Disclosure Obligations

April 13, 2006

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If there's one overriding principle to observe, in the realm of dealing with potential buyers, it's that you must be truthful and complete in the information you share about your business. It's fine to be optimistic and present the positive side of things. For example, you may prepare a selling memorandum that highlights all the advantages your company has over the competition. However, you also need to be careful that your buyer knows as much as you do about any potential problems in your business. You don't have to dwell on the problems, and you should always present possible solutions when you discuss them, but disclose them you must.

Fraud. The primary legal reason for full disclosure is that you can be sued for fraud if you make material misrepresentations of fact about your business. What is "material?" You can assume that anything that, if known to the buyer, would cause a change in the price paid for the business is "material."

Misrepresentation doesn't just mean affirmative lying — it can also mean remaining silent when you should speak up. The fact that the buyer didn't ask you if your customers were likely to cancel their contracts next year doesn't mean that you can't be sued for not mentioning it. The misrepresented information can be something that you knew but didn't disclose, or in some cases information that you were reckless or grossly negligent in not finding out. The issue of possible exposure to a lawsuit for fraud is one reason you should have your lawyer review any written material you pass on to buyers, to be sure that it is accurate and covers all the ground that it should.

The buyer has some obligations on this front, also. In a lawsuit for fraud, the buyer would have to prove that he or she reasonably relied on your statement (or the fact that you made no statement). Reasonable reliance implies that the buyer has some obligation to use common sense in accepting your statements as true. This is one reason the buyer conducts a due diligence investigation of your business before the purchase agreement is signed, although the phrase "due diligence" is actually borrowed from securities law.

Securities fraud. The concept of fraud is a general one, and potentially applies to all business transactions. If you sell the stock in your corporation, or accept stock in the buyer's corporation as payment, you may be subject to more specific disclosure obligations under federal and state securities laws. If you're contemplating a transaction that involves a sale or exchange of stock, you'll need to get expert legal assistance on a variety of issues, including what you can, can't, and must say about your business.

Fraudulent conveyance. Another legal pitfall to be aware of is the concept of fraudulent conveyance. Basically, this means that if you and the buyer set up a deal in such a way that one or both of you should have known that the transferred company would fail, you may be forced to pay back the purchase price. For example, if your predictions about the company's future growth are far too optimistic, and lead the buyer to take on more debt than the company can support, the company may go bankrupt. The bankruptcy judge can require you to pay back the purchase price and essentially "undo" the sale. The object is to give any unsecured creditors of the business a fair shake at getting paid when the company is liquidated. Your potential liability for fraudulent conveyance lasts for up to six years after the sale, so it's important that you check out the buyer and his or her resources, to be sure that the company has a good chance of survival after you sell it.