“No Undisclosed Liabilities” 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 “No Undisclosed Liabilities” representation is a common representation you’ll find in most merger and acquisition transactions that has to deal with, believe it or not, liabilities being disclosed. Here’s some typical language:

“The Company has no liabilities, obligations or commitments of any nature whatsoever, asserted or unasserted, known or unknown, absolute or contingent, accrued or unaccrued, matured or unmatured or otherwise ("Liabilities"), except (a) those which are adequately reflected or reserved against in the Balance Sheet as of the Balance Sheet Date, and (b) those which have been incurred in the ordinary course of business consistent with past practice since the Balance Sheet Date and which are not, individually or in the aggregate, material in amount.”

What does it really mean?

The idea behind this representation is to give the Buyer comfort about what liabilities it may be stepping into after the deal closes. Financial statements are great, but they only speak to a specific, historical moment in time.

This particular representation has become almost automatic in most deals. A recent American Bar Association (ABA) study shows that 97% of reported deals in 2016-2017 contained such a representation. Even in asset purchases – where the Buyer is not even assuming unknown liabilities at all – this representation is fairly common because Buyers want to, at least, know the universe of potential liabilities that might exist for the business it’s acquiring.

Why Should I Care?

Buyer: The “No Undisclosed Liabilities” representation is one of the more powerful representations available to Buyers because of its scope and breadth. At its most basic form, this representation protects the Buyer from material liabilities arising since the date of the most recent financial statements. And, if the Seller isn’t properly advised, this representation could be structured to be so broad as to function as a sort of “catch all” representation that the Buyer could point to in the event of almost any unexpected loss after the closing.

However, despite its potential breadth, this representation is usually limited both in the amount of time that the Buyer has to assert a claim post-closing, and in the amount ultimately recoverable by the Buyer – we’ll talk about these types of limits in a future installment of this series. So, while this representation may give the Buyer some comfort, it’s not without limit.

Seller: While the representation itself seems fairly innocuous for Sellers, it’s actually loaded with potential traps for the unwary. First, as illustrated in the above Buyer-favorable language, the representation imposes liability on the Seller even if the Seller has no knowledge of the liability, unless the Seller is successful in negotiating a knowledge qualifier (which isn’t common for this representation). In this way, the word “undisclosed” is a bit of a misnomer because it implies that the Seller knew something but didn’t disclose it; in most cases, it’s the unknown liabilities that come back to bite the Seller.

Second, whereas financial statements are subject to certain accounting rules that tell us what belongs in the financial statements and what doesn’t, the representation drafted above doesn’t adhere to those rules. So, for most businesses, there are tons of “contingent” liabilities that exist at any point in time, but that don’t rise to the level of requiring disclosure on the financial statements. For example, under U.S. Generally Accepted Accounting Principles (GAAP), a contingent liability may get recorded in the financial statements only if it’s more likely than not to occur. However, the language above is so broad as to include contingent liabilities that only have the slightest chance of actually occurring. As such, this representation, if not properly negotiated and worded, would give the Buyer almost free reign to claim that a liability relating in any way to a pre-closing event should be the Seller’s responsibility.

As such, both the Buyer and the Seller need to pay particular attention to this representation and be totally clear about what they’re trying to cover with it.

Next Month: “Full Disclosure” Representation

Read last month’s piece: The Definition of Knowledge