The purpose and importance of disclosure letters in business sales

A disclosure letter is an important part of a business sale. It is generally prepared by the seller’s solicitors after the share purchase agreement has been drafted and is often negotiated alongside the warranties.

Put simply, the more accurately and comprehensively a seller discloses matters that qualify the warranties, the lower the risk of a subsequent warranty claim. However, deciding what should be disclosed can be a difficult balancing act. The seller wants the transaction to proceed while limiting future liability, whereas the buyer and its advisers are responsible for carrying out due diligence and raising appropriate enquiries.

Disclosure can also be contentious, as buyers may seek to renegotiate the purchase price when previously unknown issues come to light.

Some sellers may be tempted to withhold important information in the hope that the buyer will not discover it or will be unable to pursue a claim if it does. A carefully prepared disclosure letter can help manage these risks and reduce uncertainty for both parties.

We have extensive experience advising on business sales involving companies of varying sizes across a range of sectors.

What is a disclosure letter in an M&A transaction?

A disclosure letter is prepared by the seller and used alongside the warranties in a share purchase agreement to identify matters that qualify those warranties and help define the seller’s potential liability.

A share purchase agreement will usually contain a list of warranties, which are contractual statements about the business being acquired. These typically cover a wide range of matters and can be lengthy and contentious to negotiate. Sellers generally seek to limit the warranties they give and restrict their exposure, while buyers seek comprehensive protection.

By disclosing relevant matters against the warranties, the seller may limit its liability for a subsequent claim relating to matters that have been properly disclosed. For buyers, disclosures can highlight risks that may justify further investigation, additional contractual protection or a renegotiation of the purchase price.

How does a disclosure letter work with due diligence?

Buyers will typically raise numerous enquiries during due diligence. Although sellers generally provide responses and supporting documents, buyers’ advisers will also seek warranties in the share purchase agreement covering areas such as:

• The accuracy of the company’s accounts.
• Financing arrangements and banking commitments.
• Environmental issues.
• Commercial contracts.
• Employee status and the accuracy and completeness of employee information.
• Intellectual property.
• Existing or potential legal disputes.
• The accuracy and compliance of the company’s tax affairs.

The seller’s disclosure letter may identify additional information that qualifies these warranties, including matters that were not specifically raised during due diligence.

This list is not exhaustive. The warranties and disclosures should be tailored to the particular business, transaction and risks involved.

What if the seller has not disclosed important information?

If a seller fails to disclose a relevant matter and a warranty given in the share purchase agreement proves to be untrue, the buyer may have a claim for breach of warranty. Whether a claim succeeds will depend on the contractual terms, the nature of the breach and the available evidence.

The buyer will also need to establish that it has suffered a recoverable loss. A breach of warranty does not automatically entitle the buyer to recover the full amount of an undisclosed liability or the cost of addressing the underlying problem.

Failure to disclose does not always mean full damages

In a post-completion dispute, a seller may argue that the buyer made a poor commercial decision or paid too much for the shares, rather than suffering the loss claimed as a result of the breach.

The appropriate method of calculating damages depends on the terms of the warranty and the applicable legal principles. In many warranty claims, the assessment involves comparing the actual value of the shares at the relevant date with the value they would have had if the warranty had been true. Other losses may be recoverable where the contractual and legal requirements are satisfied.

Ensuring that losses are kept to a minimum

A buyer who suffers loss as a result of a breach of warranty may be required to take reasonable steps to mitigate that loss. Failure to do so can affect the amount recoverable.

For example, if the acquired company has an undisclosed bank loan accruing interest, the buyer cannot simply stop repayments that remain contractually due. Doing so could result in additional interest, charges or other losses that might have been avoided and may not be recoverable from the seller.

Choosing the correct approach to valuing and evidencing losses is therefore important. We can help assess the available evidence, identify the appropriate valuation approach and consider the extent of any recoverable loss.

If buyers of your business later allege that you provided misleading or inaccurate information, or that the company’s accounts were incorrect, we can assist in responding to and defending claims, including those alleging breach of warranty. We regularly advise on share sales involving private companies and disputes arising from these transactions.

Please call us on 0207 438 1060.