Making disclosures – strategy

Many M&A-related contracts contain warranties. If so, the party making them will likely want to make carve-outs or to smoothen its liability exposure by making disclosures. What are ‘disclosures’ and when should you make them? That’s what this blog is about.

Triggering disclosure and clarification. In 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 ‘complete’, a seller would organise its data room consistent with such model warranties.)

Example and approaches. For example in the context of a sale of a chemical business, the buyer most likely 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 done 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 required by the buyer, it has several options:

  1. refuse to make the warranty (either in general terms “take a closer and critical look at what you are asking” or more specifically “we are unwilling to make this warranty”). In our example, refusal may imply the suggestion that the seller hides environmen­tal contaminations, and the purchaser will want the warranty even more;
  2. 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 redundant 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.
  3. 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.
  4. make the warranty, as well as a disclosure of all facts or events of which it is aware.

Strategy. The best approach depends on several circumstances: the negotiation power and leverage of the disclosing party, the sensitivity of 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 be 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 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).

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