The purpose and importance of disclosure letters in business sales

A disclosure letter in the context of a business sale is an important part of the transaction. A disclosure letter will be prepared by the seller’s solicitors generally at some point after the share sale agreement has been drafted and quite often it dovetails with negotiations over warranties.

Put simply, the more accurately and comprehensively the seller discloses information which has not been requested by the buyer as part of due diligence and enquiries, the lower the risk of a post transaction warranty claim against the seller. Understanding the balance between what should be disclosed, bearing in mind the seller wants the transaction to go through and the underlying position that it is for the buyer and it’s advisors to raise enquiries (buyer beware) can be a tricky balancing act.

Disclosure can also be a contentious area in many sales of business transactions as buyers often try to negotiate a price adjustment after certain disclosures are made.

Unscrupulous sellers may try to avoid making full disclosure in the hope the buyer does not find out if they do find out, they do not have the funds to pursue an action for loss.

We have a lot of experience of dealing with sales of varying sizes of companies across a range of sectors.

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

A disclosure letter from the seller is typically used together with seller warranties to provide comfort to the buyer.

The share purchase agreement on a company sale is negotiated and will usually include a list of warranties. The warranties are contractual statements about the state of the seller’s business when it is purchased. Warranties tend to be a lengthy and contentious (the seller will want to give as few warranties as possible and to restrict them whereas the buyer will push for warranties) part of a share purchase agreement and cover a comprehensive list of aspects of the business being sold. Clauses tend to be of the boilerplate, standard types.

By a seller disclosing information which qualifies the warranties via a disclosure letter, the seller’s risk is reduced as a buyer is unable to pursue any claims against that seller for a loss for a breach of a specific warranty where disclosure has been made about matters relating to that warranty . A prudent buyer should consider that whilst a disclosure may mean there is an increased risk he/she/they can use this as an opportunity to negotiate a lower purchase price.

What about buyer due diligence?

Buyers will typically raise lots of enquiries as part of the due diligence process. Notwithstanding that sellers will generally give comprehensive answers and supporting documents, the buyers lawyers will generally still demand comprehensive warranties from the seller in the share sale agreement covering areas including :

• accuracy of the accounts of the company being purchased
• financing and banking commitments
• environmental issues
• commercial contracts
• the status of employees and accuracy and comprehesiveness of information provided abiut employees.
• intellectual property
• that the business is not involved in any legal disputes and is unaware of any potential disputes
• accuracy and legality of information about the company’s tax affairs

The disclosure letter prepared by the seller will often disclose any additional information not requested or covered by due diligence which will qualify the warranties.

The above list is not exhaustive and warranty protection required should always be tailored for the transaction at hand.

What if the seller has not disclosed important information?

If a seller has failed to disclose an issue to you meaning that a warranty provided by the seller when the shares were purchased was untrue, you have a possible claim against the seller. The next step for you is to show that you have suffered a loss. This may seem obvious but without suffering a loss, there is no right to pursue a claim for damages.

Failure to disclose does not always mean full damages

In a post-completion dispute over a disclosure letter a seller will likely argue that notwithstanding failure to advise of potential or actual liabilities, the buyer made a poor commercial decision and overpaid for the shares. To be successful at recovering any damages,  a buyer of a business will need to demonstrate that there is a difference between the actual market value of the company  purchased and the value of the company purchased had the warranty been true and/or the matter disclosed in a disclosure letter.

Ensuring that losses are kept to a minimum

The rules of the English legal system require that if you suffer a loss, that loss is kept to a minimum as a result of a breach of a warranty. Therefore, if you have suffered a loss like , you are required to take steps to mitigate losses.

For example, if the acquired company has undisclosed liabilities such as a bank loan which is accruing interest, just because you were not told of the liability does not mean that you can stop repaying the loan when it should otherwise be repaid. By stopping repayment, you may incur additional charges raised by the lender which may not be recoverable from the seller.

Using an incorrect method of valuing a loss can be costly, which is why we are at hand to guide you through the process.