The Disclosure Letter is a critical document in any acquisition of the shares of a private company. Sellers that do not make adequate disclosures expose themselves to potential claims for breach of warranties, whilst a Purchaser that does not treat the exercise with significant care may take on liabilities which it could otherwise have avoided. By accepting disclosures made by way of a Disclosure Letter, the Purchaser accepts the commercial risks from the matters disclosed.
1. Reasons for using a Disclosure Letter
The Sale Agreement will normally provide that no liability shall attach to the Sellers, in respect of what would otherwise be a breach of warranty, to the extent that the circumstances constituting the breach are disclosed to the Purchaser in the Disclosure Letter. It will inevitably be the case that no company is in such a perfect condition that the Sellers can give all warranties in an unqualified form. The Sellers (with their professional advisors), will need to consider each and every warranty in detail and the implications of that warranty upon the business. Carefully worded disclosures will be needed to qualify liability under the warranties. This will usually be accompanied by a substantial amount of relevant documentary information, much of which may already have been supplied in connection with the replies to the Purchaser’s due diligence enquires.
2. Examples of standard disclosures
If one takes the common items which appear in the warranties, there are certain areas where the Sellers’ solicitors would always be looking to prompt the Sellers to consider possible disclosures. The most common area relate to ownership of assets, litigation and taxation. There is also almost always a warranty to the effect that the assets of the Company are the unencumbered absolute property of the Company. This particular warranty could give rise to three possible sets of disclosures: (1) There could be retention of title provisions affecting materials or goods purchased from a third party; (2) There could be a charge over all assets to secure bank borrowings; and (3) There could be assets used in the business which are subject to a lease, purchase, lease or hire purchase agreement.
Details of these exceptions to the warranties should be disclosed and copies of any relevant documents supplied.
The litigation element could involve contractual disputes with suppliers, warranty claims being made by customers or litigation with former members of staff. In the case of taxation, there will almost always be something to disclose as an exception to the warranties, which normally requires the Sellers to state that all tax returns are submitted and are up to date, and that all liabilities have been agreed. Drafting of the appropriate disclosures will, of course, require the input of solicitors/accountants.
3. Approach to making disclosures
In dealing with the disclosure aspect on behalf of the Sellers, it is vital that the Sellers’ solicitors should know what information has been supplied to the Purchaser. The Sellers’ solicitors must also be given copies of any information which the Sellers have supplied informally to the Purchaser, so that these can be formally transmitted to the Purchaser’s solicitors and contained within the Sellers’ solicitor’s records as having been disclosed. Then, at completion, the disclosure bundles of both the Sellers’ and the Purchaser’s solicitors are conformed.
4. Form of Disclosure Letter
There is a standard format that is usually adopted for the drafting of the Disclosure Letter. The extent to which the Purchaser will accept general disclosure is a matter of negotiation, but matters which would be the subject of discussion would be all matters in the public domain, all matters available upon an inspection of various registers (such as records at Companies House, land charges, local land charges or trade marks), or apparent on a physical inspection of the books and records of the target company, the targets company’s properties or indeed sometimes its plant and machinery. The Disclosure Letter then goes on to disclosure against specific warranties.
The effect of the Disclosure Letter is to concentrate the minds of the Sellers upon the precise warranties that they are giving. It is often surprising to many Sellers just how many exceptions they wish to disclose to standard warranties, even if they felt confident about the state of the business and its books and records in the first place. If the disclosure exercise is conducted properly and the clients and their professional advisers address their minds carefully to the issues, it should be possible to prevent liability to warranty claims in all but the most unforeseen of circumstances.
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