By: Daniel Avery and Linh Lingenfelter
In merger and acquisition (“M&A”) transactions, the definitive purchase agreement contains representations and warranties made by the seller with respect to the target company. The scope and detail of these representations and warranties are often heavily negotiated and tailored to reflect not only the nature of the target and its business, operations and financial condition, but also the relative negotiating strength of the buyer and seller. Representations and warranties provide information to the buyer and also allocate risk as between buyer and seller with respect to the matters covered by the representations and warranties.
One type of representation and warranty that the buyer commonly requests is a representation that the target company has “no undisclosed liabilities” (or an “NUL representation”). Both buyer and seller consider this representation important because it can significantly impact the relative risk allocation as between the parties for undisclosed—or otherwise unknown—liabilities of the target.
What is a No Undisclosed Liabilities Representation?
NUL representations may take various forms, but generally involve the seller making statements to the buyer certifying as to the absence of target liabilities that are not otherwise identified or disclosed (whether addressing specific liabilities or referencing all liabilities). An NUL representation is often one of the principal representations in an M&A purchase agreement pursuant to which the seller and buyer allocate risk of unknown target liabilities amongst themselves.
The buyer typically wants the seller to make an unqualified NUL representation to the extent possible. Specifically, it wants to ensure the representation includes minimal exceptions and covers the maximum universe of potential liabilities. A buyer-friendly version of an NUL representation may read:
The Target has no liabilities of any type whatsoever except for: (i) liabilities reflected or reserved against in the Latest Balance Sheet; and (ii) those liabilities set forth on Schedule X.
The seller, of course, often seeks to limit the scope of liabilities subject to the NUL representation. For example, it typically attempts to incorporate as many exceptions and qualifiers as possible thereby limiting its overall exposure. The seller’s efforts to limit its potential liability for breach of an NUL representation usually take one or more of the following forms:
1. Limiting the Subject Liabilities to GAAP Balance Sheet Liabilities
Because an NUL representation often references a target’s balance sheet, a seller may argue that the NUL representation should apply only to the subset of liabilities required under applicable accounting standards to be reported on a balance sheet. An example of an NUL representation including this limitation may read:
The Target has no liability of a nature required to be disclosed in a balance sheet prepared in accordance with GAAP except for: (i) liabilities reflected or reserved against in the Latest Balance Sheet; and (ii) those liabilities set forth on Schedule X.
Under an NUL representation including this limitation, the seller need only disclose liabilities of the type required to be reflected as liabilities on a balance sheet prepared in accordance with Generally Accepted Accounting Principles (“GAAP”). This is an important distinction because not all liabilities need be reported under GAAP. For example, under GAAP, the disclosure of contingent liabilities depends upon a number of different factors, including relative probability. In addition, an operating business generally has many ordinary course business liabilities that are not typically liabilities included in a GAAP balance sheet (e.g., normal, but significant contract obligations). And, because truly “unknown” liabilities cannot be disclosed on a balance sheet, they would be excluded as well. In short, GAAP liabilities can be a relatively narrow subset of a target's known and unknown liabilities.
2. Adding Ordinary Course Exceptions Carve-out
The seller often seeks a carve-out for ordinary course liabilities incurred since the balance sheet date. An example of an NUL representation including this carve-out may read:
The Target has no liability of the nature required to be disclosed in a balance sheet prepared in accordance with GAAP except for: (i) liabilities reflected or reserved against in the Latest Balance Sheet; (ii) liabilities incurred in the Ordinary Course of Business since the date of the Latest Balance Sheet; and (iii) those liabilities set forth on Schedule X.
3. Including Knowledge or Materiality Qualifiers
The seller may also limit an NUL representation to those undisclosed liabilities of which the seller had knowledge and/or to undisclosed liabilities above a materiality or other threshold.
4. Excluding Liabilities which are the Subject of Other Representations
A seller may also object to an NUL representation as being overly broad, and, with respect to any specific topic, potentially in conflict with other representations in the purchase agreement specifically covering that topic. For example, if the purchase agreement has a detailed representation regarding environmental matters that requires disclosure of liabilities arising under environmental laws in excess of $10,000, should the NUL representation separately require disclosure of environmental liabilities below $10,000? An example of a topic-oriented limitation to the NUL representation may read:
The Target has no liability … except for: … (iv) liabilities which are disclosed on any other Schedules or which are not required to be disclosed under any representation or warranty in Article X because of a materiality, dollar or knowledge threshold or qualifier.
The Buyer’s Position
The buyer often insists on a broad NUL representation because, from its point of view, the seller should bear at least some risk of undisclosed or unknown liabilities. To make its point, the buyer often argues that the seller is in a better position than the buyer to assess the risk of unknown liabilities because of the seller’s familiarity with the past and current operations of the target company, and therefore should be expected to stand behind its assessment. In practice, however, where NUL representations are present, they are usually included within the category of seller representations that are subject to an indemnity basket and cap—i.e., a minimum level of buyer loss before seller responsibility kicks in, as well as a stated maximum amount of seller liability. Thus, in this context, the buyer is already assuming some of the risk of unknown liabilities even with a normal NUL representation (specifically, those within the basket and above the cap).
The Seller’s Position
The seller may argue one or more of the following to attempt to negate the buyer’s arguments:
- If the purchase agreement covers in great detail all aspects of the target’s business, why is a broader “catch-all” representation needed or appropriate?
- If the parties have agreed that certain types of contracts and other liabilities are not required to be disclosed under specific seller representations, why should those thresholds be ignored for an NUL representation?
- Other provisions in the purchase agreement afford the buyer adequate protection against certain liabilities. In support of this argument, sellers most often cite (i) the standard seller representations with respect to the target’s financial statements and (ii) that no material adverse effect has occurred since a specified date.
Trends in Usage of No Undisclosed Liabilities Representations
Every other year since 2005 the American Bar Association (“ABA”) has released its Private Target Mergers and Acquisitions Deal Point Studies (the “ABA studies”). The ABA studies examine purchase agreements of publicly available transactions involving private companies that occurred in the year prior to each study (and in the case of the 2017 study, including the first half of 2017). These transactions range in size but are generally considered as within the “middle market” for M&A transactions; the average transaction value within the 2017 study was $176.3 million.
According to the ABA studies, M&A purchase agreements consistently include an NUL representation. Specifically, across the seven ABA studies, an NUL representation was included in 92% to 97% of reported transactions. Additionally, the five most recent ABA studies examined the use of knowledge qualifiers within NUL representations and found that these qualifiers are rare, appearing in only three and six percent of reported transactions. However, GAAP qualified NUL representations (the target favored approach) are much more common, appearing in 61% to 78% of reported transactions, though the use has been trending downward in the most recent studies.
The NUL representation remains prevalent in private company M&A transactions. Seller attempts to use knowledge qualifiers to limit exposure have been met with very little success. Additionally, the seller-friendly GAAP-only NUL representation continues to be a minority approach (though much more common than knowledge qualifiers). As discussed above, these qualifiers impact allocation of undisclosed liabilities as between buyer and seller. Counsel on both sides of an M&A transaction should consider these issues carefully when negotiating an NUL representation.
 Daniel Avery is a Director, and Linh Lingenfelter is an Associate, in the Business Law Group at Goulston & Storrs, in Boston, Massachusetts. Mr. Avery is a member of the ABA’s working group which published the 2017 ABA private company M&A deal points study. This article is based on, and updates, the article of the same name co-authored by Mr. Avery and Mrs. Lingenfelter, published in Vol. 17, Number 1376 edition of the Bloomberg M&A Law Report (2014). This article is one of a series of over 20 articles co-authored by Mr. Avery looking at trends in private company M&A deal points. The series is currently being updated to reflect the 2017 ABA private company study and will be published throughout 2018. The articles can be found on Goulston & Storrs’ “What’s Market” web page at http://www.goulstonstorrs.com/WhatsMarket and on Bloomberg Law at https://www.bloomberglaw.com/page/infocus_dealpoints.
 Note that within this article we use the terms: “seller” and “target” in the context of a stock purchase transaction. The “seller” would be the selling shareholder(s) making the representations and warranties in the M&A documents, and the “target” would be the company being acquired. In an asset purchase transaction, the “seller” would be the target company itself but for consistency we are using “seller” and “target” in a stock purchase setting. In addition, the terms “target” and “target company” are used interchangeably.
 The NUL representation is usually not the only representation dealing with unknown liabilities. Unknown target liabilities are typically addressed in different ways throughout the M&A purchase agreement. For example, if a seller provides a normal representation that the target has complied with all applicable laws during the past three years, unless that representation is knowledge qualified, the seller, by making that “flat”—i.e., unqualified—representation, has assumed, vis a vis the buyer, the risk of unknown liabilities arising from legal non-compliance during the relevant period.
 Note that the ABA studies do not look at the usage of the commonly used “ordinary course of business” exception described above. The ABA studies also do not cover the “otherwise disclosed or not required to be disclosed” exception discussed above — this exception, however, is not seen in practice as frequently as the “ordinary course of business” exception.