Legal Aspects of Company Sales: Disclosure Letters
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 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 branch 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. Accordingly, the Sellers, with their solicitors and particularly with their auditors, will need to consider each and every warranty in detail and the implications of that warranty upon the business and will wish to draft a carefully worded Disclosure Letter qualifying 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. Firstly, there could be retention of title provisions affecting materials or goods purchased from a third party. Secondly, there could be a charge over all assets to secure bank borrowings and, third party, there could be assets used in the business which are subject to a lease, purchase, lease or hire purchase agreement. Assets coming into this last category could be motor-cars, computers, photocopying machines and telephone systems. 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 up to date and that all liabilities have been agreed. The taxation warranties need to be very carefully considered with the target company's auditors, who have detailed knowledge of the up to date state of affairs and they, in conjunction with the finance director, should be asked to suggest the drafting for the taxation disclosures.
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. This is necessary so that, in the event of a warranty claim, the Sellers can research accurately from their records whether of not the particular matter was the subject of a disclosure was adequate to represent a protection against the warranties. 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' solicitors 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 Disclosures Letter. There is a general introduction making reference to the Disclosure Letter qualifying liability in respect of the warranties and also indemnities under the Deed of Indemnity and then deeming certain matters to be generally closed. 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 matters against specific warranties but will also contain the further statement that the disclosures relate to all warranties, not simply the one against which, for convenience, it has been located.
5. Tax Deed
There will often be negotiation as to whether the disclosures contained in the Disclosure Letter should also qualify the indemnities given to the Purchaser in the Tex Deed of Indemnity. The Purchaser may argue that taxation should be fully provided for in the Accounts or arise after the Accounts Date in the ordinary course of business, so that the Sellers must take full risk for any unprovided items. It may also argue that the disclosures do not constitute sufficient information to calculate the taxation effects of the disclosures and will seek to limit the effect of the Disclosure Letter to the warranties alone. Depending upon the conduct of the negotiations, it may be that the Sellers will seek to express the possible taxation effect of a particular disclosure or they may be able to indicate that certain disclosures only are intended to quality the Tax Deed of Indemnity. However, in practice, it has become rare for purchasers to agree to permit disclosures to qualify the indemnities.
6. Conclusion
The effect of the disclosure exercise is to concentrate the minds of the Sellers upon the precise warranties that they are giving. It is surprising to many Sellers just how many exceptions they wish to disclose to standard warranties even though they felt confident about the state of the business and its books and records. If the disclosure exercise conducted 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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Tony Forster Head of Company Commercial
Martino Burgess Associate
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This article summarises the law on issues which we believe may be of interest to your business. It is not a comprehensive review of the subjects and accordingly is published without responsibility for loss occasioned to any person(s) acting or refraining from action as a result of information published. This document is provided for information only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.