In negotiated acquisition agreements, representations and warranties provided by the seller are sometimes qualified by the knowledge of the seller. In such agreements, it is critical to clearly set out the standards as to what constitutes knowledge of the seller. According to the 2014 Canadian Private Target M&A Deal Points Study by the American Bar Association (ABA Study), 90% of the publicly available acquisition agreements in 2014 involving Canadian targets and acquirers contain a defined knowledge standard.
Knowledge qualifiers are sought by sellers to minimize their exposure to liability, especially in relation to representations and warranties regarding circumstances outside of their control or which cannot easily be determined. For example, a commonly accepted practice is to qualify the representation and warranty that there is no threatened litigation against the seller. The use of the qualifier in other areas is usually subject to negotiation in an attempt to allocate the risks of an acquisition. Buyers may seek to avoid knowledge qualifiers by arguing that the seller is more familiar with the company and in a better position to investigate, and therefore it is more efficient for the seller to assume such risks.
Defined knowledge standards
The main area of contention is often not the existence of the qualifier in an agreement, but the way in which it is defined. The ABA Study shows that 18% of the acquisition agreements define knowledge as actual knowledge. This definition is more favourable to the seller because of its narrow scope; sellers would only be liable for misrepresentation of facts in their actual knowledge, without any obligation to investigate.
On the other hand, 72% define knowledge as including constructive knowledge. This definition is less favourable to the seller because it imputes knowledge in certain circumstances. Out of those agreements that include the concept of constructive knowledge, 89% impute knowledge when facts should have been known after reasonable investigation or due inquiry, while 7% impute knowledge that should have been known by particular persons in the course of performing their duties.
For clarity, the parties should identify the person(s) whose knowledge is imputed to the seller, whether generally (i.e., all officers and directors) or with reference to specific individuals. The ABA Study shows that 82% of the agreements with defined knowledge standards identify the person(s) whose knowledge is imputed.
From 2010-2014, the prevalence of defined knowledge standards has been increasing from 82% to 90% of the acquisition agreements, with a growing proportion being defined to include constructive knowledge rather than solely actual knowledge (72% in 2014 as compared to 51% in 2010). Whether or not this suggests that buyers are gaining ground by imposing greater obligations on the seller to conduct investigations or inquiries, it remains clear that the various knowledge standards should be carefully considered in negotiations and properly defined in the agreement.
The author would like to thank Matthew Lau, articling student, for his assistance preparing this legal update.