Company transactions involve significant amounts of documentation to ensure the buyer fully understands the state of the business they are purchasing. A Disclosure Letter (or Letter of Disclosure of Documents) forms a crucial part of the information included in the pre-sales documents. Both the seller and buyer must review it carefully to ensure both parties are protected. In this article, we explain what a Disclosure Letter is and how it relates to the due diligence process.
What is a Letter of Disclosure?
A Disclosure Letter is a key document in any transaction involving the sale of shares or the business and assets of a private limited company. The purpose of a Disclosure Letter is to disclose general and specific information concerning the warranties the seller provides in the sale agreement.
What is a warranty in the sale of company transaction?
A warranty is essentially a set of promises made regarding the state of affairs of a company whose shares or business and assets are being sold.
For example, the seller may provide a warranty that the licences of all the company's IT software programmes are correct in terms of the number of users. Another example is a warranty that the organisation is not currently involved or at risk of any litigation.
Disclosure Letter warranties are vital components in a company sale and purchase transaction. They are contractual, meaning that if they are misleading or inaccurate at the time they were given, the company may be worth less than the purchase price.
Therefore, if false or inaccurate warranties are provided, the seller may face a civil claim by the buyer wanting to recoup some or all of the purchase price. In the case of a deliberately false warranty, criminal charges may be brought against the seller.
How does a Disclosure Letter work?
A buyer must consider the warranties and Disclosure Letter together. The Disclosure Letter essentially ‘discloses’ any information the seller knows about the warranties they are providing.
For example, in the case of impending litigation, the seller needs to disclose any risks of possible court claims. If a warranty is given for IT software licences, the seller must disclose any potential breaches, for example, employees’ family members who may be using the software for private use.
In most cases, several drafts of the Disclosure Letter will be sent back and forth between the seller and buyer, with various details negotiated before the final document is agreed on.
What is a Disclosure Bundle?
At this point, you may be imagining a Disclosure Letter to be just that, a letter of one to two pages. However, any disclosures must be accompanied by relevant documents that the buyer may require to assess the disclosure and evaluate any risks such disclosures highlight. Therefore, what the buyer will normally receive is a bundle of documents which can comprise of hundreds or even thousands of terms, contracts and agreements.
What should be included in a Disclosure Letter?
A Disclosure Letter is divided into two parts:
These cover disclosures that are already a matter of public record or that the buyer should have picked up during the due diligence process. In most cases, general disclosures are the subject of extensive negotiations between the buyer and seller, with the seller wanting to limit the general disclosures and the buyer wanting them to be as comprehensive as possible. Remember, all general disclosures are traceable through due diligence.
These constitute information that if not disclosed may result in a breach of contract by the seller. Certain warranties require specific information to be set out in the Disclosure Letter and supporting documentation to be provided by the seller. Examples include existing commercial contracts and pension schemes.
What are the specific issues for the seller when preparing a Disclosure Letter?
The golden rule for sellers when it comes to disclosure is if you are unsure whether or not to include something in a Disclosure Letter, put it in. The consequences of failing to disclose information that could affect the value of the warranties provided are severe.
Sellers must go through each warranty in turn and consider whether they are true and precise. If incorrect information is discovered, it should be fully disclosed and supporting documentation provided.
Even if the buyer is aware of the information, the seller should ensure it’s still included in the Disclosure Letter. That way, they limit their exposure to a breach of contract claim.
What must the buyer consider?
Regardless of how extensive the due diligence process is, the Disclosure Letter is almost guaranteed to bring forth issues. It’s essential for the purchaser to ask questions about any information that may be ambiguous, so they have a clear picture of the company or shares they are buying.
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Badly drafted and/or negotiated Disclosure Letters can result in the buyer having no recourse if it turns out that the value of the business they have purchased is less than what they paid due to defective warranties.
Poor Disclosure Letters can also impact the seller, leaving them exposed to expensive litigation and having to reimburse the buyer due to breach of warranty claims. Therefore, it is crucial for both parties to work with an experienced lawyer to ensure the Disclosure Letter/bundle is complete and accurate and everyone’s best interests are protected.
LawBite has helped thousands of businesses achieve their commercial ambitions. If you wish to find out more about Disclosure Letters or need support with the disclosure process, you can book a free 15-minute consultation with one of our expert lawyers who will be able to help you draft and negotiate this crucial document.