Laura Donald discusses the important differences you need to be aware of in terms of disclosure in US M&A transactions

Introduction

While not considered the star of the show in an M&A deal, one of the most important documents in an M&A transaction is the disclosure letter (or disclosure schedule as it is referred to in the US), which can have important consequences for both the buyer and the sellers in the deal. Every acquisition agreement will include representations of fact (warranties) from the sellers to the buyer regarding key aspects of the business being sold. Once these warranties are negotiated and memorialized in a definitive transaction agreement, the hard work for the sellers begins: each of the warranties must be reviewed again and the disclosure letter or schedule prepared and delivered to the buyer.

Why Care about Disclosure?

For the buyer, the disclosure letter or schedule serves as a critical part of the due diligence process to uncover potential issues or areas of concern with respect to the target’s business. For the sellers, the disclosure letter or schedule can offer protection against post-completion breach of warranty claims by the buyer.

What is the Difference between a Representations and a Warranty Anyway?

US-style acquisition agreements typically include language that the “Sellers represent and warrant that…” The term "representation," while used interchangeably with "warranty" in the US, is typically sought to be excluded in UK-style acquisition agreements based on the argument that including “representations” may give rise to tortious (i.e., non-contractual) claims and a right of rescission under the English Misrepresentation Act 1967. In a UK style acquisition agreement, sellers are typically advised to seek exclusion of any remedies for tortious claims and recission by including an express provision in the agreement that affirms the exclusion of these remedies instead of simply relying on the argument that those remedies are excluded because the warranty statements are fashioned only as “warranties” and not as “representations and warranties.”

M&A Disclosure, UK Style

In UK M&A deals, disclosure against warranties made by the sellers in the acquisition agreement is typically made through a separate disclosure letter delivered by the sellers to the buyer. The disclosure letter will typically address both general disclosures and specific disclosures.

General disclosures consist of information relating to the sellers that would be available to anyone conducting a search of publicly available information (e.g., a search of the target company’s information with UK Companies House, including basic corporate filings made by the target over the years, revealing details as to the target’s owners and directors, articles of association, board and member resolutions and any security granted over the target’s assets). These general disclosures are deemed to be disclosed to the buyer, whether or not the buyer has conducted any actual records searches, and will qualify all of the warranties in the acquisition agreement.

It is also common practice in the UK for sellers to seek general disclosure of information and documents that were provided to the buyer during the due diligence review. This is usually accomplished through a general disclosure of the contents of the virtual data room in which due diligence materials were housed and shared with the buyer and its advisers. Buyers may push back on general disclosure of the data room, and it is prudent for sellers to address this point in the term sheet. In addition, the disclosure letter is typically accompanied by a separate “disclosure bundle” consisting of a large collection of documents (which, as noted, may extend to the entire contents of the data room), and all of the contents of the disclosure bundle are deemed disclosed against all of the warranties.

Specific disclosures consist of matters that limit or qualify the scope of the warranties made by the sellers in the definitive acquisition agreement so that the warranties line up with the factual realities of the target company’s business. Creating an accurate list of specific disclosures may require different members of the target’s management team to review the warranties relevant to their functional areas and confirm the accuracy of the warranties, and this process is often facilitated by legal counsel assisting with the transaction.

The disclosure letter also typically qualifies all of the warranties (but not specific indemnities) in an acquisition agreement. However, UK court decisions suggest that sellers will not be able to defeat a warranty claim by a buyer (and thereby benefit from the protection of disclosure) unless the sellers have made disclosures that are “fair.” “Fair disclosure” means the sellers have provided the buyer with sufficient details to identify the nature and scope of the matter being disclosed against a particular warranty.

M&A Disclosure, US Style

Unlike the separate disclosure letter typically used in UK M&A deals, US M&A transactions typically use disclosure schedules that are incorporated into the definitive acquisition agreement (i.e., “integrated schedules”) and generally serve either as an affirmative disclosure or as a negative disclosure. In US M&A deals, the disclosures are typically specific, and it is unusual for a disclosure to qualify all of the warranties – generally this is permitted only where the disclosure has clear relevance to another warranty. General disclosures of the contents of a virtual data room or of a “disclosure bundle” are often met with resistance from the buyer.

Affirmative disclosures typically cover lists of various items that are important to the business being sold that are required in the warranties in the definitive agreement to be scheduled out (e.g., lists of all material contracts, all intellectual property, all real property).

Negative disclosure provides an opportunity for the sellers to limit or qualify the warranties made in the definitive acquisition agreement, again so the warranties line up with the factual realities of the target company’s business. If the warranties don’t, in fact, reflect the realities of the target’s business, the cost incurred by the buyer to rectify any issue or problem that should have been disclosed will likely come back around as an indemnity claim against the sellers.

What is an Indemnity and why Should Sellers Care?

In a UK-style M&A deal, indemnities typically cover specific concerns that may be revealed during the due diligence process, and that could potentially cause a loss in the future. For example, if an environmental hazard is discovered during due diligence, which may or may not cause subsequent loss to the target company’s business, the sellers may agree to indemnify the buyer for any losses which do actually arise from this issue post-completion. Other typical examples include potential or ongoing litigation or uncertainties around ownership of intellectual property.

In US-style M&A deals, a broad indemnity is typically given for any breach or inaccuracy of a warranty, and not just for the specific concerns that might be identified during the buyer’s due diligence review of the target company.

A key difference between US- and UK-style acquisition agreements is the basis for recovering any loss for a breach of warranty. In the UK, the buyer’s ability to recover will depend on how the breach of warranty has affected the overall value of the target company’s shares, potentially including loss of profits. As a result, it may be more difficult for a buyer to recover all of its costs in the event of a breach of warranty. In the UK, there is also likely to be a duty on the buyer to mitigate its loss. In contrast, in the US, the buyer can typically recover its losses for breach of warranty on a dollar-for-dollar basis. The key difference to the UK position is not having to show a diminution in the value of the target company shares or acquired assets; direct damages sustained on the balance sheet would typically be recoverable in the US without a need to show continuing impact on the income statement.

What about the Buyer’s Knowledge?

In almost all M&A deals on either side of the Atlantic, a buyer will embark on a fact finding due diligence exercise prior to entering into a definitive agreement to acquire a target company or business. During this exercise, the buyer (either directly, or through its advisors or agents assisting with the transaction) will obtain “knowledge” of the target company’s business activities and uncover some issues or problems.

The definitive acquisition agreement will need to address whether the buyer will be bound by what it learned (or could have learned) during the due diligence process, but prudent sellers should not rely upon the buyer being held to what it learned through its due diligence review as an excuse to avoid thorough disclosure. Although the UK position is not entirely clear as to whether a buyer’s knowledge of the facts precludes it from making a claim for breach of warranty, the leading case in the UK suggests that where a buyer has actual or imputed knowledge of certain facts, it may still be able to bring a claim for breach against sellers where this is contemplated and permitted in the definitive agreement (subject to the court suspecting that the buyer has acted unfairly). This argues strongly in favour of the sellers taking care to disclose fully against all warranties notwithstanding the buyer’s due diligence review and further notwithstanding whether the deal is a UK- or US-style transaction.