How to allocate risk you find in due diligence

We generally subscribe to the theory that commercial contracts are about allocation of risk in a transaction. Dealbook today writes about a clause in the Merrill Lynch / Bank of America merger agreement.

Here’s the clause: “(c) No investigation by a party hereto or its representatives shall affect the representations and warranties of the other party set forth in this Agreement.” It’s found in Section 6.2(c) of the merger agreement.

The purpose of the clause is questioned. In our experience, buyers typically use language like that found in this specific clause to hold targets to the terms of the reps and warranties. The idea is that even though you perform due diligence on an issue, such as reviewing a stack of material contracts, your own diligence investigation does not excuse the target’s failure to make adequate disclosures.

The situation could play out like this: material contracts are provided to the buyer that include the terms of a real estate lease that show that it must be cancelled six months before the expiration of the five-year lease or it will auto-renew. The six-month deadline has passed and so the lease will auto-renew. The target reps that there are no leases that are not cancelable on thirty days’ notice, a deadline that has not passed. When this situation starts to resolve itself, targets often say “we gave you the documents, and you reviewed them.” They may note that an item was specifically noted to be in contradiction with the rep as a reason for excusing the breach. With the quoted language in place, the due diligence investigation by the buyer is not a defense to the breach of the rep.

To outsiders, this sounds like the sort of weasel legalese that the public now expects from lawyers. A few other examples showcase the benefits: first, imagine a dispute about the legal effect of a notice (the target sent a notice that it believes is legally valid to cancel the lease, and the buyer disagrees. Under the rationale we’ve described, the deal can go forward and allocate the risk of the notice being ineffective to the target. Second, imagine further that there’s a lawsuit pending (but not served) regarding the termination of the lease. The buyer will certainly want to know about it but may not want to underwrite the litigation. Using a “no threatened litigation” representation, the buyer can shift the risk of loss from the issue to the target.

Why should targets do this? Why would they take these risks? The proper allocation of risk is much like an insurance analysis — the risk should generally lie with the party best able to manage and minimize the risk and control the outcome actual underlying event/issue. In almost every case, the target is far better equipped to at least know about the nature of the risk and appropriately price it rather than requiring the buyer to price the risk as part of what’s included in the purchase price. Usually, a knowing omission from the disclosure schedule, which is how this shift of risk is typically accomplished, is only appropriate for material risks that are hard to manage and difficult for a buyer to investigate. For example, we have used this explicitly in a situation where the founder of a technology company was being challenged by a former employer about whether the employer’s trade secrets were being used in the new company’s products.

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  1. […] parties move past the distracting issues and focuses them on the critical facts to identify in the due diligence process: the dealbreakers, the price-changers, and the term-changers. (Everything else is […]

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