Many sophisticated M&A buyers, just like buyers of certified pre-owned cars, pay a premium price for a deal in which they will have a remedy at hand if things don't turn out as promised. Inefficiency occurs when a buyer pays a "certified pre-owned" price for an acquisition and gets a "used car lot" type of deal with little or no indemnity. This happens because of arcane legal rules and poorly understood market practices, but by understanding the background legal rules, buyers can ensure that they are getting the target company that they diligenced and are not paying a premium for indemnification that they are not getting.

If after the closing of an M&A deal, the buyer discovers that the target company does not match the due diligence examination, the buyer has two avenues for relief. First, the buyer can seek the "Contract Remedies" that were negotiated in the acquisition contract, typically some form of indemnification.

Second, the buyer can sue for the "Background Legal Remedies" that apply to all transactions.

The trend in the United States has been for parties to eliminate the Background Legal Remedies. This trend is not necessarily a bad outcome, as parties in a free market should be able to contract for whatever risk allocation they want. The "inefficiency" or "problem" arises when the remedies do not conform to the parties' expectations as a result of the increasingly creative techniques used by sellers to limit Contract Remedies. This inefficiency is increased by the tendency of some courts to turn claims for breach of representation and warranty into tests of what the parties knew, as opposed to tests of how the parties allocated the risk that the representations and warranties were not true.

To deal with this trend, corporate development professionals on the buy side need to work even closer with their M&A attorneys to make sure that their contracts protect the business diligence, reflect the latest court decisions and align the contractual allocation of risk with the business deal.

The double lie

As a general matter of law, a seller may not lie or recklessly misrepresent facts. In addition, if a transaction involves the purchase or sale of securities such as corporate stock, federal and many state, anti-securities fraud rules apply as well. However, from almost the first moment of every deal, a good counsel for the seller will try to eliminate the Background Legal Remedies that flow from these rules. Two common techniques are to create the "double lie" and a "meaningless liar."

The first legally binding document in a typical M&A transaction is the confidentiality agreement. Those agreements typically contain a clause in which the party receiving the information acknowledges that the recipient understands that the seller has not made made any representation or warranty as to the accuracy or completeness of the Evaluation Material. The buyer agrees that the seller will not have any liability resulting from the use of the Evaluation Material.

Most electronic datarooms contain similar provisions in their click-through agreements. These provisions are oftentimes reinforced with what is referred to as a "zipper clause" in the final acquisition agreement, in which the buyer represents that it has relied on no representation or warranty other than those expressly set forth in the acquisition agreement.

One more nail is put in the coffin of Background Legal Remedies by another typical provision that says that if the deal closes, the only remedy for the buyer is the Contract Remedy (although such a provision may not be enforceable in certain cases of fraud).

The effect of the confidentiality agreement, the dataroom click-through agreement and/or the zipper clause is that if the buyer were to claim at a later date that it was defrauded or led astray (i.e., "lied to") by an aspect of the diligence that was not represented in the acquisition document, the seller will point to the buyer's "lie" in the documents (i.e., that it was not relying on the accuracy of anything outside of the acquisition document). At least one influential judge has referred to this situation as a "double lie" and has indicated that the buyer should not be entitled to any remedy in that situation.

Another technique that a seller's counsel will use is to create a structure in which all of the statements to the buyer are made not by the seller, but by the target company. Thus, if the buyer is "lied to," the liar is the target company (post-closing the buyer's subsidiary or portfolio company), so the buyer effectively has no one to sue for the lie. This, in effect, creates a "meaningless liar."

What buyers should do

The elimination of the Background Legal Remedies through the "double lie," "meaningless liar" and other techniques puts the buyer in a position where there is no remedy for errors, inaccuracies and outright lies in all of the management presentations, discussions with key employees, plant visits, spreadsheets, schedules, projections and other business plans unless those matters are covered by representations and warranties in the contract.

For instance, if a company acquires a business and, despite what the plant manager promised, the floating dust particles are indeed asbestos, there is likely no recovery unless the buyer got a representation covering that point.

In order to prevent that outcome, there are two techniques: One is the "10b-5 Representation," which requires the seller to represent to the buyer that it has given all material information relating to the target and that such information contains no material misrepresentations or omissions. Increasingly, 10b-5 Representations are hard to get. That leaves buyers with the second option, which is essentially, "Better and More Focused Representations." As a buyer, being limited to Contract Remedies is not a "bad thing" if they have done their homework, closely coordinated with their counsel and covered the critical factors. If buyers are to get the business that they saw in due diligence and paid for, they and their counsel need to work closely together to make sure that the representations in the acquisition contract cover the key aspects of the business diligence.

Not what you bargained for

Even if the buyer gets representations that cover the key elements of business diligence, buyers sometimes will still not get the Contract Remedies for which they bargained. This typically results from the buyer's own due diligence being used against it under "anti-sandbagging rules."

Most M&A professionals view a seller's representation and warranty both as a promise that something is true and as an allocation of risk. Thus, even if the buyer knows that the representation and warranty are not true, the buyer expects to be able to have a remedy. This expectation is consistent with general principles of New York law, which governs many acquisition agreements.

However, New York, among other jurisdictions, then "takes back" that general principle with an exception that swallows the rule: The buyer cannot recover on the warranty if it closed the acquisition knowing that the warranted facts were false. The New York exception is designed to prevent "sandbagging," in which a buyer tricks a seller by buying a business at an inflated price, knowing that it will get some of the price back through a remedy for a breach of warranty.

This exception is troubling on many fronts, including what it means to have "knowledge" and how to prove it. In addition, given the uncertainty surrounding litigation and other forms of dispute resolution, "sandbagging" — while a nice theoretical concern — is not a real risk in the vast majority of situations. Instead, what the New York exception does is to turn every claim by a buyer of a breach of warranty into a Watergate-esque inquiry asking "what did the buyer know and when did the buyer know it."

So what is a buyer, who has probably given up Background Legal Remedies and has bargained for a defined set of representations, to do? Well, there really are four solutions.

First, the buyer team needs to make sure that the seller represents in the contract to the critical aspects of the business diligence. If the plant manager says that the dust particles aren't asbestos, it's up to the buyer to make the seller represent it. Second, as a measure of "defense," the buyer should document the conclusions from its own diligence so it is clear that there is no "sandbagging" going on. This will also serve as a good double-check that all the critical issues are covered in the acquisition contract. Third, although New York has a well-developed commercial law, buyers should consider a choice of law other than New York. Finally, if they have sufficient bargaining power, buyers should seek an express provision in the acquisition contract that they are entitled to recover for a breach of representation and warranty even if the buyer has knowledge of the breach at the time of closing.


Maurice Lefkort is a partner with the law firm of Willkie Farr & Gallagher LLP and regularly advises strategic and private equity clients in the buying and selling of businesses.