(j) Disclosures in M&A agreements

Triggering disclosure and clarification. In M&A agreements, credit agreements and other major transactions, warranties serve to smoke out the facts. The process of asking and negotiating warranties should trigger the disclosure of facts and events that might not otherwise become known. In this respect, warranties spur the seller on to discharge its ‘duty to inform’, whilst at the same time the purchaser effectively conducts its ‘duty to investigate’. Asking and negotiating the warranties is therefore a natural outflow of the due diligence investigation. (Ideally, a purchaser’s due diligence questionnaire will match the set of model warranties which a purchaser would require if it had full bargaining power. At the same time, since such a set is likely to be ‘complete’, a seller would organise its data room consistent with such model warranties.)

Example and strategy. For example in the context of a sale of a chemical business, the buyer most probably wants to know whether there are any environmental contaminations for which the target company may be held liable at some point in time. The potential purchaser will ask the seller of a company to warrant the following:

Except as disclosed in Schedule 10, there have not at any time been any Spills or Contaminations on or from the Production Site.

To continue the example, the seller may have carried out environmental investigations providing a minimum of comfort that there are no environmental complications. However, there may have been hazardous spills that were not accurately reported in the records and not discovered in the soil investigation.

When the seller receives this warranty as part of the first draft set of warranties, there are several options:

(a) refuse to make the warranty (either in general terms stating “take a closer and more critical look at what you are asking” or in more specific terms stating “we are unwilling to make this warranty”). In our example, refusal may imply that the seller is hiding environmental contaminations, and the purchaser will want the warranty even more;
(b) qualify the warranty by the words to the seller’s knowledge, so that the warranty is only incorrect if the seller fails to disclose relevant facts actually known to it. (Often, reference is made to the seller’s best knowledge: the qualification best is nonsense because someone either ‘knows’ or ‘does not know’.) In many cases, the responsible former and current managers are named to further limit the scope of seller’s knowledge, imposing a necessity to scrutinise them about the warranties qualified as such;
(c) limit the scope of the proposed warranty. A mark-up of the above example could state that the seller has always had adequate waste spill reporting policies in place in accordance with the best industry practices at such moment in time, and that it has conducted adequate soil investigations;
(d) make the warranty, as well as a disclosure of all facts or events of which it is aware.

The best approach depends on several circumstances: the negotiating power and leverage of the disclosing party, the sensitivity of the negotiations generally (e.g. the level of mutual trust or confidence of the parties), the time of internal discovery of ‘defects’ in warranties (i.e. disclosure letters tend to be prepared and handed over after the warranties have been negotiated, at least to some extent), the disclosing party’s liability exposure in view of thresholds and baskets, the disclosing party’s general approach to being complete and comprehensive (or not), the willingness to address (highly) sensitive subjects (e.g. potential antitrust issues). Disclosures may also be made by excluding, or carving out, the incorrect facts or events otherwise covered under the warranty. This is appropriate if the exception is rather extensive as opposed to the scope of the warranty against which it is disclosed.
The disclosing party should realise in advance that proposing a dis­closure may in turn trigger a buyer to require specific indemnities separate from the warranties (and excluded from the warranty-related limitations of liability). Such a specific indemnity may take many forms: from a specific indemnity limited in scope, time and amount to remedial action taken by the seller (or under its supervision and at its costs).

Disclosures – best practice rules. Like warranties, disclosures are statements of facts or events. Therefore, disclosures must not contain obligations, promises or undertakings of any kind. Like warranties, disclosures may refer to annexes attached to the disclosure schedule, which annexes may list, describe or otherwise report the disclosed facts or events.
It is good practice to organise meetings with the senior employees who should potentially have any knowledge of possible warranty breaches. In other words, when a disclosure letter is to be drafted, the disclosing party’s lawyers should meet with each such employee (or small group of employees). They should explain the impact of a warranty breach (i.e. being somewhat different from ordinary course warranties), the thresholds above which a warranty breach is likely to become an issue, and explain word-by-word what is meant by a warranty. Each employee should be encouraged to give as much information as possible. After that, he or she may well be requested to sign off on the reflection in the disclosure letter, or to document any disclosure. Subsequently, it should be the negotiation project team that decides whether or not making the disclosure is appropriate.

General vs. specific disclosures. The party that prepares the disclosure letter will try to avoid the disclosure of information that is publicly available (e.g. in public registers, such as for companies, for ownership rights of real estate, or for patents or trademarks). Obviously, the work related to making such disclosures can be enormous (with a risk of missing certain specifics), whilst the information itself may not be very useful (other than having an aggregated list of items that will be transferred).
Similarly, the disclosing party will prefer to refer to existing and readily available documents, such as the transaction’s information memorandum and (the Powerpoint handouts of) management presentations, as well as any disclosed financial statements and management reports. For this reason, a first draft disclosure letter will likely attempt to include all information that is generally available to the public or otherwise available to the other party. The part of the disclosure letter that addresses these disclosures is referred to as general disclosures (as opposed to specific disclosures that are prepared in view of a certain warranty).
In an M&A-transaction a seller will try to elaborate on the opportunities that were given to the purchaser and its advisers to undertake an (extensive) due diligence investigation. Accordingly, the seller will attempt to have the complete dataroom considered to be a disclosure against all warranties.

Numbering of disclosures. It is recommended that the numbering of individual disclosures match the numbers of the warranties. Accordingly, the disclosed item gets a number that corresponds to the warranty in connection with which it is primarily included.

Disclosure against what? Because a warranty will typically have a great level of overlap with matters addressed in other warranties, the related disclosures will inevitably need to be either repeated or a statement be included that the disclosures are deemed to be made against each of the warranties (and that grouping them is for convenience only). This also implies that the party seeking the disclosure may fail to recognise its impact, whilst at the same time, the opposite approach would lead to unnecessarily extensive and repetitive disclosure letters.