How does ‘knowledge’ relate to merger and acquisition (M&A) transactions? In M&A negotiations, the seller makes representations and warranties regarding the target company. What relevance does knowledge have to this? The answer is straightforward: risk allocation.

The dance between the buyer and seller (or their lawyers)

The seller’s representations and warranties regarding the target company or business are intensely negotiated and adapted to reflect not just the target’s character and its operations, finances, and company but also the buyer’s and seller’s relative bargaining power. Ultimately, this dance is about who is going to carry more risk of the transaction between the buyer and the seller.

If you’re a buyer, you want to expand the seller’s representations and warranties during negotiations. If you’re the seller, you are going to try to keep them as restricted as possible. Incorporating knowledge qualifiers is one method a seller might use to limit the scope of its representations and warranties.

Other possible qualifiers besides knowledge include materiality, a material adverse effect, and dollar thresholds. On balance, the buyer requests unqualified representations and warranties from the seller (i.e., straight up representations and guarantees devoid of any qualifiers).

Knowledge isn’t a certain concept

When a statement is restricted by a knowledge qualifier, that statement is mad based on what a person “knows.” “To the knowledge of the Seller, there is no breach or expected breach by any party to any Contract to which the Company is also a party” is an example of a knowledge-qualified representation.

The extent of knowledge must be established even when the parties agree to employ a knowledge qualifier. Does the knowledge include “constructive” knowledge and “actual” information? Whose knowledge applies to the representations and warranties that are knowledge-qualified? These need to be dealt with in the sale agreement.

Actual knowledge (what do you actually know?) vs. Constructive knowledge (what should you know?)

Actual knowledge means that the seller (or a specified class of people) must have actual knowledge of the specific item or incident that results in a breach. It is actual and conscious understanding.

Constructive knowledge is essentially imputed knowledge; however, there may be various interpretations of this idea. It could be described as the information that a specific person would be expected to learn after exercising a certain amount of due diligence or information that person would be expected to know in their capacity as an officer, director, employee, etc. (as applicable) of the target. Some illustrations of definitions of constructive knowledge are:

  • When the term “knowledge” or any similar expression based on knowledge is used, it refers to both the actual knowledge of the [specified individuals] and the knowledge that each of them would have reasonably acquired after making appropriate inquiries.
  • When the term “knowledge” or any similar expression or qualification based on knowledge is used, it refers to the actual knowledge of the [named individuals] as well as the knowledge that each of them would have reasonably acquired while carrying out their responsibilities as [CEO, Financial Controller, etc.] of the Company.

Identifying those people who have this “knowledge”

As with the two example above, some definitions restrict the knowledge that is considered when defining knowledge to the knowledge of one or more individuals who have been specified. Negotiations between buyers and sellers frequently centre on who will be included in (or excluded from) the “knowledge group.”

The individuals who have control over the things covered by the relevant knowledge qualifying representations and warranties, and in any case those who are most likely to be familiar with pertinent information regarding them, should be included in the knowledge group from the perspective of the buyer.

It might be suitable to include all shareholders in the knowledge group in small companies with a small number of active shareholders. For larger companies, the seller’s director of human resources for the employment and HR representations or the chief financial officer for financial representations may be included in the knowledge group when the seller is a larger business with many operational roles.

Take Aways

Buyers and sellers need to agree on who belongs in the knowledge group, how knowledge is to be defined (i.e., actual knowledge only, actual and constructive knowledge), and which seller representations and warranties are qualified by knowledge. As a general rule (and there are always exceptions to reflect the specifics of any given transaction), knowledge qualifiers are typically most appropriate for facts or matters that are beyond the seller’s control or that are not susceptible to reasonable determination by the seller’s due diligence.

The use of knowledge qualifiers should be carefully considered by both sides of an M&A transaction because, in the end, what someone knows (or should know) can determine who bears the ultimate risk.