in the disclosure letter.

For example, if the seller has given a warranty that they have disclosed details of all its material supplier agreements (such as those worth over a certain amount), copies of these will be included in the disclosure bundle.

Depending on the size of the transaction, disclosure bundles can vary in length from a few pages to reams of paper. They are now often held virtually along with a paper index of the documents in the data room.

There will be two copies of the disclosure bundle:

  1. One for the seller
  2. One for the buyer

Once the disclosure letter and bundle have been agreed, the legal team for each of the seller and the buyer will meet and go through the two disclosure bundles to ensure that they are the same. They will usually initial each of the documents, or sometimes, every page, although now, in the age of electronically-held files, the paper index may simply be initialled.

General disclosures

Certain information will be deemed to have been disclosed to the buyer, and this information is known as the ‘general disclosures’.

General disclosures comprise certain public information and searches/fact-checking exercises which are quite standard across all acquisitions. They will include, for example, a review of the target company’s statutory books, a search at Companies House, property searches, and so on. That said, they are often more heavily negotiated than the specific disclosures but tend to be dealt with by the parties’ legal teams and often do not require much input from the buyer.

The seller will want the general disclosures to be as wide as possible, for example, by saying that all information that comes up in a search before completion will be deemed to have been disclosed.

The buyer, on the other hand, will seek to limit the general disclosures by limiting them to those searches they’ve made, or specifying the date on which they carried out the search. For example, ‘all information filed at Companies House on [insert date of search]’.

If the target company has been established for a long time, the buyer may also limit the general disclosures by specifying a backstop date, for example, information registered at Companies House before a certain date will not be deemed to have been disclosed.

Specific disclosures

Specific disclosures are the disclosures against the actual warranties in the purchase agreement.

So, for example, a warranty may state that the seller hasn’t recently dismissed any of its employees. If, in reality, they have dismissed a member of staff, they’ll include details in the ‘specific disclosure’ section of the disclosure letter.

Warranties will sometimes state that certain information has been disclosed to the buyer, for example, a list of the company’s registered trade marks. This list may be included as a schedule to the purchase agreement, or most usually will be included in the disclosure bundle so that the purchase agreement doesn’t get too long, and that all information regarding the target company is in the same place.

The seller’s legal team will prepare a first draft of the specific disclosures, based on its knowledge of the target company. Once this draft is complete, the seller will need to trawl through it in detail, to make sure the legal team has picked up everything.

The seller should put together a team to head up the due diligence, including their head of finance, HR and in-house lawyer (if they have one) to review the disclosures, and to make sure that all aspects of the business are covered. It is vital that all information be included in the specific disclosures, even if the buyer is already familiar with a particular issue.

Some specific disclosures may apply to more than one warranty. If this is the case, the disclosures may be duplicated in the disclosure letter across the various warranties to which they relate. There will also be catch-all wording in the disclosure letter which provides that disclosure against one warranty will be deemed to be disclosure against any other relevant warranty.

The seller will aim to draft the specific disclosures widely to ensure that the buyer has sufficient information to prevent a contractual claim from being brought at a later date.

Sometimes information may be disclosed against a warranty that has no bearing on the warranty at all. This is an attempt to give the buyer knowledge of additional information which could potentially result in a breach of warranty claim. The buyer’s legal team will resist this but will want as much information as possible about a true disclosure, especially if it’s a new issue of which the buyer is not aware.

If you’re a buyer, you’ll need to look carefully at the specific disclosures. You should feel free to request further information through your legal team to enable you to understand the whole picture.

When reviewing and negotiating the disclosures, it is crucial that any requests or passing of information or documents are made via the lawyers. Don’t be tempted to cut out the legal middleman and deal with the other party directly, even if you have a good relationship.

This is to ensure that all disclosures and related documents are captured in the disclosure letter and included in the disclosure bundle, so that you avoid costly legal wrangling about precisely what was disclosed.

When are disclosures given?

The disclosure letter will be signed at the same time as the purchase agreement. This is fine if the contract is signed (known as ‘exchange’) and the deal finalised (‘completion’) on the same day, but sometimes there’s a delay between contract signing and finalisation, for example, if certain conditions need to be met before money changes hands.

In this situation, the buyer will want the seller to repeat its warranties at completion. So, what can the seller do about issues that have arisen between exchange and completion?

The buyer won’t agree to a new disclosure letter disclosing against the warranties all over again as, by this time, it will be too late for the buyer to do anything about it (because the agreements have already been signed at exchange).

One solution is a compromise, for example, allowing the seller to make additional disclosures at completion but permitting the buyer to walk away from the transaction if the new disclosures throw up any ‘deal-breaker’ issues.

What happens after disclosure?

Hopefully, any issues that arise during disclosure will be minor, but sometimes, a significant problem crops up. What happens then?

A buyer has several options. They can ask for the price to be reduced, ask the seller to sort out the issue before completion, ask for an indemnity if the issue ends up costing them money, or as a last resort, walk away from the transaction. While walking away is drastic, it could still be the best option in the long run.

Ongoing disclosure

The disclosure exercise is ongoing until exchange and completion. So, if any new information arises regarding a specific disclosure, even if that disclosure has already been drafted, the seller needs to tell the buyer about it.

However, a buyer may not accept a late disclosure since they’d then need to investigate it to understand its potential impact. Sellers should therefore aim to disclose any information as soon as possible and not sit on it in an attempt to force the buyer’s hand.

Fair disclosure

If a seller wants to rely on a disclosure to defend itself against a claim for breach of warranty, the disclosure needs to have been ‘fair’, meaning that they’ve given the buyer enough details to identify the nature and scope of the matter being disclosed.

Sometimes a buyer will want to go further and insist that disclosures be:

  • ‘full’
  • ‘accurate’
  • ‘clear’
  • ‘specific’
  • a combination of the above

In any event, the seller needs to make sure they make honest and accurate disclosures to avoid the risk of expensive breach of warranty claims at a later date.

Confidentiality

Confidentiality can be an issue during the disclosure process. Certain information which is required to be disclosed may be confidential or protected by legal professional privilege.

Wherever possible, a seller should try to get the consent of third parties that might be affected by the release of confidential information to consent to the release of that confidential information to the buyer. It’s likely that the buyer will have entered into a confidentiality or non-disclosure agreement at the beginning of the transaction and this may provide some comfort to the seller and third parties. The seller may also be able to disclose the information by redacting sensitive information and thus avoid breaching any confidentiality requirements it’s bound by.

If a seller thinks that certain disclosures may be confidential or subject to legal professional privilege, they should discuss this with their lawyers to decide how best to proceed.

Can a seller leave disclosure to its legal team?

As mentioned at the start of this guide, the short answer to this is ‘no’. The seller must engage with the disclosure and due diligence process, involving appropriate members of their team.

Disclosure is an ongoing process and once the disclosure letter has been drafted, the seller should ensure that its lawyers know about new information that comes to light before exchange and completion which may need to be disclosed.

From the buyer’s perspective, disclosure is an important information-gathering exercise that will allow them to find out more about the target company and business prior to purchase. In some cases, the buyer may be able to use the disclosure exercise as a means of reducing the purchase price or obtaining some protection from the seller.

The disclosure exercise can be time-consuming. Whether you’re a buyer or a seller, it’s easy to ignore or minimise its importance in the face of other pressing issues. However, we advise you not to give in to that temptation as mistakes during disclosure can prove extremely costly.


What next?

If you’d like to know more about the M&A process, disclosure, due diligence or warranties, contact our team of corporate solicitors. Get in touch on 0800 689 1700, email us at enquiries@hjsolicitors.co.uk, or fill out the short form below with your enquiry.

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