The Definition of Knowledge
The Anatomy of a Deal Newsletter June 29, 2018
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?
How you define the “Seller’s Knowledge” when drafting a purchase agreement can have an important impact on both the Seller and the Buyer. It’s beneficial to both parties to establish who is responsible for what. Here’s the complicated definition:
"Knowledge of Seller” or “Seller's Knowledge" or any other similar knowledge qualification, means the actual or constructive knowledge of any director or officer of the Seller or the Company, after due inquiry.
What does it really mean?
“Seller’s Knowledge” is the legalese equivalent of “I can’t guarantee it, but to the best of my knowledge it’s true.”
It’s contract language for “Yes, as far as I know.”
In certain of the representations and warranties in the purchase agreement, a qualifier like “To the best of Seller’s knowledge…” is added in order to excuse the Seller from post-closing liability. Basically, if there ends up being some sort of violation of an agreement, these “knowledge qualifiers” protect the Seller if they did not have knowledge of the facts that resulted in the violation.
However, as you might suspect, it’s not quite that simple. For one thing, the target of these qualifiers is generally a company, not a person. And how does a company have knowledge? To solve this problem, an agreement will usually define the individual people whose knowledge is attributed to the target company, often by naming them specifically.
Setting a knowledge standard should rightfully concern Buyers, because a knowledge standard that focuses on the actual knowledge of an individual presents a couple of problems:
- How do you prove what someone knows, knew or didn’t know?
- Does setting a knowledge standard actually encourage the target company’s leadership to engage in “willful blindness” toward the company’s activities?
To solve both problems, the knowledge standard can employ a concept of “constructive” or “imputed” knowledge, which defines what an individual should have known under the circumstances, and not just what he or she did know.
Why Should I Care?
Buyers: Buyers generally resist liberal application of knowledge qualifiers on the basis that, generally speaking, pre-closing issues should rightfully reside with the Seller regardless of whether the Seller knew (or should have known) about a particular issue. However, market conditions usually warrant including at least a few knowledge qualifiers in the agreement.
As such, it’s important that the Buyer define the “knowledge people” broadly enough to capture all of the personnel at the target company who have responsibility for the key areas of potential risk. For example, if the target company has a VP of Sales who is responsible for key customer relationships, the Buyer will probably want to ensure that he or she is considered a knowledge person in order to capture the state of the company’s customer relations.
Sellers: The Seller is obviously incentivized to keep the list of “knowledge people” narrow, as doing so limits their risk. But perhaps more importantly, Sellers often – and rightly – want to limit the number of people who know about the deal. How can a Seller feel comfortable making representations and warranties that are qualified by the knowledge of people who don’t even know about those representations and warranties because they don’t know about the deal? They can’t.
So, if the Buyer insists on including these individuals in the knowledge people, the Seller must decide if and when to disclose the deal to these third parties. In these cases, robust confidentiality agreements, coupled with a “stay bonus” or similar incentive, are critical.
The Seller also wants to limit the degree to which “constructive” knowledge is attributed. Sophisticated Sellers request a middle-of-the-road “reasonable inquiry” standard and may further clarify that the inquiry only relates to an individual’s normal duties. In other words, these individuals aren’t expected to turn over every stone looking for potential issues; however, if they would normally be expected to inquire about certain issues as part of their typical duties (e.g. the CFO probably would be expected to inquire about a payment being made to a governmental official), then they would be treated as having “knowledge” whether or not they actually know it.
Next Month: “No Undisclosed Liabilities” Representation
Read last month’s piece: Material Adverse Effect/Material Adverse Change Clauses