“Knowledge is king”, so the adage goes.
What is the relationship between ‘knowledge’ and merger and acquisition (“M&A”) transactions? In M&A transactions, representations and warranties are made by the seller with respect to the target company. What does knowledge have to do with this? The answer is simple: risk allocation.
Representations and warranties not only serve to provide information to the buyer, but more crucially play the role of allocating risk as between buyer and seller. A seller will attempt to keep its representations and warranties as narrowly drawn as possible. A buyer, at the other end of the spectrum, will seek to have the seller’s representations and warranties pitched broadly.
During negotiations, one detail that lawyers lovingly quibble over are the ‘qualifiers’ to the representations and warranties. The categories of qualifiers are aplenty. The focus here will be on the introduction of ‘knowledge qualifiers’.
Assuming the parties have crossed the hurdle and agree to use a knowledge qualifier, that is not the end of the matter. Parties will still need to discuss the following:
- The scope of the definition of ‘knowledge’. Does ‘knowledge’ only cover ‘actual’ knowledge, or does it include ‘constructive’ knowledge?; and
- Whose ‘knowledge’ is relevant?
We will examine these in turn.
Actual Knowledge vs Constructive Knowledge
Actual knowledge requires the relevant party to actually know of a particular item or event that causes a breach of the representation and warranty in question. Given actual knowledge is narrower in scope than constructive knowledge, a buyer will prefer to limit any knowledge qualifiers to actual knowledge.
Conversely, constructive knowledge is, in effect, imputed knowledge, and a definition of constructive knowledge will include language referencing a duty of inquiry or reasonable investigation.
For example, constructive knowledge could be defined as the knowledge that any given individual would be expected to learn after some reasonable level of diligence, or what that individual would be expected to know in his or her capacity as an officer, director, or employee, etc. (as applicable) of the target company. Put succinctly, constructive knowledge is knowledge that the person is presumed to have. Given that it is broader in scope and application, a seller’s preference would naturally lean towards the inclusion of constructive knowledge in any ‘knowledge’ definition.
There are strong arguments for both types of knowledge, depending on whether you are a buyer or seller. More often than not, what tips the scale will be the bargaining power of the parties. That said, we are seeing a trend where parties agree on the use of ‘constructive knowledge’ but with the compromise that it is limited to the knowledge of a select group of persons.
Discussions around knowledge qualifiers will also require negotiating whether the seller’s knowledge is limited to the knowledge of specifically identified persons or categories of persons.
From a buyer’s perspective, if the seller is a company and the definition of knowledge includes constructive knowledge but with no limit as to whose knowledge is included, there is a significant risk that such definition could impute the knowledge of a wide pool of the company’s employees. Some of these employees may not have even been involved in any preparation of the representations and warranties in the transaction documents. With such a wide pool of ‘knowledge’, this raises the possibility that a representation and warranty in question is in fact qualified by constructive knowledge. A seller will therefore want to include as wide a group of persons as possible. Clearly, this would be something that buyers want to avoid.
A buyer would insist on limiting knowledge to the knowledge of named individuals (or appointment holders) having control over, and in any event those most likely to have knowledge of relevant facts with respect to, the items covered by the relevant knowledge qualified representations and warranties. For example, it is not uncommon to limit this group to founding shareholders or chief executive officers or certain levels of management.
It would also be useful to mention that when negotiating ‘knowledge’, ‘disclosure’ is something that may potentially arise as an overlap.
The M&A documentation may include a definition of ‘Buyer’s Knowledge’ as a qualifier to representations and warranties. A seller would want to include due diligence reports prepared by a buyer’s advisors within such definition of ‘Buyer’s Knowledge’. This is juxtaposed with the definition of ‘Disclosed’ (which is also a common qualifier introduced by sellers to their representations and warranties), where due diligence reports prepared and provided by the seller to the buyer are included in such definition and therefore within the knowledge of the buyer, thereby qualifying any breach of a representation and warranty. If such qualifiers are used, it is important for parties to recognise the implications of the definitions used and to consider the breadth of each definition. This is especially true given that, from experience, ‘Disclosed’ is deployed more generally than ‘knowledge’ in the M&A documentation.
In any M&A transaction, buyers and sellers should anticipate that when it comes to knowledge qualifiers in representations and warranties, the issues that are commonly raised include:
- will any of the representations and warranties be qualified by knowledge qualifiers;
- if so, how will knowledge be defined (actual knowledge only, or actual and constructive knowledge); and
- who will be in the knowledge group.
Use of knowledge qualifiers can operate to shift risk allocation for post-closing issues. Therefore, knowledge can indeed be king, but you (or your lawyers) will have to make it work for you.