Disclosure letters and their importance on transactions

Whether you are buying or selling a company or business, or investing in a company, the disclosure letter plays a key part in the documents that are prepared and agreed between the parties, Corporate Solicitor Behzad Borang.

The disclosure letter and its importance

Depending on the transaction, the parties would either look to enter into, for example, an investment agreement, a business transfer agreement or a share purchase agreement. These agreements will contain warranties which are contractual statements made by the seller(s), or in the case of an investment the company itself, existing shareholders, founder shareholders and/or the management team, made about the business being sold or invested in.

In this article we will focus on the disclosure letter under a share purchase agreement (SPA).

If any of the statements in the SPA are incorrect, meaning that the warranty is breached, the buyer may have a warranty claim against the seller(s) for compensation. Typically, under the SPA, the seller(s) will not be liable for a breach of warranty if the matter giving rise to the breach was disclosed to the buyer in the disclosure letter. Therefore, the disclosure letter is a key document for the seller(s) and provides them protection from a claim.

An example of a warranty is that the company being sold (Company) is not involved in any litigation. If the Company is involved in any litigation, the seller(s) should disclose the litigation with sufficient and clear details in the disclosure letter with any supporting information and documentation (if any). In doing so, the buyer cannot bring a warranty claim against the seller(s) in relation to  the disclosed litigation post-completion of the sale provided it was properly disclosed.

The disclosure letter (and the SPA) will need to be agreed between the parties ahead of completion and signed by both parties. It is a fundamental document not only for the seller(s) in terms of protection from a warranty claim but also for the buyer as a means of obtaining information about the Company prior to completion to support its due diligence process. If the disclosure letter discloses issues to the buyer it then has options as to what it wishes to do for example, it can :

• accept the issues and proceed anyway without any recourse to the sellers;
• request the issues are rectified prior to completion;
• seek to include indemnities in the SPA to allow the buyer to recover from the sellers the costs and liabilities arising for the company as a result of the disclosed issue. An indemnity gives the buyer the right to bring a claim even though the matter has been disclosed in the disclosure letter;
• seek to adjust the purchase price for the Company;
• abort the transaction if the issue is so serious and the buyer is unwilling to take on the risk; or
• include a post-completion obligation on the seller(s) to rectify it.

The seller(s) should always bear in mind that disclosure is very much on ongoing process up to the point of completion and if there are any changes in the Company where a warranty in the SPA is no longer true, they should make the disclosure so as to protect themselves.

Some common pitfalls in preparing the disclosure letter and their consequences

1. Not providing enough details: The seller(s) will need to ensure disclosures are sufficient to protect from a claim for breach of warranty. What constitutes sufficient disclosure is the subject of lots of case law, and SPAs also usually specify how “disclosure” is to be defined. A seller should always approach disclosure by giving full, accurate and clear explanations to enable the buyer to have a complete understanding of the issue and must ensure the information they provide complies with the requirements of the SPA.
2. General disclosures: The seller(s) will often seek to generally disclose to the buyer the contents of the due diligence that has been carried out by the buyer, matters in public records and/or which the buyer ought to be aware of, such as accounts, property searches or correspondence between the parties or their advisers. Buyers should ensure “generally disclosed” items are limited to information clearly identifiable, such as correspondence that is attached to the disclosure bundle and searches it has undertaken, so it is not prevented from claiming for breach of warranty in respect of items it has not reviewed.
3. Overlooking documents: Buyers should ensure that all documents in the bundle of documents attached to the disclosure letter have been reviewed by them or their advisers, as the content of the disclosure bundle (which often includes all of the due diligence documents provided) is typically deemed disclosed in its entirety.
4. Failing to ask for more information: Buyers should seek to better understand, seek further information and address an issue rather than go ahead with any disclosures that are unclear and seek to rely on breach of warranty or an indemnity under the SPA.
5. Losing privilege: Communications between lawyer and client to get or give legal advice carry legal professional privilege and are confidential. Delivering disclosure documents to the buyer could cause such privilege to be lost, meaning it could be required to be produced during and could prejudice the seller or business in a dispute. If the sellers are concerned about the impact of legal professional privilege in the context of the disclosure letter they should seek legal advice on this before disclosing any documents to the buyer.
6. Withholding information: A seller may prefer not to disclose certain information about the Company and instead run the risk of a breach of warranty claim rather than result in an aborted transaction. There are serious consequences to this in that:
   1. it is a criminal offence, carrying penalties of an unlimited fine and/or ’imprisonment, to dishonestly conceal material information or knowingly or recklessly make false or misleading statements to induce another party to enter into the transaction;
   2. withholding information usually causes the limitations on a seller’s liability contained in the SPA relating to warranty and indemnity claims to cease to apply, such as any financial caps on liability;
   3. depending on the circumstances, other claims could be brought against a seller, such as for deceit or misrepresentation; and
   4. the seller could have committed fraud for examples, if a warranty is given which is false (and not corrected by disclosure) and the seller does so dishonestly with the intention of making a gain or causing the buyer loss. Fraud is a criminal office and the penalties include imprisonment, and it can also attract a fine.

The importance of being properly advised

A properly drafted and negotiated disclosure letter can avoid costs and delay on both sides. Bearing in mind the various potential pitfalls and various other moving parts and documents in a transaction, it makes commercial sense to obtain legal advice before negotiating or agreeing to one.