DealMakers - Q3 2020

Use of knowledge qualifiers in respect of warranties in private company M&A transactions

Melissa Mtolo

For a purchaser, the use of a knowledge qualifier raises the following problems: (i) how to prove what someone knows, knew or didn’t know and (ii) whether the knowledge qualifier may encourage the seller to be wilfully ignorant towards the target company’s activities. On the other hand, sellers do not want to warrant the accuracy of any facts or circumstances relating to the business affairs of the target company that they could not have reasonably known. This article addresses when and how knowledge qualifiers are used in the context of private company M&A transactions.  

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Melissa Mtolo

In private company M&A transactions, a sale agreement will typically contain warranties made by the seller in respect of the target company. The scope and detail of these warranties is usually heavily negotiated between the parties. The purchaser will enter into a sale agreement on the strength of the warranties provided by the seller, not only as to the content of the warranties but also as to the period to which they apply. During negotiations, the seller will naturally attempt to keep the scope of the warranties as limited as possible to limit the seller’s exposure to liability as a result of a breach of warranty. Conversely, the purchaser will seek to broaden the seller’s warranties in order to allocate commercial risks to the seller which, in the absence of a contractual warranty, would usually lie with the purchaser – the purchaser is motivated by the fact that the seller is best placed to give the warranties and assume the commercial risk of a breach thereof, given its proximity to the business or the target company.

 

The purpose of using a knowledge qualifier is to limit the reach of a contractual provision so that it only applies to what the relevant party “knows”. As noted above, the purchaser may not be satisfied with the application of a knowledge qualifier to a representation or a warranty because practically, the seller should be familiar with the target company and well placed to assume any risk relating to the operations, activities and status of the target company without any qualification. It is important to clearly define what is meant by “knowledge”, as well as whose knowledge is being considered in order to balance the interests of the seller and the purchaser. 

 

Knowledge qualifiers should ideally be drafted to identify specific persons or categories of persons or job titles in the target company that are deemed to have knowledge of the areas of the business which the warranties relate to (“Knowledge Group”). From a purchaser’s perspective, the Knowledge Group should be as wide as possible and, at the very least, include individuals having control over those areas of the business covered by the relevant warranties and representations (such as the chief executive officer, executive directors and senior managers). The drafting should ideally state that the seller is deemed to have the same knowledge as the Knowledge Group, after having made due and proper enquiry – this forces the seller to conduct proper due diligence to verify the accuracy of warranties before it signs the sale agreement.

 

After determining who ought to have the knowledge, the sale agreement should also ideally set out the type of knowledge the warrantors are deemed to have – actual or constructive knowledge. Actual knowledge requires the relevant party to actually know of a particular fact or circumstance, whereas constructive knowledge includes imputed knowledge that an individual would be expected to know, given his/her role in or proximity to the business, or that such person would have reasonably obtained after making due and appropriate inquiry. 

 

The COVID-19 pandemic has increased the number of facts and circumstances in relation to a company which may be outside of their control or which cannot be easily determined. For example, more and more sellers are finding it difficult to warrant that it is not in breach of its material contracts without carving out any breaches that may have been occasioned by the total or partial restriction of trade imposed under the national lockdown in terms of the Disaster Management Act, No. 57 of 2002. 

 

It is important to ensure that knowledge qualifiers are used sparingly and only with respect to matters which are outside of the seller’s control or which cannot be reasonably determined through the seller’s diligence. The following are examples of warranties that are commonly qualified by knowledge –

  • warranties which pertain to a future event (e.g. a warranty relating to litigation being “threatened” against the target company but not yet instituted);

  • warranties given in respect of a third party’s acts or omissions (insofar as they affect the business), where the seller does not have any corporate control over that third party (e.g. a warranty stating that no counterparty has breached or will be in breach of its obligations in terms of any material contract with the target company); and

  • warranties relating to compliance with laws or government directives.

Purchasers and sellers involved in transactions will have to negotiate

(i) which warranties should be knowledge qualified, (ii) who should be in the Knowledge Group, and

(iii) whether the knowledge must be actual or constructive knowledge. Knowledge qualifiers should be tailored to the transaction and assessed as to how they may apportion risk between the purchaser and seller.  

 

Mtolo is an Associate in Corporate & Commercial,Cliffe Dekker Hofmeyr.

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