What’s on the Market: No Undisclosed Liabilities | Goulston & Storrs PC

Goulston & Storrs M&A attorney Dan Avery is a nationally recognized expert on M&A trends. In partnership with Bloomberg Law, Dan has developed a 25-article series that examines these trends, topic by topic, providing practical insight into where these trends are headed and the important implications for M&A professionals.

Market Trends: What You Need to Know

According to research from the American Bar Association on private-entity mergers and acquisitions:

Merger and acquisition (M&A) purchase agreements almost universally include “no undisclosed liabilities” (NUL) representation. Specifically, in ten ABA studies, NUL representation was included in 92% to 99% of reported deals.
Seven recent ABA studies have examined the use of knowledge qualifiers within NUL representations and found that these qualifiers are very rare, appearing in less than 6% of reported transactions with NUL representations (and in the most recent study from 2023, they did not appear in reported transactions at all).
Finally, NUL statements are typically (in about 60-80% of reported transactions) not qualified based on Generally Accepted Accounting Principles (GAAP) references, although over the past 10+ years, vendor-friendly GAAP qualification has become increasingly common, although still a minority position.

Entry

In M&A transactions, unknown target liabilities are typically treated differently throughout the M&A purchase agreement. The No Undisclosed Liabilities Representation is one of the key representations in an M&A purchase agreement by which the seller and buyer share the risk of unknown target liabilities.

What is a statement of no disclosed liabilities?

NUL statements can take many forms, but typically involve the seller making statements to the buyer confirming the absence of target liabilities that have not been otherwise identified or disclosed (whether specific liabilities or all liabilities).

The buyer will typically want the seller to make the non-qualified NUL statement to the broadest extent possible. In particular, the buyer wants to make sure that the statement includes the minimum exceptions and covers the maximum scope of potential liabilities. A buyer-friendly version of the NUL statement might read:

The target has no liabilities of any kind, except: (i) those liabilities included or reserved in the Most Recent Balance Sheet; and (ii) those liabilities set forth in 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 include as many exceptions and qualifiers as possible, thereby limiting its overall exposure. The seller’s efforts to limit its potential liability for a breach of the NUL representation typically take one or more of the following forms:

Limiting Objective Liabilities to GAAP Balance Sheet Liabilities

Because the NUL representation often refers to the target’s balance sheet, the seller may argue that the NUL representation should apply only to the subset of liabilities required by applicable accounting standards to be reported on such a balance sheet. In a NUL representation that includes this restriction, the seller must disclose only those liabilities of the type that must be reflected as liabilities on a balance sheet prepared in accordance with GAAP. This is an important distinction – – because not all liabilities are required to be reported in accordance with GAAP. For example, under GAAP, the disclosure of contingent liabilities depends on a number of factors, including relative probability. In addition, operating activities typically have many ordinary business liabilities that are not typically liabilities included on a GAAP balance sheet (e.g., normal but significant contractual obligations). And because truly “unknown” liabilities cannot be reported on the balance sheet, they would also be excluded. In short, GAAP liabilities may be a relatively narrow subset of the target’s known and unknown liabilities.

An example of a NUL representation that respects this restriction can be given as follows:

The Acquired Entity has no liabilities that are of a nature such that they are required to be disclosed on the balance sheet prepared in accordance with GAAP, except: (i) liabilities that are included or reserved in the Most Recent Balance Sheet; and (ii) liabilities set forth in Appendix X.

Adding a “regular rate” exclusion

The seller often seeks an exception for ordinary exchange rate obligations arising from the balance sheet date. An example of a NUL representation containing this exception might be:

The Acquired Entity has no liabilities that are of a nature that require disclosure on the balance sheet prepared in accordance with GAAP, other than: (i) liabilities that are included or reserved in the Most Recent Balance Sheet; (ii) liabilities incurred in the ordinary course of business since the date of the Most Recent Balance Sheet; and (iii) liabilities set forth in Appendix X.

Including knowledge or relevance qualifiers

Seller may also limit the NUL statement to those undisclosed liabilities of which it was aware and/or to undisclosed liabilities that exceed a materiality or other threshold.

Exclusion of obligations covered by other declarations

The seller may also object to the NUL representation as being too broad and, with respect to a particular topic, potentially conflicting with other representations in the purchase agreement that specifically cover that topic. For example, if the purchase agreement contains a detailed representation regarding environmental matters that requires disclosure of liabilities under environmental regulations exceeding $10,000, should the NUL representation separately require disclosure of environmental liabilities less than $10,000? An example of this type of limitation on the NUL representation – – excluding matters that are subject to disclosure requirements elsewhere in the purchase agreement – – might be:

The Acquired Entity will have no liability whatsoever… except:… (iv) liabilities that are disclosed in other Schedules or that are not required to be disclosed under any representation or warranty in Article X because of a materiality, monetary value or knowledge threshold or qualifier.

Buyer’s position

The buyer often insists on a broad presentation of the NUL because, from its perspective, the seller should bear at least some risk of undisclosed or unknown liabilities. To prove its case, the buyer often argues that the seller is in a better position than the buyer to assess the risk of unknown liabilities because the seller is familiar with the target’s past and present activities and should therefore be expected to stand behind its assessment.

In practice, however, when NUL statements do occur, they are typically categorized as seller statements that are subject to a basket of indemnities and a cap—i.e., a minimum level of buyer losses before seller liability kicks in, as well as a specified maximum amount of seller liability. In this context, the buyer is already assuming some risk of unknown liabilities even with a normal, “buyer-friendly” NUL statement (specifically, those unknown liabilities in the basket and above the cap). Often, these unknown liabilities are also addressed in more topic-oriented statements throughout the agreement—for example, in relation to legal compliance, labor issues, tax compliance, and the like. Therefore, in transaction negotiations, NUL statements are often described—especially if they are broad in scope—by sellers as redundant or duplicative.

Seller’s position

The seller may use one or more of the following arguments to defeat the buyer’s arguments:

If the purchase agreement covers in detail all aspects of the target’s business, why is a broader, “all-inclusive” term necessary or appropriate?
If the parties have agreed that certain types of contracts and other obligations do not need to be disclosed for specific seller statements, why should those thresholds be ignored for an NUL statement?
Other provisions of the purchase agreement provide the buyer with adequate protection from certain liabilities. In support of this argument, sellers most often rely on (i) the seller’s standard representations regarding the target’s financial statements and (ii) that no material adverse effect has occurred since a specified date.

Trends in the use of declarations of no undisclosed liabilities

Every two years since 2005, the ABA has published its Private Target Mergers and Acquisitions Deal Point Studies (the “ABA Studies”). The ABA Studies examine the purchase agreements of publicly available transactions involving private companies. These transactions vary in size but are generally considered the “mid-market” for M&A transactions; the deal values of the 108 deals in the 2023 Study ranged from $30 million to $750 million.

According to ABA studies, M&A purchase agreements consistently include NUL representations. Specifically, in nine ABA studies, NUL representations were included in 92% to 99% of reported transactions. Additionally, six of the most recent ABA studies examined the use of knowledge qualifiers in NUL representations and found that these qualifiers are rare, appearing in less than 6% of reported transactions with NUL representations (and in the most recent 2023 study, not appearing in any reported transactions).

Because NUL representations are ubiquitous and knowledge qualifiers for NUL representations are largely nonexistent, the only remaining issue of significant negotiation in this area appears to be whether NUL is to be qualified under GAAP. As explained above, limiting NUL representations to those that must be disclosed on the balance sheet under GAAP significantly reduces the scope of the representation (and is therefore a highly seller-oriented qualifier). A more buyer-friendly version of the “all liabilities” NUL representation (i.e., without GAAP qualification) was the majority approach in each of the ten ABA studies, as shown in the following chart:

Application

NUL representation remains nearly universal in private company M&A transactions. Seller attempts to use knowledge qualifiers to limit exposure have met with very little success. In addition, seller-friendly GAAP-only NUL representation remains a minority approach (although significantly more common than knowledge qualifiers). As discussed above, these qualifiers affect the allocation of undisclosed liabilities between buyer and seller. Counsel on both sides of an M&A transaction should consider these issues carefully when negotiating NUL representation.

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