M&A transactions: Why it is important to define scope of knowledge in agreements

Mergers and acquisition (M&A) transactions typically involve the buyer conducting financial, business and legal due diligence on the target prior to entering into definitive agreements. This gives the buyer an opportunity to attribute a fair price to the assets or shares proposed to be purchased and understand the affairs of the target better. At the same time, it also subjects the buyer to future liabilities that may arise on account of past actions which may have or should have come to the ‘knowledge’ of the buyer during the course of its diligence. The (Indian) Sale of Goods Act, 1930 provides that if the buyer has examined the assets or shares proposed to be purchased, the buyer cannot escape liability from any defect in the assets or shares which such examination should have revealed. In all M&A transactions, it is customary for a buyer to seek contractual assurances (in the form of representations and warranties) from the seller and/or the target company pertaining to the business of the target, the assets or shares being acquired by the buyer, the ability of the seller and the target to enter into the transaction and so on. [caption id=“attachment_3211430” align=“alignleft” width=“380”] Reuters[/caption] A breach of any such assurance gives the buyer a right to claim indemnity or damages and obligates the seller or the target to pay for such breaches. The legal and financial implications of such provisions ensure that they are some of the most negotiated and extensive clauses in sale and purchase agreements. Actual vs constructive knowledge The representations and warranties in an M&A transaction are typically sought to be qualified by ‘knowledge’ of the buyer, attributable either to the buyer’s own due diligence exercise or disclosures made by the seller or the target. As a result, the ‘knowledge qualifier’ is one of the most negotiated provisions in such transactions. This brings us to the question of what can be construed as ‘knowledge’. What is often debated upon is whether knowledge will include actual knowledge or constructive knowledge as well. Constructive knowledge means knowledge which a prudent person is expected to have after conducting reasonable diligence or enquiry i.e., what the buyer ‘should have known’. While Indian courts have not examined the validity of constructive knowledge in the context of acquisition agreements, they have not viewed it very favourably in other contexts. In Canara Bank v. Canara Sales Corporation(1987 SCR (2) 1138), the following definition of knowledge was considered by the Supreme Court of India: knowledge may include not only actual knowledge, i.e. actual awareness of the facts relevant, but constructive knowledge. i.e. knowledge attributed by law to the party in the circumstances, whether he actually had the knowledge or not, and knowledge may be attributed to a person who has sought to avoid finding out, or has shut his eyes to obvious means of knowledge_._ Canara Bank argued that the terms of contract between a bank and its customer demands that there is an implied condition on the customer to examine his statement of account, particularly when the bank issues a notice stating that if no errors are pointed out within a specified time, the bank will assume that there are no errors. The Supreme Court did not uphold this argument and dismissed the appeal. In World Sport Group (India) Private Ltd. v. Board of Control for Cricket in India (BCCI)(2011(113)BOMLR723), one of the contentions raised by World Sport Group (India) Private Limited was that, the existence of certain documents cannot be disputed by BCCI since it had the means to access such documents using ordinary diligence. Rejecting the contention, the Bombay High Court observed that the mere fact that a document was placed on the records of an organisation does not necessarily mean that the officers of such organisation had the means of discovering the contents of such document with ordinary diligence. On the other hand, English courts have dealt with the question of constructive knowledge in the context of acquisition agreements. In the case of Eurocopy PLC v.Teesdale (1992 BCLC 1067) (Eurocopy), the agreement stated that the warranties were subject only to the matters set out in the disclosure letter and no other information of which the buyer had actual, constructive, or imputed knowledge would preclude the buyer claiming breach of warranty. The court’s decision suggests that a buyer may not be able to rely on such wording where it has actual knowledge of certain facts not disclosed in the disclosure letter. However, in Infiniteland vs Artisan Contracting Limited (2005 EWCA Civ. 75) (Infiniteland), the court recorded a different view. In this case, the acquisition agreement included a provision, commonly known as a ‘pro-sandbagging clause’, to the effect that a claim for breach of warranty would not be affected by any of the buyer’s due diligence investigations of the target, except to the extent such investigations gave the buyer actual knowledge of the relevant facts or circumstances giving rise to the breach. During diligence, the seller had provided documents to the buyer’s accountant which revealed a discrepancy between the warranty on financial statements and the actual state of affairs. However, the buyer claimed to be unaware of this fact as its accountants had not informed it of the issue. The court, reading the sandbagging clause noted that unless otherwise provided in the contract, knowledge of the buyer’s advisors would not be presumed to be that of the buyer. The court went on to differentiate between actual knowledge and constructive knowledge and opined that, “had the parties intended to include ‘imputed knowledge’ in the qualification by which they cut down the scope of the relevant provision, they would have said so”. Considering the pronouncements in Eurocopy PLC and Infiniteland, it is clear that definition of the buyer’s knowledge and application of such a qualification need to be carefully crafted so as to achieve the commercial intent. Given that Indian courts have not dealt with the question of ‘constructive knowledge’ in acquisition agreements, Indian transaction lawyers tend to look to the approach of English courts on this issue. On both sides of the table, it has become increasingly important to define the scope of ‘knowledge’ and specifically deal with constructive or imputed knowledge, knowledge of advisors, form and contents of disclosures to be made by seller or target and of course, the impact of ‘knowledge’ on buyer’s ability to seek indemnification. (The authors are from Khaitan & Co)