Significance of Disclosure Schedules in M&A Transactions
While making investments, investors usually try to find ways and means to minimize their exposure to liabilities that may arise due to the company’s past conduct in terms of their compliance track record. One such way is to seek representations and warranties regarding certain vital matters from the investee company and its promoters. The investee company must provide these warranties even though the investors conduct independent due diligence exercises on the company to assess the risk associated with the particular investment. Now the question arises, can there be exceptions to the representations and warranties made to limit the liability of the investee company? The answer is, yes! This is precisely the role of a “Disclosure Schedule”.
There are many moving parts in a transaction involving Mergers and Acquisitions (M&A transactions). While all M&A transactions demand their level of due diligence, Disclosure Schedules, the documents that assist and supplement a seller’s representations and warranties—are among the most important. A poorly prepared disclosure schedule can create considerable exposure to liability for sellers and shareholders. That’s why business owners and their prospective buyers must be aware of their importance, how and why they are prepared, and some common mistakes to avoid while preparing such schedules.
What is a Disclosure Schedule and why does it matter?
Meaning of a Disclosure Schedule
A Disclosure Schedule is a general component of a purchase agreement in an M&A transaction, whether the transaction is enabled through a Share Purchase Agreement or an Asset Purchase Agreement. As the name suggests, it takes the form of a schedule to the definitive agreement whose purpose is to supplement, qualify and disclose exceptions to the representations and warranties made by the investee company in the transaction documents.
Why do Disclosure Schedules matter in M&A transactions?
- For the buyers: They act as supplement to the representations made.
One critical function of a disclosure schedule is to obtain information on the inner workings of the seller’s business. For instance, a buyer may want to know about the material contracts of the target business, the seller’s financial statements, and a list of key employees, among others. You might think buyers already obtained this information while conducting the due diligence process, so what is the purpose of a Disclosure Schedule? The answer is that the information they receive is only as good as the seller provides. Disclosure Schedules officially formalize vital aspects of the business in a legally binding manner by acting as supplements to the representations made by the seller in the definitive agreement. From a buyer’s perspective, proper disclosure alerts the buyer to potential issues. It enables it to decide whether it will willingly accept the liability or request other protections from the seller. It will also give the buyer a recourse if the seller omits or misrepresents information in connection with representations and warranties.
- For the sellers: They give exceptions to the warranties provided.
Disclosure Schedules are equally, if not more significant, for sellers for their own protection from risk exposure. Most M&A sellers provide representations and warranties on almost all aspects of their business. It allows them to disclose exceptions to the warranties made by it. For example, the seller could warrant in the purchase agreement that it has no outstanding tax liability except as provided in the disclosure schedule. Similarly, the warranty may include that neither the company nor the promoter has given or agreed to give any guarantees or indemnities, except the personal guarantee provided by the promoter to avail certain loans for the company as described in the disclosure schedule. The information included or not included in them has legal consequences for the seller and provides risk protection for the buyers.
It is evident from the above examples that the main aim of a disclosure schedule is to avoid a breach of warranty claim by the buyers at a later date. Assuming the disclosure was adequate in each case, the seller will receive significant protection against post-closing allegations that the selling company breached its representations and warranties.
Information included in a Disclosure Schedule
While the nature and scope of information disclosed vary from transaction to transaction, the following are some of the most common types of information M&A sellers must include in their Disclosure Schedules:
- Material Contracts
- Payment of taxes
- Pending litigation
- Loans due
- Pledge of promoters’ holdings
- Corporate Guarantees
- Right of First Refusal
- Tag along and drag along rights granted
- The exit of key employees
- Ownership of intellectual property
- Financial statements and accounting information
- Contingent liabilities
- Rights of existing investors
- Details of convertible securities
- Key customers and suppliers
- Compliance with laws
- Licenses and permits
Common pitfalls and mistakes to avoid while drafting Disclosure Schedules
Many sellers have the misapprehension that the due diligence process and the Disclosure Schedules concerning the purchase agreement are two distinct parts of the transaction. Even if the information has been provided during the due diligence process, it is in the interest of the seller to state the information in the Disclosure Schedules expressly. Preparing Disclosure Schedules can be time-consuming and arduous, but they present a vital and final written record of crucial information and thus are a critical part of the process. The following are the common mistakes made by the seller while drafting and negotiating a Disclosure Schedule:
- Failing to take into account full scope of representations and warranties.
- Providing an incomplete list of material contracts.
- Details about leases is missing vital information such as title of the lease, lessor, lease terms, security deposits, etc.
- Providing incomplete details concerning intellectual property.
- Not disclosing complete details about employees, including details of employees who left the company, but there is a continued obligation regarding their salaries, bonuses, and other vital information.
- Details about key customers or suppliers and key contractual obligations with them .
- Providing an incomplete list of software and information technology used in the business and the licenses for using them.
- Failing to provide a complete list of disclosures in relation to dispute resolution, investigations and other governmental proceedings.
- Providing incomplete disclosures about company’s bank accounts, insurance policies and any liens on the company’s assets.
- There are incomplete financial statements or liability disclosures which are required by the seller’s financial representations and warranties.
- Non-disclosure of complete details of contingent liabilities
- Failing to coordinate with the right employees having the required knowledge regarding the subject matter of warranties sought by the buyer in preparing disclosure schedules.
- Making vague disclosures.
Considering the pitfalls above, the significance of Disclosure Schedules cannot be understated or ignored. They form an integral part of any M&A transaction. Hastily prepared Disclosure Schedules are more likely to be incomplete or inadequate. This can create unnecessary risk, delay the closing of a transaction or even tank the deal, besides potential liability on the seller post-closure of the transaction. Working with seasoned professionals can assist you not only with the preparation and review of Disclosure Schedules but also help you understand their purpose, scope and implications.
If you’re looking for assistance in drafting and negotiating key agreements and disclosure schedules to mitigate risk and liability, enforcing contracts and other aspects of mergers and acquisitions, then please get in touch with us.