Classification: Moderately Material
Section: Representations and Warranties of Seller
Negotiation Time: Minimal to Moderate
Transaction Costs: Insignificant
Major Impact: Risk Management
What is This? One major purpose of the Agreement is to detail how certain liabilities of the Business will be treated after the Closing. This term focuses on a particular set of liabilities, those that are unknown to the Buyer at the time of the sale, and requires the Seller to either disclose them in the Disclosure Schedules or remain on the hook for them post-Closing.
The Middle Ground: Since the Balance Sheet Date on which it was delivered prior to Closing, the Seller represents that all liabilities of the Business are reflected or reserved against in the Balance Sheet, except for immaterial liabilities incurred in the ordinary course of business, consistent with past practice.
Purpose: This representation is targeted at unknown liabilities that transfer to the Buyer (along with the Business) as a matter of law. Major liabilities can usually be predicted and planned for, so it is unlikely the Buyer will be held responsible for a significant, unplanned-for liability incurred by the Seller. Even so, this representation provides some level of comfort to the Buyer by shifting the risk of unknown pre-Closing liabilities back to the Seller.
Buyer Preference: The Seller may try to limit this representation or exclude it altogether, but the Buyer will want to include it as is on the grounds that any liabilities incurred by the Seller should be borne by the Seller. If the Seller does try to limit the applicability of the representation, it will likely argue for (1) a knowledge qualifier, (2) a materiality or Material Adverse Effect qualifier, (3) a GAAP qualifier, or (4) excluding certain specified liabilities. For the Buyer, argument (1) is a non-starter because the entire reason the Buyer wants this provision is to avoid shouldering liability for unknown liabilities, plus the Buyer does not want to be forced to prove the Seller’s knowledge about a particular topic. Similarly, the Buyer wants to exclude the GAAP qualifier because including it would mean the representation does not apply to unknown contingent liabilities and those liabilities are exactly why the Buyer is seeking the protection offered by this representation. Including materiality qualifiers of some sort or excluding specified liabilities may be more agreeable to the Buyer, but the Seller’s risk from small inaccuracies can be addressed just as well by applying a Basket to the Buyer’s indemnification rights, and taking that approach doesn’t create much additional risk for the Buyer.
Seller Preference: The Seller likely wants this representation excluded in its entirety, or, alternatively, to implement one or more of the limitations listed above. The Seller’s best hope is to exclude certain categories of liabilities, especially if they are addressed elsewhere in the Seller Representations and Warranties (i.e. environmental liabilities). Otherwise, the Seller may have to give in on a different point of negotiation in order to lower its risk from unknown pre-Closing liabilities.
Differences in a Stock Sale Transaction Structure: This representation is a necessity for the Buyer in a stock sale since, under that transaction structure, all of the Business’s liabilities are transferred to the Buyer by operation of law. The content of the representation may not change, but the Buyer’s level of risk if the clause is excluded increases exponentially when the transaction structure changes from asset to stock sale.
We want The Middle Ground to be an ongoing dialogue for and resource to the lower middle market M&A community. The outline above is generally applicable, but there is always specific case law and nuance around certain industries that can be useful in helping buyers and sellers come together. If you are a lawyer or deal professional, we encourage you to add your perspective below.