In an agreement for the sale of a business, there will
be a number of representations and warranties by the seller across the spectrum
of the company’s business, including its ownership of assets, its financial
condition, its compliance with a variety of laws (among others, employment and
environmental laws), and the existence of any adverse material events. If an
issue arises post-closing that violates the representations and warranties,
then the indemnity provisions in the agreement will dictate that the seller
must compensate the buyer for any resulting loss, including payment of
attorneys’ fees, settlements, judgments, etc.

Because a breach of the seller’s representations and
warranties can result in a costly indemnification obligation, the seller will
be keenly interested in limiting its exposure to the extent possible. One way
to do this is with a knowledge qualifier for certain representations and
warranties, i.e., language which limits the extent of the representation and warranty
on a specific matter to the actual or constructive knowledge of the seller.

As an initial matter, the distinction between actual
and constructive knowledge standards is an important one in this context.
Actual knowledge of course means that the seller must actually know about the
circumstances giving rise to the breach of the representation and warranty in
order to be held liable for that breach. Constructive knowledge, on the other
hand, will dictate that a breach will occur if seller either knew or should
have reasonably known about the facts giving rise to a breach. Obviously, a
seller much prefers an actual knowledge standard, as it precludes delving into
the factual circumstances to determine whether a reasonable party should have
known about the underlying facts of a breach.

To examine the effect of knowledge qualifiers in the M&A
context, we’ll use the example a representation and warranty pertaining to existing
lawsuits against a company, as well as any present basis for a legal claim to
be brought in the future. This very common representation and warranty is
generally bifurcated by a knowledge qualifier as follows: (1) the first clause relating
to existing lawsuits is unqualified with regard to sellers knowledge; and (2)
the second clause, pertaining to any current facts giving rise to a basis for a
potential claim, is qualified or limited by the actual or constructive knowledge
of the seller.

Let’s begin by analyzing the first clause and the lack
of any knowledge qualifier. If there is an existing lawsuit against the seller
as of the time of closing, whether seller knows it or not, the seller will have
breached the representation and warranty on absence of lawsuits unless that lawsuit
is listed on a disclosure schedule to the agreement. The allocation of risk in this
regard makes logical sense, because the suit has been filed before closing based
on conduct of seller, and should be seller’s responsibility. In addition, with
regard to the issue of knowledge, a lawsuit is a public record and generally
needs to be served promptly after filing, so in most circumstances, seller is
going to be aware of such litigation. And, if due to a quirk of timing, the seller
is not so aware, a buyer is not willing to take on that liability by using a
knowledge qualifier.

As for the second clause, however, the existence of
any basis for a future claim, generally speaking this clause will be subject to
an actual or constructive knowledge qualifier. The allocation of risk here is
that if the seller did not actually know (under an actual knowledge standard)
or reasonably know (under a constructive knowledge standard) of the basis for a
subsequent claim, the seller will not have breached the representation and warranty,
and will not owe an indemnity obligation. The reasoning behind the general use
of the qualifier here is that a seller cannot be held to know everything about
the company, and that some dividing line should be drawn with respect to
unasserted claims.

The trend in M&A is for a constructive knowledge
standard to be used as the knowledge qualifier. The buyer’s argument in this
regard is straightforward: they are unwilling to make the substantial investment
in purchasing a company or its assets while allowing a seller to avoid liability
based on lack of actual knowledge of its errors or misconduct. Indeed, buyer
will argue, such a standard rewards neglect, in that an unknowing seller will
escape liability while a more diligent company would have been aware of the
issue.

There are a variety of ways to define constructive
knowledge in an agreement. One common way is to define knowledge by connecting
it to what specific individuals in the company, often the selling principals
and officers or directors, knew or should have known in the exercise of
reasonable diligence. A seller will want to pay careful attention to this
definition to ensure that the constructive knowledge standard does not become
overly broad so as to open the door too wide to potential liability. Seller and
its attorney should also carefully review the agreement to confirm that
knowledge qualifiers are being used appropriately throughout the representations
and warranties to limit their scope.

A seller’s indemnity obligation is generally the chief
source of liability after closing, so careful review of knowledge qualifiers
during the drafting process is a key way for seller to effectively manage this potential
exposure.

Jeffrey Petersen

This post is for informational purposes only
and does not constitute legal advice.