One of the most important features of any merger and acquisition (M&A), share sale or asset process is ‘disclosure’ and the preparation of a disclosure letter. In this article, we discuss what a disclosure letter is and why disclosure is important in a merger or acquisition.
Why is disclosure important in M&A?
Disclosure is important because of the existence of numerous warranties in the typical sale and purchase agreement. Warranties are statements of fact, given by the seller, about the company, business or assets being sold. 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 and, sometimes, misrepresentation.
Similarly, many investment agreements also contain warranties given by the target company and its founders or managers.
Why are warranties important in M&A?
Warranties are important to a buyer since they are used to obtain information about the target from the seller and also act as an allocation of risk by diverting it on to the seller. The seller can manage this risk by disclosing information relating to the warranties in the disclosure letter. This has benefits on both sides. The first is to act as a defence for the seller in a breach of warranty claim since, if the disclosure is legally adequate, no claim can be made against the seller in relation to that claim. The second is that it provides information to the buyer that it may not have obtained in the due diligence process.
Disclosure can be clarified further with some examples. The sale agreement may include 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 in the disclosure letter and provide further details to the buyer as part of the disclosure process.
What is a disclosure letter?
The disclosure letter is a formal letter given by the sellers to the buyer and it may be accompanied by a bundle of supporting documents (disclosure bundle). The seller’s legal team can assist with the disclosure letter although it requires substantial input from the sellers themselves as most disclosures require intimate knowledge of the business of which the legal team will not be aware.
If a due diligence exercise has been undertaken this will assist the disclosure process however it does not replace it. We discuss what due diligence means in the context of a share sale, the process, and why it is so important to both parties in this article. It is important for any information qualifying any warranties to be properly disclosed in the disclosure letter and the sellers must not assume that because they think the buyer already knows something or it was buried in a data room that this will protect them as this is unlikely. The best defense is the disclosure letter itself.
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’. General disclosures relate to information readily obtainable from public registers such as Companies House. Specific disclosures relate to specific numbered warranties in the sale and purchase agreement.
Preparation of specific disclosures requires thorough analysis by the seller of each of the warranties set out in the agreement in conjunction with their knowledge of the business and consideration if there are any facts or matters that make any of the statements untrue. On the seller’s side it may be necessary to include various team members in this process, such as the head of HR and finance, their accountants, and individuals on the commercial side of the business. The seller’s lawyers can assist by using this information, once they have it, to ensure that the disclosure meets the legal standards to be valid.
On the buyer’s side, ideally when reviewing the disclosure letter, they will not find any major surprises if a thorough due diligence process has been undertaken. Any critical items disclosed which present a specific risk to the buyer can be mitigated, resolved, or dealt with in the sale and purchase agreement up front before it is signed. This is significantly preferable to finding issues later and having to submit claims following completion of the transaction.
Can a seller leave disclosure to its legal team?
The short answer to this is ‘no’. The seller must engage with the disclosure 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.
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.
Making sure you have experienced legal and financial advisors on board together with early preparation and planning are the key takeaways to achieve a successful M&A process. You can learn more about the seven steps of an M&A transaction and what to expect in our article. For more answers to commonly asked questions and advice on company acquisitions and assistance with your disclosure process, consult our M&A solicitors.