M&A fundamentals: contractual statements in M&A transactions

When a company or business is bought or sold, the relevant acquisition agreement will contain various contractual statements or assurances relating to the parties and the target business.

In this article we consider these provisions in the context of company mergers and acquisitions (“M&A”) in the UK. We will explain the various types of contractual statements, how they are used, why they are important and the consequences of them being untrue.

This article will focus on a sale of shares in a UK company pursuant to a sale and purchase (or share purchase) agreement (“SPA”). However, many of the areas discussed will also apply to other types of transaction structures (including business or asset sales).

Warranties

What are warranties?

Warranties are contractual assurances or promises made by the parties in relation to the target company of an acquisition (the “Target”) or the parties themselves. Warranties given by the seller are designed to provide the buyer with confidence in the condition of the business and affairs of the Target at completion and the accuracy of the information provided in due diligence. As such, a seller’s warranties are generally far more extensive than a buyer’s (which are often limited to the buyer’s capacity to enter into the transaction documents). Seller warranties are typically lengthy (ordinarily included in a separate schedule to the SPA) and cover all aspects of the Target’s business, including its corporate group, share capital, financial information, material contracts, intellectual property, data protection, employees, regulatory matters, litigation, real estate and tax matters.

Warranties serve two main purposes. Firstly, if a warranty is found to be untrue, it may provide the buyer with a financial remedy if it can demonstrate that it suffered a loss (see below). Secondly, the buyer will use the seller’s “disclosures” against the warranties to elicit information about the Target.

What is disclosure?

The SPA will generally contain a “disclosure” mechanism, whereby the seller is able to disclose to the buyer any exceptions or qualifications to the warranties by way of a “disclosure letter”, executed in parallel with the SPA. Any information disclosed in the disclosure letter is deemed to qualify the seller’s warranties and, to the extent that the seller has met the standard of “fair disclosure” defined in the SPA, the specific information or circumstance disclosed will not constitute a breach of warranty.

What are the consequences if a warranty is breached?

If a warranty is breached, the buyer may have a contractual claim for damages. In the context of a share sale, these damages are calculated on a “warranty true/warranty false” basis, i.e. by comparing the difference in value between:

(i) the value of the shares had the warranty been true (which is typically calculated by reference to the consideration paid for the shares [1] ); and

(ii) the actual value of the shares in light of the warranty being untrue.

The quantum of any damages claim will therefore be dictated by the impact of the breach of warranty on the market value of the shares. This means that a buyer is not entitled to pound-for-pound compensation for the loss suffered and, in order to bring a successful claim, the onus is on the buyer to demonstrate breach and a quantifiable loss (i.e. a diminution in the value of the shares). This is often difficult to prove. In addition, under English common law, it will be difficult for a buyer to establish that it has suffered a loss in respect of something it knew about at completion. As a result, warranties are generally not viewed as providing adequate protection in respect of known issues. A buyer will therefore ordinarily seek an indemnity in respect of any risks relating to the Target which are known and quantifiable at completion.

Contractual claims by a buyer for breach of warranty will typically be subject to various limitations, including time limits, limits in quantum and other customary limitations. The nature and scope of the limitations will be a matter of negotiation between the parties.

Indemnities

What is an indemnity?

An indemnity is, in essence, a promise by the seller to reimburse the buyer on a pound-for-pound basis in respect of a particular type of liability. As such, indemnities are often used where a warranty may not provide the buyer with adequate protection, for example, where:

(i) the buyer had knowledge of the relevant matter before signing the SPA; or

(ii) the breach of warranty might not necessarily diminish the value of the shares in the Target, but the buyer will nonetheless incur costs to remedy it.

As indemnities are designed to address risks to the buyer (which will be highlighted during due diligence and/or the disclosure process), the specific indemnities that a buyer may request will ultimately depend on the status of the Target. For example, if the Target is actively involved in litigation, the buyer may require the seller to assume the risk of the litigation’s outcome (and any related costs) through an indemnity.

In addition to any specific indemnities for known risks, the seller will also usually provide the buyer with a tax indemnity (or tax covenant) for any liabilities of the Target for taxation in respect of the period prior to completion.

Representations

What are representations?

A representation is a statement of fact made by one party which may induce the other party to enter into a contract. In the context of an M&A transaction, this may be a statement about the Target’s business (e.g. that the Target is not involved in any litigation). This can be distinguished from warranties which are, in essence, a risk allocation mechanism – ensuring that the buyer can seek a financial remedy if any warranty proves to be incorrect.

On M&A transactions, a buyer may sometimes seek for statements about the Target to be given as both warranties and representations. This should be resisted by the seller, as representations are a different type of legal statement and may give the buyer additional remedies (see below).

What happens if a representation turns out to be false?

To bring a claim for misrepresentation, a buyer would have to demonstrate that the relevant representation was untrue, that it induced the buyer to enter into the transaction and thereby caused the buyer loss. Misrepresentations can either be fraudulent (intentional deceit), negligent (making a statement carelessly or without reasonable grounds for believing its truth) or innocent.

A key difference between a claim for misrepresentation and one for breach of warranty is that, if the buyer can prove that a statement was a misrepresentation, it may be entitled to rescind (i.e. unwind) the transaction. In addition, depending on the type of misrepresentation, damages will generally seek to put the buyer in the position it would have been in had the misrepresentation not occurred (i.e. as if it had not entered into the transaction at all). This would be advantageous, for example, for a buyer that has made a bad bargain (as damages calculated on a warranty true/warranty false basis will not provide any recourse where the business would’ve been worth less than the buyer paid, even if the relevant warranty was true).

Other liability for misleading statements

In certain scenarios, a buyer might also seek to argue that a seller has made fraudulent statements in relation to the transaction. Fraud is a complex area of law; for the purposes of this article, the key points to note are that:

(i) fraud (whether at common law for fraudulent misrepresentation or under the Fraud Act 2006) is extremely difficult to prove (not least as the claimant will have to prove the defendant’s intention/state of mind in making the relevant statement); and

(ii) if a buyer is able to prove fraud, none of the limitations in the SPA will apply (and, essentially, “all bets are off”).

A claim alleging fraud is therefore generally viewed as a last resort, suitable for the most egregious scenarios only.

In addition, it is also worth mentioning that, under the Financial Services Act 2012, making false or misleading statements (or dishonestly concealing facts) in relation to a sale of shares may also constitute a criminal offence.

Entire agreement clauses

An SPA will usually contain an entire agreement clause, typically comprised of one or more of the following elements:

(i) a statement that the written agreement constitutes the whole understanding between the parties to the transaction and supersedes all prior pre-contractual statements and representations;

(ii) a statement that the parties have not relied on any representation not set out in the agreement;

(iii) an express exclusion of liability for misrepresentation;

(iv) a statement limiting the remedies of the parties to damages for breach of contract and excluding the remedy of rescission; and

(v) a confirmation that the clause is not intended to exclude liability for fraud.

Although typically a boilerplate clause, an entire agreement clause is particularly important for sellers, as it prevents the buyer from relying on statements or representations made, for example, during pre-contract negotiations or due diligence (to the extent that these are not explicitly included in the SPA). It should also (if properly drafted) prevent the buyer from bringing a claim in misrepresentation or rescinding the contract.

Conversely, where an SPA contains an entire agreement clause, it is vital that a buyer ensures that any key statements or information relating to the Target which the buyer is relying on are expressly covered by warranties or other statements in the SPA.

Conclusion

Contractual statements in M&A transactions can take various forms. It is crucial that parties to transactions understand which types of statements may be included in the SPA, what the consequences/remedies are if such statements turn out to be untrue and whether the relevant provisions will provide the requisite degree of contractual protection. It is critical that parties take appropriate legal advice to ensure that these provisions are carefully drafted and properly negotiated to safeguard their commercial interests.

___

[1] However, it would be open to a party to seek to demonstrate that the true value of the Target at completion was more or less than the actual purchase price.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at September 2024. Specific advice should be sought for specific cases. For more information see our terms and conditions.

If you would like any further information or to discuss a specific matter, please do not hesitate to contact Nina Searle, Adam Kuan or Joe Gallon in TLT’s Corporate team using the contact details below.