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The Significance of Disclosure Letters

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When purchasing a business whether by a share purchase or an asset purchase, there will always be an element of risk. Even if you are lucky enough to have the most honest of sellers, there is always a chance that you could purchase a business in a state which had been falsely represented to you.

In order to mitigate this risk, a buyer can request for a seller, in the purchase agreement to give warranties to the effect that they are purchasing what is being represented. If it is discovered that there were some misrepresentations regarding the business, the purchaser is able to rely on the warranties giving in the purchase agreement to recover some damages relating to the purchase price.

Greenaway Scott takes a look at what sort of things you are likely to see in disclosure letters and why they are important to both the seller and the buyer in an acquisition process.

Approach for Sellers

For sellers, there is one overriding rule that everything relevant must be disclosed. The disclosure letters allow the buyer to be fully briefed on all possible breaches of warranty, and therefore allows them to make an informed decision regarding the purchase of the business. The letter must explain the breach of warranty, going into as much detail as possible about how it amounts to a breach and providing any necessary corresponding documentation. This includes, where possible, quantifying the extent of the breach and its impact. Further, the seller must identify each breach and explain the extent that they link together. Lastly, the seller cannot just provide a minimum amount of detail expecting the purchaser to work it out for themselves, it needs to be set out simply and in detail. In practice, the disclosure letter is accompanied by a disclosure bundle with documents which highlight the breach of warranty.

Approach for Purchasers

Equally, a purchaser will carry out due diligence checks on the seller but the checks should not stop there. A purchaser should use the first draft of the disclosure letter to delve deeper into the business and clarify each disclosed breach of warranty to ensure they have a full understanding and can make an informed choice on whether to purchase the business. This means that any problems can be dealt with at the negotiation stage, rather than following the completion of the purchase, when the problems are more detrimental to them.

Fair Disclosure

What is to be considered as fair disclosure is something which has historically been unclear. However, in a recent case decided by the Court of Appeal (Infiniteland Ltd v Artisan Contracting Ltd), it was stated that what amounts to fair disclosure is based on what that the parties intended, which is decided by interpreting the precise wording of the agreement between them. This means that the warranty clause within the acquisition agreement is crucial as this sets out the level of disclosure that the purchaser is willing to accept.

General Disclosures v Specific Disclosures

With the requirement of fair disclosure, it has become apparent that general disclosures are more likely to give rise to breach of warranty claims. General disclosure is a commercial norm in practice as the seller provides general warranties, and the purchaser will then commence their own investigations in the forms of due diligence reports. This said, the courts have reinforced that if parties wish to commence with this form of agreement, they are opening themselves up for a breach of warranty claim. As such, using specific rather than general disclosure protects both parties and ensures there is certainty and transparency with the transaction.

Disclosure letters are of great significance as they ensure that a purchaser is obtaining a business which has been correctly represented to them, and also a seller is not at risk of being sued for breach of warranty at some point in the future. This means that the seller should be transparent and up front about any adverse issues the business may have faced, this allows the purchaser to make an informed decision on whether they still wish to proceed and prevents any breach of warranty claims occurring.

The information contained in this article is for information purposes only and is not intended to constitute legal advice. If you require further information our corporate team would be more than happy to assist you. Please contact us at [email protected] or call us on 029 2009 5500 to speak to one of our team.