M&A Vocabulary – Understanding the Experts: “Seller’s Knowledge”

A key characteristic of guarantees—as opposed to warranties—is that the guarantor, such as the seller of a target company, is liable for breaches regardless of fault. If a guarantee is therefore incorrect, the guarantor’s liability does not depend on whether they

• are responsible for the occurrence of the guarantee event; or
• knew about the underlying facts.

Many sellers consider this extensive liability to be too broad. They therefore seek to limit it. One way to restrict a guarantee is to base it on the seller’s knowledge. This is precisely what the inclusion of “knowledge” or “best knowledge” is intended to achieve.

Basically, two cases can be distinguished where such a restriction seems appropriate:

• The subject matter of a guarantee involves circumstances outside the seller’s sphere; or
• the subject matter of a guarantee involves circumstances that can hardly be fully overseen by management in a company.

How exactly the terms “knowledge” or “best knowledge” are used depends not least on which law a SPA is subject to.

Terms in German SPAs

If the terms “knowledge” and “best knowledge” are not defined in SPAs subject to German law, or if the definitions used contain gaps, these terms must be interpreted according to statutory regulations.

In principle, “knowledge” is understood here as actual knowledge of information, whereas “best knowledge” also includes negligent ignorance and is therefore broader and less favorable for the seller.

However, it should be noted that even if a guarantee is limited to the seller’s “knowledge,” the seller cannot invariably claim they were unaware of a fact. This applies particularly if the seller is also a member of the board or a managing director of the target company. In this case, the knowledge of their “organization”—i.e., the knowledge existing within the target company—may be attributed to the seller as a member of the management body. This attribution usually occurs when the information is such that it should have been known to the seller as part of the organization in the performance of their duties as a management body. Consequently, the limits that the term “knowledge” places on a guarantee are not as broad as is often assumed.

If the term “knowledge” is understood in this way, the question arises as to how it differs from the term “best knowledge,” which includes negligent ignorance in addition to positive knowledge. It is important to understand here that negligent ignorance does not simply mean having overlooked something. Rather, the criterion of negligent ignorance results in a duty of inquiry on the part of the guarantor. Therefore, if the seller provides a guarantee subject to the “best knowledge” restriction, they have a duty to check whether there are facts that make the occurrence of a guarantee event appear likely and whether the guarantee provided is therefore correct in scope. Only if this check has been successfully carried out has the seller fulfilled their duty in this regard and can rely on negligent ignorance to exclude their liability.

Terms in English SPAs

For SPAs under English law, if a guarantee is limited by the phrase “so far as the seller is aware,” “to the best of the seller’s knowledge,” or a similar formulation, the seller is generally obliged to inform themselves about the subject matter of the guarantee. The seller cannot escape liability by intentionally failing to inform themselves about matters concerning the target company.

The advantage for the buyer in this case is that the test of knowledge is subjective in nature, i.e., it concerns things that the seller can reasonably be expected to know. This is particularly important in the context of a target company owned and managed by the seller; the seller cannot rely on a lack of knowledge if they, as managing director of the target company, can reasonably be expected to have such knowledge. In practice, the buyer’s consent to a knowledge restriction is often hard-fought, but they are more likely to accept it for warranties relating to forward-looking matters than for current or historical events in the company.

Once such a restriction has been accepted, it is important to consider what the seller must know or assumes they know. The seller will want to limit this to the actual knowledge they have without making any inquiries. Furthermore, the seller will want to avoid a definition of knowledge that includes constructive knowledge (knowledge they should have) and imputed knowledge (knowledge their advisors or agents might have). The buyer, in turn, will want a broad definition of knowledge, with an obligation on the seller to make all due, careful, and diligent inquiries to give the buyer assurance that warranties were not given without the necessary care.

In any case, if the seller accepts the obligation to conduct inquiries, they will often want to limit this as much as possible. If the seller is a legal entity, they will want “Seller’s Knowledge” to extend only to a minimum number of people outside the seller’s organization, if at all. This may not be entirely acceptable to the buyer because, due to their limited information about the target company at the time of acquisition, they cannot verify whether the list of persons includes all individuals who might have knowledge of the subject matter of the warranty in question. A compromise could be for the buyer to accept a lower standard of inquiry (i.e., reasonable inquiries) while explicitly requiring inquiries to be made of a non-exhaustive group including, but not limited to, the target company’s directors, key employees, and advisors.

Knowledge Representatives of the Seller

Since a seller usually does not manage the sale of their company alone, the buyer has an interest in attributing the specialized knowledge of certain groups of people from the seller’s sphere to the seller. These typically include lawyers and tax advisors who advise the seller in the transaction process, the management of the target company, or other key knowledge holders of the target company who were involved in the sale. It is in the seller’s interest to keep this group of people as manageable as possible. After all, the seller is not always fully aware of the respective level of knowledge of these individuals.

In SPAs subject to German law, it is often advisable for a seller who is also a managing director of the target company to allow a corresponding clause. Although this may appear to extend their liability at first glance, in the absence of such a provision, an interpretation of the terms “knowledge” and “best knowledge” can lead to the aforementioned extension of liability. As a result, the knowledge of other groups of people may be attributed. In this case, the extension of liability through interpretation can be significantly broader than a balanced contractual provision.

In SPAs subject to English law, the extension of the seller’s knowledge to the knowledge of the seller’s representative would not apply unless expressly provided for. However, a seller will generally resist such a broad definition of knowledge.

Conclusion

Regardless of whether a contract is subject to German law or the law of England and Wales, it is always advisable to define the terms “knowledge” or “best knowledge” precisely and as exhaustively as possible in the SPA. The group of knowledge representatives should also be defined, ideally by name.

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