Warranties and what is accepted as effective disclosure against those warranties is one of the most time-consuming and heavily negotiated areas of any M&A transaction. Disclosure matters to sellers because an effective disclosure will protect the seller against a claim for breach of warranty. Effective disclosure is also important for buyers, as it means that buyers have no remedy in relation to a disclosed matter unless they make a price adjustment or seek specific protection.
Recent case law has questioned a generally held assumption as to what constitutes an effective disclosure and is likely to result in changes to the way the disclosure process operates and agreements are drafted. Here is a snapshot of the cases and their impact, followed by some tips on disclosure for buyers and sellers.
What amounts to Disclosure?
Prior to the Infiniteland case1, there was a generally held assumption that for a disclosure to be effective it had to pass a qualitative hurdle – lawyers generally refer to this as the concept of "fair" disclosure. Whether a disclosure is made fairly will depend on a number of factors, including the circumstances of a transaction.
Generally speaking, disclosures need to be clear to be made fairly: courts have found against sellers where disclosures were not "sufficiently precise"2. However, the requirement for clarity is not a matter of mere accuracy. The courts have also objected to disclosure by:
- omission from a list (in a case where seller claimed that a missing key licence of target business had been fairly disclosed simply by not including it on a list of licences that the target did have)3; or
- mere reference to another source where the information could be found, e.g. the target company’s accounts (as opposed to a clear indication which detail in the accounts amounts to the disclosure) 4.
Timing of disclosures can be another factor – courts are unlikely to look favourably on last minute disclosures by the seller. Conversely, if the buyer has had plenty of time and has used a range of expert advisers to assess disclosures, a court may accept a lower standard of specific disclosure as fair.
Crucially, as a result of the Infiniteland decision (discussed below), the courts will now look to the language used by the parties in the agreement as to what constitutes an effective disclosure (and will not apply a standard qualitative test to determine whether a disclosure is effective).
Infiniteland and its implications for disclosure standards
The facts in Infiniteland can be simply summarised as follows: after completion, a buyer became aware that a general accounts warranty (that the accounts showed a true and fair view) was untrue due to an overstatement of profits. The buyer brought a claim for breach of warranty against the seller on the basis that the accounts overstatement had not been disclosed. The seller’s defence against the claim for breach was that details of the overstatement had been provided to the buyer’s reporting accountants during their due diligence exercise and had therefore been sufficiently disclosed to the buyer.
The agreed disclosure letter provided that all "matters from the documents and written information" supplied to the buyer’s reporting accountants during their due diligence review were deemed to be included in the disclosure letter. Unfortunately for the buyer, its reporting accountants had failed to pass on their finding of the accounts overstatement to the buyer.
At first instance, the judge dismissed the buyer’s claim for breach of warranty on the grounds that the buyer had been aware of the profits overstatement. The judge did not stop there, but also referred with approval to the 1997 New Hearts case5. In New Hearts, warranties in the Sale and Purchase Agreement (SPA) had been given "subject to matters fairly disclosed (with sufficient details to identify the nature and scope of the matter disclosed) in the Disclosure letter" – a standard which the disclosures had failed to meet, according to the ruling of the judge in New Hearts.
It followed, in the view of the first instance judge in Infiniteland, that the disclosures at issue were not "sufficiently full, accurate and clear, and they would not match up to the standard expressed or implied in the New Hearts case". Effectively, then, the judge applied the New Hearts test to the disclosures under consideration in Infiniteland.
By contrast, the Court of Appeal rejected the idea of a standard qualitative test set by case law – instead, its judgment emphasised that the effectiveness of disclosures needs to be measured against the agreement (including the disclosure letter) in the case at hand. Put differently, the Infiniteland agreement simply did not have a provision analogous to the New Hearts wording, and therefore a comparison with New Hearts was not appropriate. The Court of Appeal found that on the basis of the facts and documents there had been a general disclosure of the written material supplied to the reporting accountants and that therefore there was no breach of warranty.
Finally, the Court of Appeal also pointed out that the buyer could have improved its contractual position by (i) refusing general disclosure of what was supplied to its reporting accountants and/or (ii) insisting on disclosures which were specific to each individual warranty. The buyer had chosen to do neither.
The key signal from the Infiniteland decision is that it sounds a warning to buyers by highlighting that they should robustly negotiate disclosure standards and carefully consider which general disclosures to accept.
Infiniteland – whose knowledge counts?
Having dealt with the question of disclosure standards, the Court of Appeal also commented on the issue of attributing advisers’ knowledge to a buyer. At first instance, the judge had decided that the buyer’s accountants’ actual knowledge amounted to actual knowledge of the buyer because the accountant was acting as the buyer’s agent. However, the majority of the Court of Appeal was of the view that actual knowledge could not be imputed to the buyer unless there was an explicit agreement between the parties – otherwise, the differences between actual, implied or constructive knowledge would be blurred. The Infiniteland agreement only referred to the buyer’s actual knowledge; therefore, it would be wrong to attribute the accountants’ knowledge to the buyers.
Interestingly, one of the Court of Appeal judges disagreed with the majority opinion: in his dissent, Pill LJ took the view that if an accountant is undertaking a due diligence review on behalf of the buyer, the accountant’s actual knowledge should be attributed to the buyer. Pill LJ used as an example what he described as the analogous situation of a conveyancing transaction where a seller is entitled to assume that information provided to the buyer’s solicitor is also to being given to the buyer.
The Court of Appeal’s observations on buyers’ and their agents’ knowledge are not binding law – it remains to be seen whether future decisions adopt the majority (buyer-friendly) view.
Since Infiniteland, we have seen more buyers setting out in greater detail the required qualitative standard for disclosure, for instance by following the New Hearts wording quoted above. It remains to be seen what other changes there will be in generally accepted market practice, such as the US-type approach of insisting on disclosure schedules that refer only to specific disclosures relating to specific warranties. To date, this approach has been strongly resisted by UK sellers. However, the Court’s suggestion in Infiniteland that it had been open to the buyer to ask for only specific disclosures has certainly served to strengthen buyers’ resolve to limit the scope of disclosures. What is clear, though, is that the courts will treat what the parties agree in a given transaction as the contractual yardstick to measure what is an effective disclosure.
PRACTICAL TIPS FOR BUYERS:
- negotiate the standard of disclosure with the seller: a court will not apply an overriding "fairness" standard, but will look closely to the wording in the SPA. For example:
- "the Warranties are subject to matters fairly disclosed (with sufficient details to identify the nature and scope of the matters disclosed) in the Disclosure Letter."
- include a provision protecting you from consequences arising from your own knowledge of matters for which a warranty claim may be brought – this should be limited to your actual knowledge and should also exclude the knowledge of your advisers or agents.
- ensure that the disclosures are as clear and specific as possible; mark up the draft disclosure letter if disclosures seem vague.
- ask for specific disclosure against each warranty (as opposed to wholesale disclosure against any warranty) – this is standard practice in the US, but still generally resisted in the UK.
- request a draft disclosure letter as soon as the warranties are reasonably finalised: although disclosures will "move" with the warranties - often negotiated until the last minute - it is important to have sufficient time to review and to investigate disclosures pre-signing in order to assess their impact on the warranties and the price.
- accept general disclosures if you are not actually in a position to verify these properly before signing.
- accept general disclosure of correspondence or of information supplied to your investigating accountants or your other advisers, particularly if the seller rejects the specific wording above.
- allow the seller to pressure you into accepting last minute disclosures.
- rely on being able to bring a successful claim for breach of warranty if you were aware of the breach before you signed the SPA – you may be able to sue under a knowledge saving provision in the SPA, but the courts may only award minimal damages if you knew about the breach. Instead, highlight the matter to the sellers and ask for indemnity protection or reduce the purchase price accordingly.
PRACTICAL TIPS FOR SELLERS
- expect more negotiation over the required standard for disclosures.
- try to agree with the buyer that general disclosures are acceptable.
- ask the buyer for a warranty or acknowledgement that they are not actually aware of a breach of warranty: this will give you comfort that the buyer is not signing the SPA knowing that they have a claim for breach.
- dedicate sufficient time and resources to the disclosure process.
- be tempted to make late or imprecise disclosures (a court may construe this against you when deciding whether disclosures have met the agreed standard of fairness).
- omit a matter that could amount to a breach of warranty from the disclosure letter, even if you are sure that the buyer is aware of it.
1 Infiniteland v Artisan Contracting Ltd and another  EWCA Civ 758,  All ER (D) 236 (Jun)
2 Levison and others v Farin and others  2 All ER 1149
3 Daniel Reeds Ltd v EM ESS Chemists Ltd  CLC
4 New Hearts v Cosmopolitan Investments  BCLC 249
5 New Hearts v Cosmopolitan Investments  BCLC 249
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.