This weekend, I decided to explore the implications of the Buyer knowing, pre-closing, that a Seller representation is inaccurate. (I haven’t seen the various aspects of this topic treated together in any detail from the perspective of the drafter.) Here’s what I put together; you should consider it a first draft. I’d be happy to receive comments.
Disclosing Pre-closing Knowledge of Inaccurate Seller Representations
It’s relatively commonplace for an M&A contract to contain a provision that addresses disclosure, pre-closing, of inaccuracies in the Seller’s representations. Such provisions can apply to the Buyer or the Seller. Let’s consider Seller provisions first.
Disclosing the Seller’s Pre-closing Knowledge
In many agreements, the issue of the Seller’s pre-closing disclosure of inaccuracies is addressed in terms of the Seller’s being required to update its disclosure schedules if any Seller representation was inaccurate when made or would be inaccurate at closing. In a number of respects, such provisions are problematic.
First, from a drafting perspective, rendering accurate an inaccurate representation might require amending that representation in addition to, or instead of, updating any disclosure schedules. For instance, if a given representation didn’t provide for any scheduled exceptions, then fixing that inaccuracy by adding a schedule of exceptions would, strictly speaking, also require revising the representation itself to refer to that schedule.
Second, such provisions commonly require that the schedules be updated not only to reflect inaccurate representations but also any failure by the Seller to perform any obligation and any event that would prevent any condition to the Buyer’s obligations from being satisfied. Updating schedules to reflect the latter two categories of events or circumstances would require schedules to perform something other than their intended function, which is limited to stating factual information that supplements or constitutes exceptions to a set of representations.
Third, while it could be argued that such provisions allow schedules to be updated to take into account ordinary-course changes such as the Seller’s entering into contracts between signing and closing, the better way to provide for such changes would be to include the date of the agreement as a “date of reference” in any affected representations and to address pre-closing change in either a pre-closing obligation (if the change is under the control of the Seller) or a condition (if it isn’t). (I’ll be discussing the significance of the “date of reference” in an article to appear in 2007. Or maybe I’ll do a blog entry about it beforehand.)
And fourth, provisions that address the Seller’s updating of schedules usually go on to specify that updating the schedules serves merely to inform the Buyer and has no effect on closing conditions or the Seller’s indemnification obligations. (Such language has broadly the same effect as the “indemnification-even-if-you-know” provisions discussed below.) In other words, the schedules are being updated, but not really. It would be simpler instead to incorporate the concept of updating in a way that leaves the schedules unaffected.
This can be accomplished by providing for the Seller to notify the Buyer of any relevant information. Such a provision would best be placed in an article stating various pre-closing obligations, and it might look like this:
2.11 . The Seller shall promptly notify the Buyer of any event or circumstance as a result of which any of the conditions stated in section 5.1 [Conditions to the Buyer’s Obligations] could not or would not reasonably be expected to be satisfied.
Here are some issues I considered in wording this provision:
First, note that unlike many provisions calling for schedules to be updated, the proposed section doesn’t lump together inaccurate representations, obligations that haven’t been performed, and conditions that can’t be satisfied. Instead, it refers only to any of the conditions to the Buyer’s obligations not being satisfied. You don’t need to refer to inaccurate representations or obligations that haven’t been performed, because they would be addressed by the bringdown condition and the performance-of-obligations condition, both of which would be included in a standard set of closing conditions. This is one reason why the proposed section is much shorter than the analogous “Notification” section in the ABA Section of Business Law’s Model Asset Purchase Agreement (2001) (at page 166).
Second, because this provision refers to conditions that could not or would not reasonably be expected to be satisfied, the Seller would be required to disclose not only actual but also potential dealbreakers.
Third, there’s the question of timing. Some updating provisions require that the Seller notify the Buyer no later than a stated number of days before the closing, but from the Buyer’s perspective it would be best to require that the Seller notify the Buyer promptly.
And fourth, assuming that the bringdown condition is qualified by materiality, the proposed language wouldn’t require the Seller to disclose any non-material inaccuracy in a representation. I think most buyers wouldn’t be troubled by that.
Disclosing the Buyer’s Pre-closing Knowledge
Agreements sometimes address the Buyer’s disclosure of any inaccuracies in the Seller’s representations that it becomes aware of. The purpose of such provisions is presumably to give the Seller the opportunity to rectify before closing any inaccuracy that it hadn’t been aware of—the cost of doing so might well be less than any claim for indemnification arising from that inaccuracy.
The best way to address this issue would be by means of (1) a representation with the signing date as the date of reference and (2) a pre-closing obligation:
3.13 . As of the date of this agreement, to the Buyer’s Knowledge none of the representations made by the Seller in article 2 is inaccurate [, except for any inaccuracies that would not reasonably be expected to result in a Seller Material Adverse Change].
4.15 . The Buyer shall promptly notify the Seller if at any time before the Closing the Buyer acquires Knowledge, from any source other than the Seller or any of its representatives, of any inaccuracy in any of the representations made by the Seller in article 2 [, except for any inaccuracies that would not reasonably be expected to result in a Seller Material Adverse Change].
These provisions makes use—admittedly slightly awkward use—of the defined term “Knowledge” to avoid any argument as to what “knowledge” means and whose knowledge is to be imputed to the Buyer. You could add a materiality qualifier to each, but not much would be at stake.
Specifying the Consequences of the Buyer Knowing Pre-closing that a Seller Representation Was Inaccurate
There are two ways that the Buyer might learn before a deal closes that one of the Seller’s representations is inaccurate. The Seller might disclose the inaccuracy to the Buyer post-signing but pre-closing, possibly by means of a “last minute dump.” Or the Buyer might uncover the inaccuracy in the course of its due diligence. In the latter instance, the Buyer might elect to close without informing the Seller of its knowledge, with the idea of bringing a claim for indemnification—in other words, with the idea of “sandbagging” the Seller. See Robert F. Quaintance, Jr., Can You Sandbag? When a Buyer Knows Seller’s Reps and Warranties Are Untrue, M&A Lawyer, Mar. 2003.
However the Buyer came by its knowledge, the question arises whether it is entitled to seek to be indemnified for the inaccurate representation. The case law—discussed in Rob Quaintance’s article—is unclear on the subject. You can greatly increase your odds of not adding to that case law if you include in your contracts a provision addressing the consequences of such knowledge.
The Seller might want to include a provision to the effect that the Buyer would not be entitled to be indemnified for an inaccurate Seller representation if the Buyer knew of that inaccuracy before the closing. Such provisions are known as “anti-sandbagging” provisions, although they wouldn’t apply only to sandbagging. For instance, you might just as well call them “pro-last-minute-dump” provisions. I prefer a less loaded, albeit clunkier, term—“no-indemnification-if you-know” provisions. Here’s such a provision:
8.12 . The Seller is not required under section 8.2 [Indemnification of the Buyer] to indemnify any Buyer Indemnified Party for any Loss resulting from an inaccurate representation made by the Seller in article 2 if the Seller can establish that the Buyer had Knowledge of that inaccuracy before the Closing.
Agreements sometimes contain a narrow form of no-indemnification-if-you-know provision that only precludes the Buyer from seeking indemnification for inaccuracies that the Seller discloses pre-closing—the Buyer is still free to seek indemnification for other inaccuracies that it learns about. (Usually such language is tacked on to a provision of the sort discussed above regarding the Seller’s updating of its disclosure schedules.) I’m not aware of any logical basis for this distinction. See Lou Kling & Eileen T. Simon, Negotiated Acquisitions of Companies, Subsidiaries and Divisions § 15.02 (noting that in this context “the economics of the situation are really no different than … where the Seller was aware of the problem and supplemented its disclosure schedule”).
Buyers strongly resist no-indemnification-if you-know provisions. For one thing, if the Seller discloses inaccuracies after signing, the Buyer could be faced with an unpalatable choice between (1) not closing and seeking indemnification and (2) closing and foregoing indemnification. If the Buyer invested considerable resources in the transaction, walking away may not be an option. And the buyer will probably feel that it should have the benefit of the bargain it made at signing.
Also, such provisions add an element—the Buyer’s pre-closing knowledge—to any claim for indemnification for an inaccuracy in a Seller representation. See Kling & Simon at § 15.02. In that regard, the no-indemnification-if-you-know provision above at least makes it clear that the burden is on the Seller to demonstrate that the Buyer had that knowledge.
The opposite approach is reflected in what I call “indemnification-even-if-you-know” provisions. Here’s an example:
8.12 . The Seller’s obligation under section 8.2 [Indemnification of the Buyer] to indemnify any Buyer Indemnified Party for any Loss resulting from an inaccurate representation made by the Seller in article 2 will not be affected if the Buyer has Knowledge of that inaccuracy before the Closing.
As Rob Quaintance points out in his article, the Buyer can’t assume that such a provision would guarantee that it would be entitled to be indemnified for an inaccurate Seller representation that it knows about at signing, as opposed to at closing. The Buyer would be advised to use that inaccuracy to try to get the Seller to reduce the purchase price or grant the Buyer a specific indemnity. (And it should seriously consider using a similar approach if the inaccuracy comes to light after signing.)
For the Seller in fear of being sandbagged, this provision could be defanged by having the Buyer make the representation regarding absence of pre-signing knowledge and the obligation regarding pre-closing knowledge included above.
Incidentally, I recall seeing one agreement that stated that while the Buyer was free to seek indemnification for inaccuracies disclosed pre-closing, it couldn’t use those inaccuracies as a reason not to close. That would seem an unusual arrangement—in order for the Seller to be able to negotiate such a provision, it would need significant bargaining power and would have to be more concerned with getting the deal done than avoiding claims for indemnification.