Disclosure in the context of private m&a transactions

In which context is "disclosure" relevant in private m&a transactions?

Disclosure is a key element of private m&a transactions. It is primarily used in the context of representations and warranties as well as for procedural / structural aspects.
How is disclosure relevant for representations and warranties for a buyer?The buyer makes an investment decision based on its knowledge of the target business, which is derived mainly from information about the target business disclosed by the seller (disclosed information). A prudent buyer will want to assure the assumptions underlying its investment decision (investment assumptions) via representations and warranties. Disclosed information is therefore used to determine the scope of the representations and warranties (eg if a target business utilises a key supplier, the buyer will want protection via representations and warranties that the supply agreement with that key supplier is valid and has not been terminated).

How is disclosure relevant for representations and warranties for a seller?
For the seller, the disclosed information ideally forms the basis for its disclosure defence.
What is a "disclosure defence"?The disclosure defence allows a seller to disclaim liability for breaches of representations and warranties if the underlying matters have been disclosed to the buyer. This is typically as heavily negotiated as the scope of the representations and warranties themselves, as the parties' interests are contrary. A buyer will want a catalogue of representations and warranties that is not qualified by disclosed information, whereas the seller will want all information available on the target business to qualify its liability.

How do parties typically resolve the "disclosure defence" discussion?Typically, the parties either agree that only specific matters disclosed in a transaction document (or even in a separate disclosure letter) are deemed "disclosed" and thereby limit the seller's liability (the buyer-friendly approach) or the parties agree that the information disclosed during the due diligence will limit the seller's liability (the seller-friendly approach, typically seen in private m&a transactions). In the latter case, parties can further tweak the "disclosure standard", ie which level the disclosure must reach to limit the seller's liability. Here is a typical definition that further determines the disclosure standard:

"Disclosed" means any disclosure in the Data Room that is sufficiently detailed to identify the nature and scope of the matter disclosed and to enable a reasonably experienced purchaser active in the Target Group's sector, advised by professional advisors, to assess its impact on the relevant Target Company and the Target Companies taken as a whole.
How is the disclosure defence applied in practice?In practice, a disclosure defence is complex, as whether a matter can be identified as a breach of warranty is always subjective. Sellers should therefore ensure that known issues are properly disclosed in a way that any investor can identify the issue. 

What is a "disclosure warranty" and is it market standard?It is said that disclosure warranties have their origin in Rule 10b5 of the US Securities and Exchange Act of 1934, which determines the liability of the company and the underwriters if a prospectus contains any untrue statement of a material fact or omits material facts necessary to ensure that the statements made in the prospectus are not misleading. To mitigate risks, underwriters typically request so called "10b-5 disclosure letters" from both their and the company's counsels to ensure the absence of any such misstatement or omission. Investors in private m&a transactions took that concept and translated it into the private m&a world by requesting the seller to warrant that the information disclosed is true, accurate, complete and not misleading. Here is a typical buyer-friendly disclosure warranty:

1.1 All information contained in or referred to in the Data Room or which has otherwise been disclosed to the Purchaser or its advisors is true and accurate in all respects.

1.2 The Seller has disclosed all information relating to the Target Group and their respective businesses, assets and undertakings (including financial information) which may be relevant to a purchaser's decision to enter into this Agreement and there is no fact, matter or circumstance which renders any such information misleading because of any omission, ambiguity or for any other reason.

From a seller's perspective, such a warranty is difficult as the question whether the disclosed information is "complete" and "not misleading" is very subjective and there are no rules that define these terms. A prudent seller will therefore try to limit such warranties as much as possible.

How is disclosure relevant for procedural / structural aspects?Disclosed information further helps to migrate the target business into the buyer group, including defining requirements for transitional services. A prudent buyer will thus review as part of its due diligence if and to what extent the target business can operate on its own or whether it is dependent on services from the seller's group. Also, change of control clauses and other matters that are relevant for structuring a transaction can be derived from the disclosed information.

Further reading
Supervisory Board: Disclosure of conflicts of interest and confidential information
Privacy-related representations in m&a agreements