Unknown liabilities are one of the main concerns when buying a company – the “skeletons in the closet”.
These unknown liabilities are handled in different ways in a purchase agreement in M&A transactions. To allocate the risk associated with unknown liabilities, one of the primary representations in an agreement is the “no undisclosed liabilities” representation.
The goal is to reassure a buyer about what liabilities it is taking on after the deal is done.
Why should you care?
For buyers, the “No Undisclosed Liabilities” representation is one of the most powerful representations available. In its most basic form, this representation shields buyers from liabilities that do not need to be disclosed in financial statements or that arise after they have been prepared.
For sellers, if they aren’t advised properly, this representation could be drafted so broadly that it acts as a “catch-all” that a buyer can use if they suffer almost any kind of loss after the deal closes.
So, what is a “No Undisclosed Liabilities” (NUL) Representation?
Usually this involves the seller making statements or warranties/representations to the buyer that there are no target liabilities not explicitly identified or disclosed.
Buyers prefer that sellers provide an unqualified NUL representation. The buyer aims for a representation that minimises exceptions and encompasses the broadest possible range of potential liabilities. This approach seeks to maximise clarity and assurance in addressing undisclosed liabilities associated with the target.
It’s only natural that sellers want to narrow down the scope of liabilities covered by the NUL representation often because they say: “I don’t know what I don’t know” (at least privately to their advisers). To achieve this, a seller often endeavours to introduce numerous exceptions and qualifiers, strategically aiming to restrict its overall exposure. This tactic allows the seller to define and limit the extent of their responsibility regarding undisclosed liabilities in the transaction.
The seller’s strategies to mitigate potential liability for breaching a NUL representation typically manifest in one or more of the following ways:
Limiting the liabilities to balance sheet liabilities according to accounting standards
Given that a NUL representation usual refers to the target’s balance sheet, the seller may assert that the NUL representation should be restricted to only those liabilities required by the relevant accounting standards to be reported on the balance sheet.
In this kind of limited NUL representation, the seller must disclose only those liabilities that need to be recorded on a balance sheet prepared in accordance with accounting standards. This distinction is significant because accounting standards don’t require all liabilities to be recorded. For instance, the disclosure of contingent liabilities relies on various factors. In addition, things that are truly “unknown” can’t be shown on a balance sheet, so they would be left out as well.
This means that liabilities covered by accounting standards might constitute a relatively narrow subset of a target’s known and unknown liabilities.
Adding an “ordinary course” carve-out
In negotiations, sellers commonly aim to incorporate a carve-out about ordinary course liabilities that have arisen after the balance sheet date.
This carve-out allows the seller to exclude liabilities incurred as part of the regular, day-to-day operations of the business after the specified balance sheet date. By doing so, the seller seeks to safeguard itself against potential liabilities considered standard and inherent to the business’s ongoing operations, offering a nuanced approach to liability allocation.
Incorporating knowledge or materiality conditions
To further refine the scope of an NUL representation, the seller might restrict it to undisclosed liabilities within their knowledge.
Alternatively, the representation could be tailored to encompass only undisclosed liabilities surpassing a specified materiality threshold or other defined criteria.
This limitation allows the seller to mitigate potential exposure to those undisclosed liabilities that they were aware of or those deemed significant based on predefined materiality parameters.
Omitting liabilities addressed in other representations
In certain instances, a seller might contest the expansiveness of an NUL representation, expressing concerns that it could conflict with other representations within the purchase agreement that specifically address the same topic. This objection often arises when the seller believes that the NUL representation, if applied broadly, might overlap with and potentially contradict representations already made in the agreement, particularly those about specific topics.
Negotiation points for the Buyer
From the buyer’s standpoint, a comprehensive NUL representation is often insisted upon because the buyer believes the seller should shoulder some risk associated with undisclosed or unknown liabilities. The buyer’s argument typically revolves around the notion that the seller, due to its intimate knowledge of the target company’s past and present operations, is better positioned than the buyer to assess the risk of unknown liabilities and, therefore, should stand behind its evaluation.
Despite the buyer’s insistence on a robust NUL representation, practical considerations often come into play. When NUL representations are incorporated, they frequently fall within the realm of seller representations subject to financial thresholds and caps. This means there’s a minimum threshold of buyer loss before the seller becomes responsible and a predefined maximum limit on seller liability. Consequently, the buyer is already assuming a portion of the risk related to unknown liabilities, even with a standard, buyer-friendly NUL representation (specifically, those unknown liabilities falling within the basket and exceeding the cap). Furthermore, these undisclosed liabilities are frequently addressed in more specialised representations throughout the agreement, such as those concerning compliance with laws, employment matters, tax compliance, and similar topics. As a result, in the course of deal negotiations, sellers often argue that NUL representations, exceptionally if expansive, may be redundant or duplicative.
Negotiation points for the Seller
The seller might counter the buyer’s stance by presenting one or more of the following arguments:
Comprehensive agreement coverage: If the purchase agreement meticulously addresses every facet of the target’s business, the seller can rightly question the necessity or appropriateness of a broader “catch-all” representation. The argument is that the detailed provisions within the agreement already sufficiently capture and address potential liabilities, making an expansive NUL representation redundant.
Specific thresholds for non-disclosure: If the parties have mutually agreed that specific contracts and liabilities are exempt from disclosure under seller representations, the seller can question the rationale for disregarding these established thresholds in the context of a NUL representation. This perspective underscores the importance of consistency and adherence to predefined criteria in the agreement.
Existing protective provisions: The seller contends that other provisions within the purchase agreement already provide the buyer with ample protection against specific liabilities. Commonly cited are (i) standard seller representations regarding the target’s financial statements and (ii) the assertion that no material adverse effect has occurred since a specified date. According to the seller, these existing provisions are robust safeguards and render an expansive NUL representation unnecessary.
In essence, the seller aims to demonstrate that the intricacies of the purchase agreement, along with agreed-upon thresholds and existing protective provisions, collectively offer the buyer comprehensive coverage and protection against potential liabilities.
Takeaways
The NUL representation remains nearly ubiquitous in private company M&A transactions. How this is negotiated plays a pivotal role in determining the allocation of undisclosed liabilities between the buyer and seller – and ultimately who bears the risk of skeletons in the closet.