Disclosure is a key stage in a company merger and acquisition, or a company share or asset sale. It is the process by which all important information about the company is disclosed by the seller to the buyer before completion. It is in both the seller’s and the buyer’s best interests for full and frank disclosure to be given.
A disclosure letter is an essential document in the disclosure process. It is the document in which formal disclosure is given.
This guidance explains to businesses the importance of the disclosure letter in the disclosure process – for both the buyer and the seller.
What is a disclosure letter?
A disclosure letter provides the disclosure of vital facts about a company in the process of that company being sold, either by way of a share sale or an asset sale. The disclosure letter is a key document in the disclosure process of the sale and should be read in conjunction with the share purchase agreement or the business purchase agreement, which will refer to the disclosure letter and its contents.
The disclosure letter is prepared by the seller’s legal team, but input by the seller is crucial to ensure all important facts are disclosed. The letter will be accompanied by a disclosure bundle which is the set of documents referred to in the disclosure letter. This bundle is usually sizeable, and the documents are now often held in a virtual data room, rather than a physical data room, which can be accessed by both parties and their legal teams. Two sets of the bundle are prepared, one for the buyer and one for the seller, and both bundles will be checked by both legal teams to ensure they are identical.
Due diligence, which is essentially a fact-finding exercise, will be carried out by the buyer not only on the documents in the data room, but also by researching all publicly available information about the business for sale, so that they buyer knows exactly what they are buying. However, due diligence does not always cover everything, and this is where warranties are important, as they back up and strengthen the disclosure process and provide the buyer with extra crucial information that is not in the public domain.
Warranties and disclosure letters: what is a warranty?
Warranties and disclosures should be considered together. A warranty is a statement of fact about the business for sale, made by the seller in the share purchase agreement or the business purchase agreement. The seller will make a series of such warranties which he is declaring as true at exchange and completion.
If the warranty proves to be untrue or misleading, the buyer can bring a claim for breach of warranty against the seller. However, if the facts relating to the breach were disclosed in the disclosure letter, such a claim will fail.
It is therefore in both parties’ interests to give full and accurate disclosure. The buyer will have the fullest picture possible of the business they are hoping to acquire, and the seller will be protected from a breach of warranty claim or have a defence against such claim at the very least. If a breach of warranty claim is successful, the seller will have to pay damages to the buyer, so that he is put in the financial position he would have been in if the warranty had been true.
Prior to completion, a seller can either remove untrue or misleading warranties from the purchase agreement, or they can ‘qualify’ them in the disclosure letter: that is, they can make full disclosure as to why that statement is untrue or misleading. If a significant issue arises from disclosure against the warranties, a buyer can either ask for a reduction in the purchase price or ask the seller to rectify the issue before completion or ask for an indemnity if the buyer will incur costs as a result of them rectifying the issue themselves. As a last resort, the buyer can choose to walk away from the transaction.
What should be included in a disclosure letter?
A disclosure letter consists of two sections: general disclosures and specific disclosures.
General disclosures consist of information that will be deemed to have been disclosed to the buyer by virtue of them having made the proper enquiries themselves. This includes information in the public domain, such as information held at Companies House, property searches, checking the statutory books and any other pre-contract enquiries and searches the buyer has made.
However, general disclosures are often negotiated quite heavily by the legal teams of the seller and buyer: the seller will seek to ensure these general disclosures are as broad as possible, as a catch-all clause limiting any possible relevant liability, whereas the buyer will want to limit these disclosures, perhaps by way of a backstop date or to searches they’ve made on a particular date.
Specific disclosures on the other hand are disclosures against the warranties in the purchase agreement and relate to matters which if not disclosed by the seller would amount to a breach of warranty, thereby allowing the buyer to bring a claim against the seller. Some specific disclosures may apply to more than one warranty; these can be duplicated. Warranties can also sometimes state that certain information has been disclosed to the buyer: this information will usually be included in the disclosure bundle.
The seller’s legal team (usually consisting of heads of HR, finance, and the in-house lawyer) will prepare the specific disclosures, which then must carefully be checked by the seller to ensure every aspect is covered. The seller will want to draft these specific disclosures widely to give the buyer enough information to prevent a claim being brought against them. The buyer should look through these disclosures very carefully and raise any queries or request any further information as they see fit to understand the full picture of the business.
The disclosure letter will be signed at exchange when the purchase agreement is also signed. If exchange and completion take place on the same day, this won’t affect the disclosure process. However, if there is a significant delay between exchange and completion, and further issues arise in this period, which are not covered by the disclosure letter, the parties may seek to compromise. The buyer may allow the seller to make additional disclosures at completion, but if any issue is a ‘deal-breaker’, the seller will allow the buyer to walk away from the purchase.
Disclosure is an ongoing process until exchange and completion have taken place. Late disclosures are always risky as the buyer may not accept them without having had ample opportunity to investigate the impact of this new information.
Common pitfalls when drafting a disclosure letter
Not enough detail
The seller must ensure they have provided full, accurate and detailed disclosures to protect them from a breach of warranty claim. The sale agreement will usually specify the definition of ‘disclosure’, but what is considered to be sufficient disclosure is the subject of much case law. If a seller wants to rely on a disclosure to defend a breach of warranty claim made by the buyer, the disclosure needs to have been fair, that they have given the buyer adequate information to understand the matter being disclosed. Sometimes, the buyer will go further and insist on disclosures being full, accurate, fair, and specific, or any combination of these.
General disclosures are not clearly defined
Buyers should ensure that general disclosures are limited to information that is clearly identifiable such as the contents of the disclosure bundle and searches they have already made.
Overlooking documents
Buyers should go through the disclosure bundle very carefully to ensure every document has been reviewed.
Failure to raise queries
A buyer should always raise queries if there is any doubt whatsoever about a certain piece of information.
Privilege
Communications between a lawyer and client are privileged and are confidential. The disclosure process can however result in this privilege being lost.
Confidentiality
The seller should make sure a confidentiality agreement with the buyer is in place so that any confidential information that arises during the disclosure process is not disclosed to a third party. The seller should also try to obtain consent from any third party likely to be affected by releasing the confidential information to the buyer.
Seller’s refusal to disclose
A seller may decide to run the risk of being sued for a breach of warranty and withhold information it doesn’t want to disclose in case that information jeopardises the transaction.
Legal advice should always be sought when drafting and negotiating disclosure letters. Poorly drafted documentation should never be an option.
Disclosure can be incredibly time-consuming, but it is vital that both parties carry out the exercise properly and carefully and take the time to understand every issue that arises; otherwise, they risk facing the consequences, as detailed below.
Consequences
If a seller does not disclose information that they should, there can be serious consequences, and this should always be kept in mind when carrying out the disclosure process. Disclosures should be given in as much detail as possible; if in doubt about whether to include a piece of information or not, a seller should always err on the side of caution and include it.
A successful claim for breach of warranty may result in the buyer being able to recover some, or occasionally all, of the purchase price. The value of the claim will depend on the loss the buyer has suffered because of the breach.
Section 89 of the Financial Services Act 2012 states that it is a criminal offence for a person to make false or misleading statements knowingly or recklessly, or dishonestly conceal information so as to induce another person to enter into a transaction. Therefore, if a seller misleads or conceals information from the buyer during disclosure for a company purchase, they will be liable for this offence, which carries an unlimited fine and/or seven years in prison.
A seller can also be liable for misrepresentation if they choose to stay silent on an issue that results in the buyer failing to comply with a positive representation.
If a seller gives a false warranty (not corrected during disclosure) dishonestly with the intention of making a gain or causing the buyer loss, they can also be liable for fraud, for which there is a penalty of ten years imprisonment and a fine.
Withholding information will also usually mean the limitations on the seller’s liability under the terms of the purchase agreement will no longer apply.
All in all, a seller should think twice about withholding any information during the disclosure process.
Disclose letter FAQs
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Legal disclaimer
The matters contained in this article are intended to be for general information purposes only. This article does not constitute legal advice, nor is it a complete or authoritative statement of the law, and should not be treated as such. Whilst every effort is made to ensure that the information is correct, no warranty, express or implied, is given as to its accuracy and no liability is accepted for any error or omission. Before acting on any of the information contained herein, expert legal advice should be sought.
Author
Gill Laing is a qualified Legal Researcher & Analyst with niche specialisms in Law, Tax, Human Resources, Immigration & Employment Law.
Gill is a Multiple Business Owner and the Managing Director of Prof Services - a Marketing Agency for the Professional Services Sector.
