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Key Takeaways:
- AI is now a critical due diligence workstream. As AI becomes increasingly integrated into business operations, transaction parties must pay close attention to how a target's use of AI is addressed in transaction agreements, including identifying specific AI systems deployed, their functions, and any third-party technologies or data sources involved.
- Understand the full scope of AI deployment. Buyers and sellers should assess whether AI is used in customer-facing products, internal operations, or decision-making processes, as each use case presents distinct risks and regulatory considerations.
- Representation and warranty insurance considerations are evolving. RWI underwriters have started performing their own AI diligence on targets, with policy coverage exclusions beginning to surface.
As artificial intelligence ("AI") becomes increasingly integrated into business operations, transaction parties must pay close attention to how a target company's use of AI is addressed in transaction agreements. AI is now a critical component of due diligence and risk allocation in M&A and other corporate transactions. This alert outlines practical guidance for drafting and negotiating the representations and warranties for such transactions (and related areas of focus in due diligence).
Understanding the Scope of AI Use
Whether working on the buy-side or sell-side, when conducting diligence or drafting representations and warranties, it is essential to understand the extent and nature of the target company's use of AI. This includes identifying the specific AI systems deployed, their functions within the business, and any third-party technologies or data sources involved. Parties should also consider whether AI is used in customer-facing products, internal operations, or decision-making processes, as each use case may present distinct risks and regulatory considerations.
The importance of understanding a target's integration of AI into its business must become a critical diligence workstream. Buyers and potential targets should now consider not only the regulatory implications of AI deployment, but also specific operational risks that arise from internal AI use. These risks include AI-enabled hiring practices that may raise discrimination and employment-law concerns, use of "shadow AI" by employees without formal company approval that can lead to privacy leakage, and of course, heightened compliance requirements for companies operating in regulated industries such as financial services and healthcare. Relatedly, representation and warranty insurance ("RWI") underwriters have started to perform their own AI diligence on targets, with RWI policy coverage exclusions starting to surface and a greater prevalence expected to follow.
Key Issues to Address in Representations and Warranties
When marking up or preparing initial drafts of transaction agreements, parties should focus on several core issues:
- Compliance with Laws and Regulations: Representations should confirm that the target's AI systems comply with applicable laws, including data privacy, consumer protection, and emerging AI-specific regulations. Furthermore, the representations should address any internal use of AI by the target and ensure such usage has not resulted in violations of other (non-AI specific) laws (e.g., with respect to AI-enabled hiring practices).
- Intellectual Property Ownership: Representations should address the ownership and licensing of AI technologies, including software, algorithms, and training data, to ensure there are no undisclosed third-party rights or infringement risks.
- Data Integrity and Security: Given AI's reliance on large datasets, representations should cover the accuracy, provenance, and security of data used in AI systems, as well as compliance with data protection requirements.
- Ongoing Maintenance and Support: Representations can address the target's ability to maintain, update, and support its AI systems post-closing, which is crucial for business continuity.
Conclusion
As AI continues to transform business models, robust representations and warranties regarding its use are essential for effective risk management in transactions. Dealmakers should work closely with legal and technical experts to tailor and negotiate these provisions to the specific circumstances of each deal, ensuring that both parties are protected against the unique risks associated with AI technologies. Target companies should monitor and understand their AI use and practices well, and be prepared to respond to detailed diligence requests from buyers and their RWI underwriters.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
