Last updated on May 13th, 2020 at 09:32 am
The disclosure process
The disclosure process is a key part of a private acquisition and a full and proper disclosure exercise is in both parties’ interests. It is the seller’s opportunity to disclose any liabilities or potential liabilities to the buyer in order to have a successful defence against a potential claim for breach of warranty from a disgruntled buyer. It is the buyer’s opportunity to flush out any skeletons in the closet as it supplements the due diligence exercise in giving the buyer a fuller picture of the target company or business. It is better for a buyer to find out about a previously unknown issue before the acquisition so that it can walk away or negotiate a reduction in the purchase price rather than have to litigate against the seller after completion.
What is a warranty?
A share purchase agreement (for share sales) or a business purchase agreement (for asset sales) usually contain a series of warranties. A warranty is a contractual statement of fact that the seller is standing behind as true and accurate as at exchange and/or completion. If a warranty is incorrect or misleading then the seller can either 1) remove the warranty from the acquisition document or 2) make a full and proper disclosure against the corresponding warranty as to why it is untrue or misleading.
What is a disclosure?
‘Disclosed’ will usually by defined in the acquisition document. This definition is important as it sets the standard that a disclosure must meet in order to qualify the corresponding warranty. In order for a disclosure to be deemed to be ‘Disclosed’ (and therefore qualify the warranty that it relates to), it must contain sufficient detail to enable the buyer to identify the nature and scope of the matter disclosed. For example, if a warranty states that ‘the company is not engaged in or involved in any litigation’ and this is untrue, then a disclosure in relation to this warranty that states ‘the company is involved in litigation’ is unlikely to reach the threshold of ‘Disclosed’.
Case law indicates that courts usually look at the strict drafting of disclosures and the definition of ‘Disclosed’ in the acquisition agreement. If a disclosure does not meet the threshold of ‘Disclosed’, then the seller would not have a successful defence in the event of a breach of warranty claim by the buyer.
What is a disclosure letter?
The Disclosure Letter is a letter from the seller to the buyer which identifies any exceptions to the warranties that are given by the seller in the acquisition document. The Disclosure Letter is commonly divided into two parts – ‘general disclosures’ and ‘specific disclosures’, and will have attached to it copies of the documents being disclosed (known as the ‘disclosure bundle’).
General disclosures cover certain matters which appear in public records and/or of which the buyer was aware or ought to be aware on the basis of pre-contract enquiries or searches actually made, or which a buyer would normally make. General disclosures are likely to be the subject of much negotiation between the parties as there is a conflict of interests between the buyer and the seller. It is in the seller’s interest to include as many broad general disclosures as possible, whereas it is in the buyer’s interest to limit the general disclosures as much as possible. The buyer should treat the proposed general disclosures with caution. For example, if matters ‘in the public domain’ are treated as disclosed, would that include something available on the internet?
A specific disclosure relates to actual matters which, if not disclosed, would or might constitute a breach of warranty. If a seller makes a sufficiently detailed disclosure in relation to a specific warranty then they will usually have a successful defence in the event of a breach of warranty claim by the buyer.
Two copies of the Disclosure Bundle should be produced so that one hard copy folder is delivered to the buyer with the Disclosure Letter and the other is retained by the seller. Two CDs may be produced instead of hard copy folders, particularly if a virtual data room has been used. Prior to completion, the buyer’s and seller’s solicitors should ensure that both copies of the Disclosure Bundle are identical and initial both hard copy folders or CDs as appropriate.
The first draft of the Disclosure Letter will normally be prepared by the seller’s solicitors. The seller should ensure that the Disclosure Letter contains everything relevant, even if it knows that the buyer is aware of a particular matter. If the seller has any doubts as to whether something should be included, the prudent approach is to include it.
When preparing the Disclosure Letter and Disclosure Bundle, the seller should retain copies of all documents provided as part of the due diligence process and create an index of the documents that have been disclosed. The seller will need to continually monitor the warranties and may therefore need to update the Disclosure Letter and Disclosure Bundle immediately prior to exchange and/or completion.
Regardless of how thorough the buyer is in its due diligence, the first draft of the disclosure letter almost always reveals new issues that the buyer was previously unaware of. The buyer should therefore ask for the Disclosure Letter to be prepared as soon as the majority of the warranties in the acquisition document are substantially in final form.
The buyer should raise further enquiries in relation to disclosures in the Disclosure Letter and Disclosure Bundle to ensure that the disclosures are clear and it fully understands the consequences of accepting them.
If the seller makes a material last minute disclosure then the buyer should either reject the disclosure or be prepared to delay exchange/completion in order to properly consider the potential impact of the matter being disclosed.
What are the consequences?
If a seller makes inadequate disclosures, it may find itself on the receiving end of breach of warranty claims which it could have avoided. A breach of warranty claim may allow the buyer to recover some or even all of the purchase price. The value of the claim will depend on the severity of the breach of warranty and the subsequent loss that the buyer has suffered as a result of the breach.
Under section 89 of the Financial Services Act 2012, it is a criminal offence for a person to conceal information or make a misleading statement in order to induce another party to enter into an investment agreement (which would include a share purchase agreement). The offence carries an unlimited fine and/or seven years’ imprisonment.
In addition, if a seller a seller chooses to remain totally silent about a known issue and this results in the seller failing to comply with a positive representation, this would constitute a misrepresentation. For example, a positive representation would include a warranty that states ‘The company maintains, and has at all material times maintained, adequate insurance cover against all losses and liabilities, including business interruption, and all other risks that are normally insured against by a person carrying on the same type of business’. If the company has not and/or does not maintain adequate insurance and the seller chooses not to disclose this problem to the buyer then this would constitute a misrepresentation.
The seller should therefore be very careful if it decides to deliberately withhold information which should ordinarily be disclosed during the disclosure process.
If a buyer fails to review a disclosure letter properly, it may be in for some unpleasant surprises which could result in the company or business being worth significantly less than the buyer initially thought.
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