Welcome to MJ Hudson’s monthly On Target, where you’ll find useful tips and insights to ease you through your M&A transactions.
This month we focus on five principles for a seller to follow when preparing to provide details about the target company to a buyer, in response to the buyer’s demands for warranties (actionable statements of fact regarding the state of the company and its business). That process, integral to any company sale, is known as “disclosure”. For the purposes of this article we shall assume that the entire share capital of a company is being sold by a single corporate seller, in an arm’s length transaction on customary terms, to a single corporate buyer.
From the start of due diligence, a buyer will request materials to inform its decision whether to proceed, and if so on what terms. In practice a seller will have anticipated this, and prepared a data room to provide what it anticipated a buyer would want to see (e.g. regarding financials, contracts, employee details, regulatory permissions etc).
However, the heart of “disclosure” is the seller’s substantive responses to the set of warranties in the sale and purchase agreement (SPA) (or separate warranty deed) supported by documentation in the data room. These responses are known as “specific disclosures”.
The seller will specify, usually in a letter or appendix to the SPA called the “disclosure letter”, to what extent it is unable to stand behind the buyer’s requested warranties. This may be because the statements of fact that constitute the warranties are not entirely true or accurate, or could be considered misleading.
For example, a buyer will typically request confirmation that a company has no litigation. If there is one item of litigation involving the company, rather than striking out the entire warranty (which the buyer will never accept) the seller will provide details of the exceptional litigation in the disclosure letter. Similarly, if there is a dispute that doesn’t, strictly speaking, constitute litigation, the seller might disclose details of it in case agreeing with the proposed warranty is considered misleading.
Warranties are legally actionable statements of fact and the buyer will be entitled to sue the seller in respect of loss or harm suffered due to reliance on an incorrect/misleading warranty. A seller can obtain a shield against such action by informing the buyer’s understanding through “disclosure” of relevant exceptions to the warranties. Disclosure, therefore, is a seller’s friend; the more thorough the approach to disclosure, the stronger the seller’s shield.
If the seller has prepared the draft SPA, the first set of warranties is likely to be seller-friendly, and so any disclosures prepared on the basis of these warranties will be inadequate. For example, if a warranty states that the company has no customer contracts with a value over GBP 500,000 and limited disclosures are prepared in respect of this (i.e. details of customer contracts over that value), those disclosures will be incomplete if the buyer then lowers the threshold to GBP 20,000.
It is important to identify the realistic “high watermark” (i.e. most buyer-friendly package) of warranty cover before commencing the disclosure process. Subsequent negotiations may improve the seller’s position, but if the buyer doesn’t compromise then any disclosures based on the worst case scenario will still be adequate.
Where the seller drafted the SPA, the natural “high watermark” is the buyer’s first mark-up of the SPA. Where the buyer drafted the SPA, disclosures could be prepared based on this draft (as the final agreed form shouldn’t be any worse for the seller). It is also reasonable to wait until the buyer responds to the seller’s first mark-up which may be a more realistic reflection of the buyer’s true demands, particularly if the buyer’s first draft was considered aggressive.
The second timing point for a seller to consider is at what point to include particularly sensitive disclosures in the disclosure letter. It is good practice to ensure that the seller’s first draft of the specific disclosures is as comprehensive as possible. However in some instances a seller may wish to delay making a disclosure, for example where litigation is expected to reach a favourable settlement imminently.
A word of caution is required here; late disclosures can annoy a buyer, as the buyer will need time to assess the impact of the disclosed facts. Late disclosures can undermine the trust and confidence between the buyer and seller, and the buyer could use the late disclosures as a pretext to enhance its warranty and indemnity cover and revisit limitations on liability (such as financial caps).
In order to ensure that disclosure against all warranties is comprehensive and accurate, a seller will need to involve key, often senior, individuals who have the relevant specialist knowledge to review the warranties and detail all exceptions to them.
The SPA may even identify those individuals who have to be consulted on certain matters – for example where warranties are subject to the seller’s awareness, the SPA may list senior individuals whose awareness is attributed to the seller, and state that specified other employees, consultants or advisers are deemed to have been consulted by those senior individuals. If the potential transaction is being kept confidential within the target company, this consultation process will need to be managed carefully.
The best approach is to map out, in advance, which individuals are best placed to review the suite of warranties relevant to their specialist area and send them the “high watermark” version of those warranties in good time. In our experience a meeting or conference call with all relevant individuals and the seller’s lawyer early in the process can help to flush out any pertinent exceptions to the warranties.
A buyer wants the disclosures to (i) tell a story of the facts that contradict the relevant warranty – who, what, where, when, how, why; (ii) explain the impact of those circumstances on the business, be in terms of cost, risk or interruption; and (iii) do so clearly and comprehensively.
Taking the example of litigation again, if a warranty confirms there is no litigation and a claim is in fact going through court, it is insufficient to disclose that “Mr. X has brought a claim against the company”. Such a basic response will only prompt the buyer to ask further questions, consuming further management time. A far more comprehensive response would note “Mr. X is claiming damages of £X plus legal costs of approx. £Y from the company for a breach of contract dating back to 2016. The claim is currently scheduled to be heard in the High Court on [date]. The company is defending the claim and has received legal advice that the claim has no realistic prospect of success. The company estimates that its total legal fees to trial will not exceed £Z”.
Clear and comprehensive disclosures also maximise the strength of the disclosure ‘shield’ and, if the content of those disclosures are also warranted, an incomplete or misleading disclosure could even create a cause of action against the seller in and of itself.
If a disclosure is knowingly withheld, or knowingly or recklessly made, a seller also risks committing the criminal offences of fraud or (in the case of a share acquisition) making misleading statements under financial services legislation.
If a seller is finding that the “high watermark” warranties are so wide that the potential disclosures against them would run to pages and pages, or it is simply not within the seller’s powers or knowledge to know if the warranties are true, another tactic can be to attack the warranties themselves; typically in tandem with the preparation of disclosures.
By way of example – a warranty that “there is no litigation” could require pages of disclosure of low value, insignificant claims. But if the warranty was negotiated down to “there is no single item of litigation with a claim value over £[x]”, the disclosures could be much more manageable.
Similarly, if the warranty were “no client intends to terminate their contract in the next 6 months”, and the seller simply doesn’t know if this is true or not, the warranty could be preceded by “so far as the seller is aware” or could be modified to say “no client has notified the company of its intention to terminate their contract…”.
Another tactic is to focus on what information in the SPA or disclosure letter is considered to be “generally disclosed”. It is standard for certain information, for example public records at Companies House, to be “deemed disclosed”; i.e. the ‘shield’ applies to information in those records. It is a matter of negotiation whether the contents of the data room are deemed disclosed.
However a seller will only obtain the protection of the ‘shield’ if the deemed disclosed information is sufficiently clear to allow a buyer to understand the nature and impact of what is being said (i.e. the disclosure is “fair”). Information that is ambiguous, out-of-context or hidden may not pass this test.
Is this brief too brief? Do you need any help with your upcoming sale process? Expert legal advice is on hand from MJ Hudson’s M&A team. Just contact any of the On Target team (details below) or your usual MJ Hudson M&A contact, and we’ll gladly help.
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