“Full Disclosure” Representation

The Anatomy of a Deal Newsletter

Each month, Eric Duffee looks at a different piece of The Anatomy of a Deal – a series of easy-to-digest articles that break down complicated aspects of business transactions – helping you better understand terms + processes that can shape the direction of your business.

What is it?

The “Full Disclosure” representation comes in many different flavors. Here’s some very Buyer-favorable language:

Seller is not aware of any fact, condition or circumstance that may materially and adversely affect the assets, liabilities, business, prospects, condition or results of operations of Seller or the Business that has not been previously disclosed to the Buyer in writing. Furthermore, no representation or warranty or other statement made by Seller in this Agreement, the Disclosure Schedules, or otherwise in connection with the transactions contemplated hereby contains any untrue statement of material fact or omits to state a material fact necessary to make such statements not misleading.

What does it really mean?

Depending on who you ask, the “Full Disclosure” rep is either a completely innocuous representation intended to backstop the other more specific representations and warranties in the agreement, or it’s a “catch-all” that can be very dangerous to Sellers. For this reason, Sellers should be very wary about including such a representation.

The representation recited above actually includes two distinct components. The first component (shown in bold above) is a true “catch all” that places broad responsibility on the Seller to tell the Buyer anything else that’s material to the business. In essence, the Buyer is saying to the Seller: “I know you’ve just given me dozens of pages of detailed representations and warranties about your business, but if I forgot to ask you about anything else I should care about, you better tell me now.” Fortunately for Sellers, this form of the “Full Disclosure” rep is very uncommon.

The second component (the so-called “10b-5” rep, shown in italics above), however, is more common and speaks to whether the Seller has failed to disclose to the Buyer any material fact, the disclosure of which would be necessary to make the other representations and warranties in the agreement true.

Wait, what? If the Seller hasn’t disclosed something, and as a result of such failure to disclose, another representation is rendered inaccurate, then why do we even need this additional representation?

That’s the multi-million dollar question. This 10b-5 rep is intended to emulate SEC Rule 10b-5, which essentially exists to root out fraud in sales of securities. However, at best, it’s questionable whether this representation should exist in M+A transactions for the following reasons:

  1. If it’s a sale of securities (e.g., sale of corporation stock or LLC membership interests) – but not a sale of assets – Rule 10b-5 already applies anyway. In that case, what’s the harm of putting it into the agreement? For starters, Rule 10b-5 requires the Buyer to show that the misstatement or omission was made with knowledge and that the Buyer must have actually relied on that misstatement or omission in entering into the transaction. The above language doesn’t require either of those; and
  2. It arguably creates an additional disclosure standard that isn’t already required by the agreement. As noted above, if the Seller fails to disclose information necessary to make the other reps and warranties in the agreement accurate, then the Seller has, by definition, breached those other reps and warranties. We don’t need a separate rep to cover that. So it’s just redundant; what’s the harm? Well, courts take the approach that every clause in a contract must have independent meaning, whenever possible. So the risk to Sellers is that a court interprets the narrower 10b-5 representation as something more akin to the dreaded “catch-all” representation shown above.

Despite these concerns, a recent American Bar Association study found that the 10b-5 rep (separate from the broader “catch-all” rep described above) still shows up in about 25% of transactions. In recent years, that percentage has been even higher. So, either some Buyers are good at persuading Sellers that they need this rep to provide some additional protection, or some Sellers aren’t carefully focusing on the risk.

Why should I care?

Buyer: Buyers would obviously love to get both the broad “catch-all” and the narrower 10b-5 representation into their agreements. Doing so would give them some comfort that nothing “slipped through the cracks” in the Buyer’s due diligence and its negotiation of the other more detailed reps and warranties in the agreement. However, Buyers are rarely successful at getting the complete “catch-all” representation. As such, most of the negotiation focuses on the importance of the 10b-5 rep. While there are differing views among M+A professionals, this more than likely falls into the “nice-to-have” bucket rather than the “have-to-have” bucket.

Seller: On the flip side, it should be abundantly clear that Sellers must strongly resist the complete “catch all” representation. But how hard should a Seller fight against the inclusion of a 10b-5 rep? Professionals also have differing views on this point, but my view is that the inclusion of such a rep can only create additional uncertain liability for the Seller. In fact, a quite common approach is to delete the entire 10b-5 rep and replace it with an affirmative disclaimer of any other representations and warranties that go beyond the dozens of pages of specific representations and warranties already included in the agreement. In other words, the parties are expressly agreeing that the only representations and warranties the Seller is making are the specific representations and warranties negotiated elsewhere in the agreement. No catch-alls, no uncertainty. Then, if the Buyer thinks it’s not adequately covered by those specific representations and warranties, this invites the discussion about whether to include any other specific representations and warranties. Sellers should insist on total certainty about the commitments it’s making, rather than broad and ambiguous catch-all language.

Next Month: Preparing to Sell Your Company

Read last month’s piece: The “No Undisclosed Liabilities” Representation