Knowledge Definition Clause

Summary

This Knowledge definition clause may be used to qualify representations and warranties in an acquisition agreement. This clause includes practical guidance and drafting notes. Click here to see recent examples of Knowledge definitions in Market Standards—M&A, the searchable database of publicly filed M&A deals from Practical Guidance that enables users to search, compare, and analyze its comprehensive database of transactions using over 150 detailed deal points to filter search results. In a purchase agreement relating to an M&A transaction, the seller will make numerous representations regarding the business or assets being sold. The form and substance of those representations will be the subject of negotiation for a number of reasons. First, the representations are the buyer's main source of comfort regarding the business or assets it is purchasing. Second, representations often serve to allocate risk of uncertainties between the buyer and the seller. From the seller's perspective, however, making representations might result in an unfair allocation of risk, particularly if the seller is required to make representations about aspects of its business or assets over which it has no knowledge or control. For instance, the seller might refuse to give a representation that there is no threatened litigation against the target company it is selling to the buyer because it would be impossible for the seller to be aware of all lawsuits threatened or to be threatened against the target. One way in which the seller can qualify an uncertainty relating to a representation is by introducing a "knowledge" qualifier with respect to that representation. By introducing a knowledge qualifier, the seller is representing a purported fact to the buyer, but only to the extent of the seller's "knowledge." In other words, if the purported fact being represented is inaccurate, but the seller did not have "knowledge" of that inaccuracy, then the representation itself is accurate. Thus, in the example above, the seller might qualify a litigation representation as follows: Seller represents to Buyer that, to Seller's Knowledge, no Person has threatened to institute any litigation against the Company. If at the time this representation is made a person has threatened to institute litigation against the company, but the seller does not have "Knowledge" of that threat, then the seller's representation is accurate. The use of knowledge qualifiers is not limited to seller representations. Depending upon the nature of the buyer's representations, a buyer might seek to qualify certain of its representations with knowledge. Often, the buyer will be able to qualify by knowledge those of its representations that parallel seller representations that have been qualified by knowledge. The definition of "Knowledge" is typically drafted as a universal term that can be applied to any of the parties to the agreement. Arguments For and Against Knowledge Qualifiers A seller will often seek to qualify certain representations by its "Knowledge." A seller with a good degree of leverage might try to qualify as many of its representations by "Knowledge" as possible. The seller's reasons for introducing knowledge qualifiers might include the following: • It is not reasonable to ask the seller to make representations about events, circumstances, and facts of which it has no knowledge. This argument is essentially a "fairness" argument. The argument may be more compelling where the seller is selling a discrete subsidiary or set of assets, since the extent of the seller's knowledge will depend on the degree of control the seller has over such subsidiary or assets. • Certain representations are customarily qualified by knowledge. See Representations that are Commonly Qualified by Knowledge. As such, term sheets or letters of intent relating to the M&A transaction that refer to "customary representations and warranties" should contemplate including such knowledge qualifiers and the buyer should factor the associated risks into the purchase price established in the term sheet or letter of intent. • Representations about uncertain matters are subject to negotiation and including knowledge qualifiers are a compromise between the seller making an unqualified representation about the subject matter and not making a representation about that subject matter at all. A buyer will often push back on knowledge qualifiers to the seller's representations, particularly if the representation at issue is not customarily qualified by knowledge. The buyer might argue the following: • Assessing whether the seller had knowledge of a given fact will inevitably involve a factual inquiry, which could be a costly endeavor for both parties. • If a representation is meant to serve as a risk-shifting mechanism, then the seller's knowledge of the representation's accuracy is irrelevant. What matters for such a representation is that the seller bears the burden of any losses associated with the statement's inaccuracy. • If applicable, the term sheet or letter of intent describing the transaction provides that the M&A agreement will contain "customary representations and warranties." Therefore, representations and warranties that are not customarily qualified by knowledge should not be so qualified. Defining Knowledge A key component of qualifying representations by knowledge is defining what is meant by the term "Knowledge." The definition of "Knowledge" raises two main issues: • Whose knowledge matters for purposes of the qualification, and • The extent of such knowledge. The parties to an M&A agreement will almost always define "Knowledge" with respect to both individuals and entities. With respect to entities, the "Knowledge" definition will need to address how an entity will be deemed to know something. This is usually accomplished by referencing the knowledge of certain individuals or categories of individuals associated with the entity. For example, in defining what constitutes the "Knowledge" of an entity, the parties might refer to the knowledge of specific individuals who are listed on a schedule or more generally to the knowledge of an entity's executive officers, directors, or key employees. If there are one or more specific subjects that are of particular concern to the buyer, then the buyer might seek to include within the "Knowledge" definition the knowledge of individuals having awareness of that subject matter. For example, if the seller's compliance with environmental laws is a major issue for the buyer, then the buyer might argue that specific individuals who would be expected to have knowledge about environmental compliance should be included in the definition of the seller's "Knowledge." The "Knowledge" of an individual or entity is often bifurcated into two types of knowledge: actual and constructive. Actual knowledge is the knowledge that the individual at issue actually possesses. Absent language in the M&A agreement setting forth when an individual will be deemed to possess actual knowledge, the question of whether that individual actually knows of information will depend on the facts and circumstances of the situation and the memory of the individual. For example, if an individual attended a meeting at which certain information is purportedly disclosed, whether the individual possesses actual knowledge of that information will depend upon, among other things, whether that information was actually disclosed at the meeting, what the nature of the disclosure was, and whether the individual remembered any such information at the time that a given representation was made. Since the seller's representations are more likely to be qualified by knowledge than the buyer's representations, the seller often seeks to limit the definition of an individual's "Knowledge" to actual knowledge. The buyer may argue that such a limit may deter the seller and its representatives from investigating a particular matter that is likely to render a seller representation inaccurate, so that those representatives do not gain actual knowledge of the inaccuracy. As a practical matter, however, a seller might be hard-pressed to forgo an inquiry or investigation that it would otherwise customarily undertake, particularly if the purchase agreement obligates the seller to conduct its business in the ordinary course or includes a representation that the seller has done so. The buyer will attempt to extend the definition of "Knowledge" to include both actual knowledge and some form of imputed, or "constructive," knowledge. Given the uncertainty surrounding whether a representing party (or an individual associated with a representing party) actually knew of the facts supporting a representation, the buyer is usually successful in incorporating at least some level of imputed knowledge into the parties' definition of "Knowledge." Standards for incorporating a constructive knowledge concept into the definition of "Knowledge" include one or more the following: • If the individual could have (or could reasonably have) acquired such knowledge in the ordinary course of performance of his or her duties; • If the individual could have (or could reasonably have) received such knowledge from those who directly report to such individual; • If the individual could have (or could reasonably have) acquired knowledge after inquiry (or reasonable inquiry) with respect to such fact or matter with the target company's employees or of those who directly report to such individual; and • If the individual could have acquired knowledge after reasonable investigation with respect to the subject matter to which such fact or matter relates. Note that, even if reference to the term "reasonably" or "reasonable" is omitted, a court might imply a reasonableness standard. Of course, what constitutes "reasonable inquiry" or "reasonable investigation" (and other notions of "reasonableness") would be context dependent and, as is the case for assessing actual knowledge, would involve a factual determination. Representations that are Commonly Qualified by Knowledge There are certain seller representations that are routinely qualified by the seller's knowledge. Many of these representations include facts that relate to circumstances and events outside of the seller's control or beyond what the seller could reasonably be expected to know. Examples of representations that are commonly qualified by the seller's knowledge include representations with respect to: • Whether any litigation (or other dispute) has been threatened against the seller; • Whether any contract counterparty has threatened to terminate any contract to which the seller is a party; • Whether any contract counterparty is in breach of a contract to which the seller is a party; • Whether a contract to which the seller is a party is enforceable against the contract counterparty to such contract; and • The plans or status of vendors, suppliers, and other third parties with which the seller conducts its business. Representations that are Not Commonly Qualified by Knowledge Similarly, there are certain seller representations that are customarily not qualified by the seller's knowledge, including representations concerning: • The capital structure of the seller or the target entity being sold (if the equity of the seller or target is being purchased); • The power and authority of the seller to consummate the transactions contemplated by the purchase agreement; and • The seller's or the target's compliance with laws and the fact that the transactions do not contravene any applicable laws or contracts (although these representations are often qualified in some respect by materiality). The buyer's rationale in insisting that the seller make these representations without reference to the seller's knowledge is grounded in the notion that the substance of these representations is fundamental to what the buyer is acquiring and to the seller's or target's existence and operations. These representations also cover information the seller should know about itself or the business it is selling. Accordingly, these representations are typically given without knowledge qualifiers notwithstanding the seller's negotiating leverage or, if applicable, extent of control over the target being sold. Knowledge Definition Precedents Click here to see recent examples of Knowledge definitions in Market Standards—M&A, the searchable database of publicly filed M&A deals from Practical Guidance that enables users to search, compare, and analyze its comprehensive database of transactions using up to 150 detailed deal points to filter search results.