When purchasing a business, one of the most important parts of the purchase agreement for a purchaser is the seller’s representations and warranties. In this all-important clause, the seller represents and warrants certain information to the purchaser based on things that the seller knows about the business. These representations are the foundational assumptions that the purchaser is basing the entire deal on, such as information regarding the ownership and the condition of the assets to be purchased. A purchaser is entitled to and typically does rely heavily on these representations.
What is a Knowledge Qualifier? Within the purchase agreement, you may further come across the term “knowledge qualifiers.” What does this mean? Put simply, knowledge qualifiers are phrases that limit the scope of what a party is responsible for knowing and disclosing in a contract. Here is a bit more about what it means and why it matters:
Defining “Knowledge“: The term “knowledge” can have several meanings if not clearly defined, particularly in the legal context. It could include both actual knowledge (what one party is aware of) and constructive knowledge (what they should have known or discovered with reasonable diligence). How the seller’s knowledge is defined in the contract becomes very important in the overall deal. Sellers will want the knowledge definition to be as narrow as possible, while purchasers will want this definition to be as broad as possible.
Why Knowledge Matters: For Sellers, knowledge qualifiers are important because they clarify the level of responsibility the seller bears for the disclosure of information. Without these knowledge qualifiers, the seller could be held liable for facts or issues that they were unaware of at the agreement was signed. For Buyers, a knowledge qualifier is important as they determine additional due diligence requirements based upon how the seller is determining what they know, so as not to be blindsided by undisclosed problems.
Types of Knowledge Qualifiers: These can vary, but often include phrases like “to the best of seller’s knowledge” or “seller’s actual knowledge.” These phrases limit the seller’s obligations to disclose certain information to the purchaser. A knowledge qualifier “to the best of seller’s actual knowledge” should cause a purchaser to pause. It is the contractual equivalent of answering a question with “Yes, as far as I know.” This can be a good start but would require the purchaser to undertake additional due diligence to substantiate the seller’s answer. Meanwhile, a broader definition of knowledge allows the purchaser to rely more confidently on the seller’s answers alone, and have recourse if the seller fails to appropriately make a given warranty or disclosure.
For example, a seller may represent and warrant in an asset purchase contract that there are no liens on the assets being sold. This is of the utmost importance to a purchaser who wants to buy assets unencumbered by a lien from the previous owner. But perhaps the seller has forgotten about or never checked a term in a loan that they took out, which is secured by a blanket lien on all of their assets and inventory. If the knowledge qualifier is “to the best of the seller’s actual knowledge”, then the seller did not know about the lien on the assets and inventory and has made an accurate representation to the purchaser. But if the knowledge qualifier is what the seller “knows or should have known,” then suddenly they have made a false representation. Even if they did not know that the loan was secured by a lien, that is a piece of information that arguably they should have known with a bit of reasonable research. The purchaser has further recourse for the information that should have been revealed to him.
Materiality Thresholds: Another important aspect of knowledge qualifiers is materiality. This refers to how important or impactful a piece of information is. The parties might agree that a seller might only need to disclose information if it exceeds a certain dollar amount threshold or if it is instrumental to the operation of the business. For example, if a seller represents that they have a certain 2021 office computer that is being transferred as part of a sale, but after closing, the purchaser determines that it is a 2022 office computer, that is probably not material to the business operations. But if a seller represents that they have a 2021 office computer as part of the sale, and it is a 1999 computer, suddenly that’s something that is material as a 2021 device and a 1999 device are very different in terms of functionality and longevity.
Conclusion
The clearer the understanding by both parties of the representations and warranties by both parties at the outset of the agreement, the smoother the sale is likely to progress. The attorneys at Way Law are here to help you with everything you need to know about knowledge qualifiers (and more!) in your purchase agreement!