Many readers will be aware that the default position on a business sale under English law is caveat emptor (buyer beware). In M&A (as in any other transaction) risk passes at point of sale – when something is sold the seller passes all legal responsibility for loss to the buyer. For this reason, a buyer of a business will seek to include a number of warranties in a purchase agreement about the status of the business (and tax warranties about the tax status of the business).
Breach of warranty claim is a breach of contract claim
The starting point is that if any of the seller's warranties end up being untrue the buyer can claim for breach of contract. This is the buyer's way of protecting against the caveat emptor principle. If a warranty is untrue the buyer can claim damages and effectively reduce the purchase price.
However, the seller and the buyer usually agree that there will not be a right to claim for breach of contract where facts regarding the breach are disclosed prior to the sale. These facts are generally included in a disclosure letter. Essentially, a disclosure letter acts to identify and put the buyer on notice of any exceptions to these warranties.
The warranty section of the purchase agreement is often the most heavily negotiated (after the price). M&A lawyers will be familiar with last minute negotiations as to whether a particular warranty can be qualified by reference to the "seller's actual knowledge".
In reality, it is rare for a buyer to bring a breach of warranty claim due to both the expense of bringing a breach of warranty claim and also the limitations around warranty claims invariably set out in the purchase agreement.
Why are warranties are so strongly contested?
Given the scarcity of breach of warranty claims in M&A deals, why do sellers spend so long trying to chip away at the warranties proposed by the buyer? In part because the whole procedure of negotiating warranties and the disclosure letter focuses the attention of both the seller and the buyer on the liabilities of the asset or business being acquired. The process allows the buyer to extract information which can be used to determine whether the price the buyer is offering is too high or if in fact the buyer should walk away.
The warranty section of the purchase agreement is often negotiated much more heavily than the disclosure letter itself. The seller will argue that they cannot prepare a disclosure letter until the warranties are set and not subject to any further drafting changes (i.e. when the purchase agreement is in final form). Inevitably this means that a draft disclosure letter is presented to the buyer very late on in the deal.
The disclosure letter – if in doubt disclose
The disclosure letter is typically split into two parts: general disclosures and specific disclosures.
General disclosures are usually matters of public record e.g. documents filed at Companies House or the Intellectual Property Office. Specific disclosures will be set against individual warranties. For example, on a sale of a company there is likely to be a warranty that there have never been any employment claims brought against the seller's company.
If the seller knows this is incorrect because an employee brought an employment claim against the company 6 months previously, the seller would include this information in the disclosure letter as a specific disclosure. This would mean that the buyer could not bring a breach of warranty claim against the seller if damages ended up being paid to the employee by the company.
Indemnity – the buyer’s best remedy?
This then brings into play a whole new provision of the purchase agreement, the indemnity clause. If the seller has put the buyer on notice of a particular risk by setting out detail in the disclosure letter the buyer may then ask for an indemnity from the seller covering that particular risk. It is often said that an indemnity is closer to "insurance" than a warranty. A claim for breach of warranty follows the same rules as any breach of contract claim: there has to be proof of loss and the buyer is required to mitigate (minimise) his losses.
For an indemnity claim all that is required is that the buyer shows that an event has happened (using the example above, if there was an indemnity given that the seller would indemnify the buyer regarding employment claims, the employee winning his employment claim would be enough to trigger the indemnity). An indemnity clause refers to a specific risk. The usual provision is that indemnities cannot be disclosed against.
The interaction between due diligence and disclosures
As M&A lawyers will testify, another lawyer to lawyer dialogue that can reach into the early hours of the morning is how much of the information shared by the seller during the due diligence process is considered "disclosed" for purposes of the disclosure letter.
The first document the buyer's lawyer will send to the seller is usually the due diligence checklist. This can run to dozens of pages and is invariably met with gloom as the seller is typically required to furnish a data room with answers to questions regarding every aspect of the seller's business including suppliers, customers, employees, insurance, intellectual property, contracts, litigation, policies and corporate governance. The data room now is typically an online "virtual" data room rather than the actual room set aside in pre-internet days.
Having spent many hours answering all these questions and populating the data room, the seller then typically wants all this information to be considered "disclosed". The seller may argue that if information is in this data room it is unreasonable for the buyer to claim they did not know about it. The buyer's response tends to be that they would not know that a specific document in the data room was addressed to a specific warranty or there might be a document in amongst the thousands that had not been brought specifically to their attention. For this reason, a buyer tends to insist that only the documents actually attached to the disclosure letter will operate to limit a breach of warranty claim.
Buyer knowledge of breach of warranty means no warranty claim
There is currently debate in the English Courts that (despite the wording of a purchase agreement) if a buyer knows about a breach of warranty before completing the purchase the buyer will not be able to bring a claim – even if the seller has failed to include detail in the disclosure letter. The advice to a buyer therefore should be that if they are put on notice of an undisclosed issue the buyer cannot necessarily rely on a breach of warranty claim. The buyer should seek to either reduce the purchase price or include an indemnity to cover the particular risk.
The seller must take care preparing the disclosure letter. The wording in the purchase agreement typically requires that to be "disclosed", the disclosure must be given "fully fairly and specifically". A breach of warranty claim may still be successfully brought by the buyer where a disclosure is insufficiently precise. If the seller has any doubts as to whether something should be included in the disclosure letter, the cautious tactic is to include it.
Finally, the buyer should also satisfy themselves that the disclosures are unambiguous to avoid future disputes – the aim of the entire process.
