Crafting Language in an Acquisition Agreement
By J. Marc Ward
What goes on when crafting an acquisition agreement to purchase a company? Or to say it differently, why do lawyers insist on one phrase or word over another? “Legalese” has its place. Here are a few examples.
“Knowledge is Good,” so says the motto of Faber College. Of course, a lawyer’s retort is, what do you mean by “knowledge”? Representations by the seller are often qualified by the knowledge of seller. In acquisition agreements, knowledge can mean different things. Sometimes it is actual knowledge:
“Knowledge or Knowledge of Seller means the actual knowledge of [name the executive officers and sometimes the directors].”
Other times it’s constructive knowledge, such as this provision creating a standard of conduct to measure the seller’s knowledge:
“Knowledge or Knowledge of Seller means (i) the actual knowledge of [name the executive officers] and (ii) the knowledge that any such person referred to in (i) above, as a prudent person, would have obtained in the conduct or performance of his or her duties as an officer.”
Another constructive knowledge clause imposes a duty on the seller’s officers to take their head out of the sand:
“Knowledge means the actual knowledge of [name the executive officers] as if these officers shall have made a due and diligent inquiry of those employees and directors of the seller whom the officers should reasonably believe would have actual knowledge of the matters represented.”
Knowledge qualifiers like those above are used to qualify or limit representations that would otherwise be unqualified or unlimited. For example, the representation that “The seller’s business has been and is being conducted in compliance with all applicable laws” is rather breathtaking in its scope.
Naturally in such cases the seller wants to qualify that representation by adding “To Seller’s knowledge” at the beginning of the sentence. And seller wants to limit the meaning of “knowledge” to actual knowledge of the president of the company. Buyer will naturally push back and want the definition not only to include what the president knows, but what he should know, and buyer might also want to broaden the list of officers and key personnel to whom the knowledge definition applies.
No Undisclosed Liabilities
A buyer’s favorable “no undisclosed liabilities” representation, for example, would say something like this:
“Except as disclosed in Schedule X, Target has no liabilities other than those liabilities reflected or reserved against in the balance sheet or the interim balance sheet and current liabilities incurred in the ordinary course of business.”
This is a blanket warranty that there are no liabilities other than what are reflected on the balance sheet. None. A seller would prefer a “no undisclosed liabilities” representation more along these lines:
“Except as disclosed in Schedule X, Target has no liability of the nature required to be disclosed in the liabilities column of a balance sheet prepared in accordance with GAAP….”
This limits seller’s commitment to what GAAP requires, eliminating the immaterial, the unforeseen and highly contingent.
Full Disclosure Representation
Buyers and their lawyers love the full disclosure and 10b-5 disclosure. These disclosures can make up for a lot of missed opportunities in the other representations by seller. The full disclosure representation goes something like this:
“Seller does not have knowledge of any fact that may materially adversely affect the assets, business, prospects, financial condition or results of operations of the seller that has not been set forth in this agreement.”
More popular with buyers is the 10b-5 representation:
“No representation or warranty or other statement made by seller in this agreement or otherwise in connection with this transaction contains any untrue statement or omits to state a material fact necessary to make any of them, in light of the circumstances in which it was made, not misleading.”
Sellers should avoid these all-encompassing representations. If there is something specific the buyer is concerned about, address it in the representations. The buyer’s comeback is to say that the seller knows its company; buyer does not. As you might expect, buyers and sellers win on this issue about half the time. A compromise is to have the representation “knowledge qualified.”
I’m convinced that lawyers come up with exotic terms like “sandbagging” to enliven their otherwise dreary world. What do lawyers mean by sandbagging and anti-sandbagging provisions? Well, what should happen if during the course of a buyer’s due diligence, buyer comes across a file, the contents of which will obviously lead to litigation at some later date, post-closing? Does the buyer have a duty to tell the seller or not? Sandbag the seller or not?
A pro-sandbagging clause might look like this:
“The right to indemnification based upon the seller’s representations, warranties and covenants shall not be affected by any investigation conducted with respect to or any Knowledge acquired at any time with respect to the accuracy or inaccuracy of or compliance with any such representations, warranties and covenants.”
An anti-sandbagging clause would instead say:
“No claim for indemnity for a breach of a representation, warranty or covenant shall be made after the closing if the Buyer had Knowledge of such breach as of the closing.”
The reasons why a seller would want an anti-sandbagging clause are obvious. Buyers on the other hand would want to avoid such a clause because it shifts the inquiry from the breach of a representation, warranty or covenant to whether the buyer had knowledge of it. What if a representative of the buyer receives a file and either neglects to look at it or doesn’t realize its implications? Does the buyer have knowledge?
Be prepared to negotiate the many fine points involved in preparing an acquisition agreement. The lawyers on each side are trying to achieve a fair result while still accomplishing what the clients want – a deal.