Lawyers spend a lot of time negotiating the representations, warranties and the indemnity package in a merger and acquisition deal since these are arguably the most important risk allocation tools in an M&A document. An equally important risk allocation tool which is inter-linked with the above is a disclosure letter.
A disclosure letter contains items of disclosures which act as a qualifier to the representations and warranties provided by a seller. The buyer will not be able to claim remedies for a breach of a representation and warranty if the event leading to such a breach was already disclosed by the seller.
Therefore, it is important for the sellers to make adequate disclosures to avoid future claims as well as for buyers to completely understand the matters which are being disclosed so that they can make an informed decision while making an investment or an acquisition.
A comprehensive disclosure letter is in the interest of a seller as well as a buyer. It shields a seller from a claim for breach of representations and warranties. It helps a buyer in flushing out details regarding the target which may be of interest.
From a seller’s perspective, it is important to ensure that all relevant disclosures are made in as much detail as possible. The approach must be one of disclosing more rather than less. When the seller makes all relevant disclosures to the buyer at the outset, it can substantially mitigate any claims of fraud or misrepresentation.
The exact definition of ‘disclosed’ in an M&A document is a topic of much debate. Buyers would typically want a very high standard of disclosure and include various criteria such as the information being fully, fairly, specifically, adequately and accurately disclosed.
Even if the seller is able to negotiate a lower standard of disclosure than described above, it is always better for the seller to disclose the matter in sufficient detail so as to enable a buyer to understand the purport of such disclosure.
In case the seller does not adequately disclose the matter, then the buyer may allege that the disclosure was insufficient, and the seller may be exposed to a liability for breach of a representation and warranty.
At the time of preparation of the disclosure letter, the seller should consult with all its functional departments and obtain all relevant disclosures. The seller should constantly update the disclosure letter for any new findings during the course of the negotiations as the seller typically reserves the right to update the disclosure letter until the transaction is completed.
Apart from giving factual disclosures, the seller should also consider enclosing all relevant documents and records which further substantiate the disclosure. Also, the seller can negotiate to include certain general disclosures which may include the information contained in the target’s financial statements, websites or from other public sources such as government websites which a buyer usually reviews etc.
The buyer’s rights with respect to the seller’s disclosures have also been a topic of debate. As explained below, the buyer may seek various alternate rights with respect to the disclosures made by the seller. The seller should strongly resist the right of the buyer to terminate the agreement on account of a disclosure made by the seller.
The golden rule is that the buyer should not accept any general disclosures given by the seller. Even though as part of its due diligence, the buyer may have reviewed general information pertaining to the target and publicly available documents. The seller is required to specifically highlight all disclosures to the buyer; and the onus of assessing the impact of the disclosure should not be placed on the buyer.
Further, the buyer should not accept any new disclosure made by the seller which relates to the review period of the due diligence exercise carried out by the buyer but were not disclosed at the time of conducting due diligence.
The buyer should probe in full detail the disclosures made by the seller and all attendant documents to fully assess the impact of such disclosure on the target and accordingly assess the impact of such disclosure on the transaction.
In case the seller’s disclosures are not acceptable, the buyer can explore a variety of options. The buyer may direct the seller to exclude such disclosures from the disclosure letter to allow the buyer to make indemnity claims in relation to any liability arising due to the disclosed item. The disclosed item may even be made a specific indemnity item by the buyer.
Also, in case the disclosure item has a severe impact on the target company, then the buyer may exercise the right to terminate the transaction or renegotiate the consideration.
The seller would like to retain a right to mutually agree on the way forward regarding the disclosure item on the basis of severity of the disclosure item so that the buyer does not have a unilateral right with respect to the same.
The buyer should not provide an unrestricted right to the seller to disclose matters pertaining to the target. The buyer may only accept disclosures between signing and closing of the transaction pertaining to the matters which have occurred between signing and closing only.
Further, the buyer should retain a right to terminate the agreement or seek specific indemnity related to such item or re-negotiate the purchase price in case the matter disclosed in the updated disclosure letter has a material impact on the operations of the target.
Disclosures in times of uncertainty
Due to the impact of the COVID-19 pandemic on the global economy, it has become increasingly difficult for buyers to access and examine all the details regarding operations and the financial condition of the target while performing their due diligence. Therefore, the importance of disclosure letters for the buyers to flush out the details of the target cannot be overstated.
Equally, since the pandemic has undoubtedly had an impact on businesses in all spheres, the sellers can also use the disclosure letter as a shield against claim for breach of broadly worded representations and warranties due to such adverse impact.
Prasenjit Chakravarti is Partner and Nitish Goel is Principal Associate at law firm Khaitan & Co. Views are personal.