Herald of the Federal Arbitration Court of the Moscow District № 3, 2012
The article considers one of the most important instruments of English contract law relating to M&A which is also widely used for structuring russia-related transactions. the author describes rules regulating “fair” disclosure to a purchaser. disclosure is material for warranties and the evaluation of assets. the author also investigates reasonable limits of disclosure in the course of negotiations.
English law is widely used in many Russian transactions. There are several reasons for this. English law allows for many legal concepts and provisions that are not yet fully recognised and/or utilised under Russian law, such as warranties and indemnities, conditions precedent, restrictive covenants, veto rights, put and call options, tag and drag provisions, share ratchets, good & bad leaver provisions, limited recourse liability, escrow accounts, earn outs and completion accounts, deadlock mechanisms such as “Texas shoot out” and “Russian roulette”. These concepts are well recognised and used in international financing and corporate transactions worldwide, and there is an abundance of court precedent which allows the parties to understand the rights and obligations that they are agreeing to, and to accurately predict the likely outcome of any dispute relating to them (1).
This article focuses in greater detail on one of the key components of many Russia-related business contracts governed by English law — the concept of fair disclosure against the warranties.
When considering English law, it is important to bear in mind that we have a common law system, based on a combination of legislation and case precedent. English law is not set out in a single civil code. The effect of this is that the courts are constantly developing and shaping English law, in order to fit its use with modern business circumstances and practices.
However, as with many modern legal systems, this also means that close analysis of recent court decisions is often required, and it is not always possible to definitively conclude what the legal position is on a particular issue. Instead, whilst working on transactions, legal practitioners will develop what they collectively consider to be acceptable market practice based on their interpretations of those court decisions. As will be seen below, the concept of fair disclosure is a good example of this.
Background to warranties under English law
Warranties are statements by the seller as to the state of affairs of the target company, its business and assets, and also the seller’s own ability to enter into the contract (2). For example, a party may warrant that it has obtained all internal approvals necessary for entry into a contract, that it has the capacity and authority to contract and that the contract, when signed, will be legally binding on it.
Warranties are designed to protect a buyer against potential risks. If these statements are untrue and cause the buyer loss, the buyer may have remedies against the seller. Generally speaking, the buyer will be entitled to damages for its losses arising from the breach of contract. The buyer will need to show that the warranty was breached and that there is quantifiable loss related to this breach of warranty (for example, the reduction of the value of the business/company acquired).
There are also a number of special legal tests that will need to be considered, such as whether the breach of warranty actually caused the buyer’s loss, whether the loss suffered is too remote to be reasonably recoverable from the seller, and whether the buyer took reasonable steps to mitigate (reduce) its losses. There may also be cases where the buyer is deemed to have partially contributed to its own losses (in addition to the seller’s breach) by its own acts or omissions (3).
It is well established in English law that in ordinary commercial relations, unless there has been a voluntary assumption of responsibility, the parties usually owe no duty of care to one another and are not generally obliged to disclose matters to one another. In the context of share and business sales, the buyer will seek to redress this rule of caveat emptor by requiring the seller to give warranties.
The warranties sought by the buyer depend upon the nature of the company being acquired. They should be drafted in such a way as to ensure that they cover all the important assumptions being made by the buyer about the target and relied upon by it when deciding whether to buy the target, and when agreeing the purchase price. Many warranties will be standard to most companies, such as, for instance, warranties relating to the corporate and financial status of the company, its accounts and financial records, its assets and liabilities, banking arrangements, trading contracts, employees, real estate assets, IP and IT, licences and permits and litigation matters.
Background to disclosures
The usual warranty process involves the buyer seeking warranties in relation to those matters which are of concern to it, on the basis that the seller should then have the opportunity to disclose specific details of matters which, if not disclosed, would cause the warranty to be breached. These disclosures are commonly set out in a separate disclosure letter (and accompanying bundles of documents) which are incorporated into the main sale agreement by reference.
To the seller, the preparation of the disclosure letter is as important as negotiation over the wording of the warranties and the provisions dealing with limitations of liability. This is because the warranties are qualified (and so the liability of the seller under the warranties is reduced) by the matters disclosed. In effect, each warranty is a statement to the effect that the information warranted is true apart from the matters described in the disclosure letter.
The buyer will assess the merits of the proposed acquisition in light of the disclosures. If material adverse matters are disclosed then the buyer may seek a specific indemnity (and, perhaps, a retention), or otherwise factor the relevant circumstance into the terms on which the acquisition is made, such as the terms of payment, the amount to be paid, or the time at which it is paid. In the case of a truly material and adverse disclosure, where the parties cannot agree to restructured deal terms and/or price, this may ultimately lead to the proposed buyer deciding not to proceed with the transaction and instead pulling out of the deal. This in turn may trigger the right for one party to claim a break fee, depending on what contractual arrangements (if any) have been put in place between the parties at the earlier heads of terms/term sheet stage of the transaction.
Disclosures against the warranties and “fair” disclosure
English case law has established the parameters for effective disclosure which, until a recent English Court of Appeal decision, broadly speaking, had to be “fair”. In other words, there had to be a reasonable level of information disclosed for a reasonable buyer to properly understand the disclosure and its implications for the warranty in question. English cases which used to be cited as authority for the fair disclosure principle were the cases of:
(i) Levison v Farin (4), in which disclosure of the causes of a ‘probable cause of loss’, rather than disclosure of an actual drop in value, was held to be an insufficient disclosure against a ‘no material adverse change in net asset value’ warranty; and
(ii) New Hearts Limited v Cosmopolitan Investments Ltd. (5), in which a general disclosure by reference to the target company’s accounts was held to be insufficient to rebut a claim based on a net asset warranty. In New Hearts Lord Penrose stated that: “Mere reference to a source of information, which is itself a complex document, within which the diligent enquirer might find relevant information will not satisfy the requirements of a clause providing for fair disclosure”. In other words, simply providing a large document containing disclosure information, without highlighting that relevant disclosure information could be found inside and giving some guidance as to where to look for it in the document, did not in that case prove to be sufficient to make an effective disclosure to the buyer.
However, the scope of the decision in the New Hearts case was narrowed by the Court of Appeal judgment in the case of Infiniteland Limited and another v Artisan Contracting Limited and another (6). In that case, the Court of Appeal rejected a broad application of the proposition in New Hearts in favour of a more restrictive application, based on the wording of the sale agreement in question: “the adequacy of the disclosure in the present case must be measured against the requirements of the share sale agreement into which these parties have entered; not against the requirements of a different agreement in another case”. In Infiniteland, the general disclosures were broadly drafted, and so, applying the new test which did not impose an overriding concept of “fair” disclosure, operated strongly in the seller’s favour.
Following the case of Infiniteland, the parties can, in theory at least, agree contractually that the seller has no liability in respect of any matter which is contained in the disclosure letter and documents attached to it, even if a full explanation of the matter in question is not set out in the disclosure letter and the implications of the matter are not evident from the face of the disclosure. That position would, however, be a very aggressive one for the seller to take, and English courts will often find against a party who is seen to take an overly aggressive or unreasonable position, even if there are technical reasons to support that party’s aggressive stance.
An interesting counterpoint to the case of Infiniteland is the case of MAN Nutzfahrzeuge AG and others v Freightliner Ltd. and others (7). The English High Court considered the scope of a general disclosure of “all matters that would be revealed by… an inspection of the books and records of [the companies]… any matter which is or should be revealed by inspection of the statutory registers and books and minutes… which would have been revealed by the making of such inspection as would have been made by a prudent purchaser and its professional advisers”. That general disclosure was considered (obiter, i.e. not binding (8) ) not to amount to a disclosure of inferences to be drawn from the items inspected. The judge suggested that in order to achieve the seller’s intention, wording along the lines of “any information that could be derived from a reasonably thorough examination of the company’s accounting records is to be treated as having been disclosed” would be necessary. The court’s decision in this case illustrates certain limits on the scope of general disclosures.
Practical implications for transactions under English law
In the light of the above cases:
the parties must now consider carefully the terms of the sale agreement and the disclosure letter relating to the meaning of “disclosed” or “fair” disclosure;
depending on the meaning of “disclosed” or “fair” disclosure, the seller may need to crossrefer all disclosures as fully as possible to all matters to which they relate; and
the parties should consider the scope of the general disclosures carefully, making sure that they extend to all matters and documents which the seller has in mind and, if in doubt, referring to the matter or document specifically.
Market practice is now to include in the sale and purchase agreement an agreed definition of what is meant by “disclosed”. The first draft of the agreement prepared by the buyer’s advisers will normally include something along the following lines:
“A matter shall be regarded as having been fairly disclosed in the disclosure letter only to the extent that accurate information about it is contained in the disclosure letter in sufficient detail to enable the buyer properly to identify its nature and scope and to evaluate the purpose and effect of the disclosure, including the likely associated cost or liability and the warranties which are to be qualified by it”.
A seller will usually seek to remove the second limb of this test, by deleting “and to evaluate the purpose and effect of the disclosure, including the likely associated cost or liability and the warranties which are to be qualified by it”.
English law concepts of warranties and disclosures continue to be relevant for many Russian deals. I am very interested to see how this position develops, once the new changes to the Russian Civil Code are introduced. I understand from my Russian colleagues that, amongst the proposed changes, there will be a concept of representations which can be used in sale and purchase agreements under Russian law. It will be interesting to observe how this is implemented, and how lawyers then frame this into legal wording when drafting and negotiating contracts and referring to any due diligence or disclosure information which is necessary or desirable in order to qualify and limit those representations. I suspect that the lessons and experience of English law in these areas will be one of the useful reference points for lawyers here. It will of course also be interesting to see how Russian court practice interprets all of this in the event of a dispute between the contracting parties, and to what extent, over time, this court practice is consistent with — or becomes divergent from — our own English legal perspective.
1 See for more details: Ivory I., Rogoza A. Use of English Law in Russian Transactions. Moscow, 2012
2 See for more details: Beale H. Chitty on Contracts. London, 2008. Vol. 1. Part 4.
3 See for more details: Peel E. Treitel: The Law of Contract. London, 2011. Ch. 20. Part 4.
4 Levison v Farin  2 All ER 1149.
5 New Hearts Limited v Cosmopolitan Investments Ltd.  2 BCLC 249.
6 Infiniteland Limited and another v Artisan Contracting Limited and another  EWCA Civ 758.
7  EWHC 2347 (Comm).
8 A precedent consists of ratio decidendi and obiter dicta. Ratio decidendi is a binding part of the judgment, “the general reasons given for the decision… upon which it is based, detached or abstracted from the specific pecularities of a particular case which gives rise to the decision” (see: Words and Phrases Legally Defined. 2007 (supplement 2010). P. 731). Obiter dicta is a judicial comment made while delivering a judicial opinion, but one that is unnecessary to the decision in the case and therefore not binding (see: Stroud’s Judicial dictionary of Words and Phrases. 2012. P. 1947).
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