Due diligence risk allocation in share and business purchase agreements has kept the courts busy recently. The commercial approach to interpreting them adopted by the courts in 2012 will please transaction lawyers, but important questions remain unanswered.
An off-market purchase of a going-concern business is fraught with risk. The business is dynamic and accurate information about it is likely to be historic rather than fully up-to-date. Indeed, the opportunity to acquire such information will often be limited either by confidentiality concerns of the vendor, the speed with which such transactions must often occur, or the extent to which either party is willing to invest in a complete due diligence exercise.
One of the ways in which purchasers will usually seek to manage this risk (and the vendor will seek to ensure that the purchaser does not use this risk to talk the price down too far) is the inclusion in the transaction documentation of provisions describing important elements of the business, such as, that management accounts represent a true and fair view of the business. These provisions are usually referred to as ‘warranties’, although terminology can vary and be of great importance as described below. They are intended to impose liability upon the vendor if they prove to be inaccurate.
Managing the risk
A vendor giving warranties will seek to manage the risk assumed in a number of ways:
- Ensuring that the contractual statements about the business are precise and limited.
- Qualifying the warranties by providing the purchaser with detailed and correct information about the business (preferably formalised in a disclosure letter which forms one of the transaction documents).
- Ensuring that the contract provides a framework for the remedies available if the warranted information proves to be incorrect. This often limits the total amount that can be claimed and prevents claims for relatively small losses. The contract may also impose a short period within which claims can be made and require prompt notice to be given when a claim arises, provisions which are likely to be strictly enforced by the courts: Ener-G Holdings v Hornell .
Valuing the Risk
A warranty for this purpose is a contractual promise that a given statement of fact is correct. If it is not correct, the vendor is in breach of contract and the purchaser will be entitled to contractual damages, which are calculated so as to put the purchaser in the same position as it would have been had the warranted facts in fact been true. The damages will usually be the difference between the value of the business if the warranted fact had been true and the value of the business actually transferred.
A disappointed purchaser can also consider making a misrepresentation tort claim. Damages for the tort of misrepresentation are calculated differently: they are designed to put the purchaser into the same economic position as if the misrepresentation had not been made, that is, usually, that no contract would have been made (indeed, the contract could be rescinded although damages will frequently be awarded in lieu of rescission). The usual damages measure applied is the difference between the price paid and the value of the business actually transferred. So, for example, if the purchaser paid more than the market value, it can recover not only the value of the warranted fact but also the loss suffered because the purchaser overpaid for the business in its warranted condition.
Proving the value is key but complex and controversial. The court will look for the best evidence of value. This is not necessarily either the price paid or the way accountants usually value companies. But faced with a difficult valuation task, a court may accept that the best evidence of value in the warranted condition is the price that was paid, and that the best evidence of value in actual condition is the price actually paid less the cost directly attributable to the inaccuracy of the information: see eg Minster Trust Ltd v Traps Tractors Ltd . In this way it can give a ‘cost of cure’ measure. Not only is that a similar approach to that used more directly in other jurisdictions but it can also answer a main justification used by purchasers for labeling warranties also as ‘indemnities’.
There are two other major risks for the vendor posed by the possibility of a tort misrepresentation claim. First, by contrast with the carefully controlled content of the contractual warranties, a claim for misrepresentation can be based on any part of the due diligence process. Secondly, there is a danger that it will sidestep the risk allocation provisions in the contract: many such provisions operate by reference to claims for breach of ‘warranty’.
Limiting the Risk
For these reasons, a vendor will typically look to include in the transaction contract clauses intended to eliminate the possibility of misrepresentation claims, leaving the purchaser the benefit of the negotiated contractual warranties (and subject to any limitations which may be agreed about liability for breach of warranty). The starting point of achieving this objective is usually an entire agreement clause stating that the agreement, including its warranties, supersedes any prior agreements or representations.
However, in AXA Life v Campbell Martin Ltd , the Court of Appeal reduced the effectiveness of these clauses, holding that although the agreement stated that it superseded prior ‘representations’, it used this term in a contractual sense and so did not prevent inaccurate statements amounting to misrepresentations for the purposes of a tort claim. However, the Court of Appeal expressly commented that liability for misrepresentation could be excluded by the inclusion of a clause stating either that there have been no representations or that there has been no reliance on any representations that have been made.
Nonetheless, the difficulties of such a clause had been highlighted by Arnold J in Invertec v De Mol Holding BV . Invertec purchased the entire issued share capital of a company from the defendant. The purchase agreement included various ‘warranties’, each warranted to be ‘true and accurate in all material respects’, although this was qualified by reference to information ‘fairly disclosed in the disclosure letter’. It also contained various limitations on liability ‘under the warranties’, including a clause limiting recoverable damages to the total purchase price and an entire agreement clause. The entire agreement clause stated ‘that in entering into this agreement… [the parties] do not rely on, and you have no remedy in respect of, any statement, representation, warranty or understanding other than as expressly stated in this agreement as a warranty, representation or undertaking’ (emphasis added). These italicised words are used frequently; indeed, each of the 2012 decisions referred to below also contained this qualification.
A number of the warranties proved to be incorrect. The purchaser claimed to have suffered damage considerably in excess of the purchase price and so brought misrepresentation claims based on innocent and fraudulent misrepresentation.
The fraud claim succeeded and so the judge’s comments about the scope and effect of the entire agreement clause were strictly obiter. However, they were important because they were directed at a qualification to the clause very commonly adopted in the context of business and share purchase agreements.
Arnold J decided that the qualification italicised above had the effect that any statement included in the contract itself fell outside the non-reliance wording, whether labeled ‘warranties’ or ‘representations’. In either case, the purchaser could rely on them as misrepresentations, especially where they had been included in earlier negotiations.
In two 2012 cases, judges have taken a very different approach, recognising the careful and negotiated allocation of risk represented in contracts of this type. Both judges considered that to be an important factor in interpreting the risk allocation provisions leading both to prevent a claim in misrepresentation being made in respect of a contractual warranty.
The facts of both cases are essentially similar to those of Invertec, except that in neither of the 2012 cases was it alleged that the inaccuracy of the warranties had been fraudulent. In both cases the incorrect statements about the company were set out in the purchase agreement and described as ‘warranties’. Both agreements contained detailed provisions regulating the liability for breach of warranty including entire agreement clauses aimed at eliminating the possibility of a claim for misrepresentation, but containing a qualification similar to that found in Invertec and italicised above.
In Sycamore Bidco Ltd v Breslin  Mann J stated in very clear terms that he disagreed with the approach taken by Arnold J. He noted that the parties had carefully described the term in question as a ‘warranty’ not a ‘representation’. He specifically referred to the fact that the contract documentation had been negotiated at arm’s length by commercial parties, the purchasers were highly experienced in such transactions and both parties had been advised by experienced professionals. In these circumstances the parties’ deliberate decision to distinguish between warranties and representations and to distinguish their liability consequences ought to be respected and enforced. The incorrect statements were ‘warranties’ and gave rise to claims for contractual damages and were limited by the risk allocation provisions in the agreement dealing with breach of warranty.
In the Commercial Court decision, Bikam OOD v Adia Cable Sarl , Simon J reached the same conclusion but elaborated the importance of the commercial background in rather more detail. He stated that the agreement included ‘a calculated allocation of risk and remuneration’ and took the view that the Court should ‘have in mind the contractual allocation of risk and reward when deciding whether the parties are to be taken to have intended that a claim for misrepresentation based on the same facts as give rise to the claim for breach of warranty’ ought to be unaffected by the liability regime carefully prepared and specifically directed at breach of warranty. He concluded that it would be ‘an uncommercial reading of this provision to construe it as permitting [a misrepresentation] claim without limitation of liability based on [breach of the contractual warranties]’.
Both judges doubted whether a tort claim for misrepresentation could in fact be advanced in respect of inaccuracy of statements appearing in the contract itself, although neither decided the point. Mann J described what he referred to as a ‘conceptual problem’. An essential element of a misrepresentation claim is that the contract must have been entered into as a result of the incorrect statement, which appears to require a prior statement that then subsequently led to the making of the contract. Simon J, said that he shared this doubt. It should be noted that s2 of the Misrepresentation Act 1967 does not provide that any inaccurate statement contained in a contract can give rise to a misrepresentation claim. It simply abolished the common law rule that prevented a misrepresentation claim being brought in respect of the precontractual statement which had subsequently been incorporated into the contract.
Two possible solutions to this conceptual problem were raised in the judgments. Before Simon J, it was argued that language in drafts circulated in the course of negotiations was capable of amounting to a representation. Although he referred to conflicting dicta in Court of Appeal cases, he appears to have rejected that argument on the basis that the relevant statements were always described as ‘representations’, although this is not clearly set out in the judgment. Mann J said that labelling statements also as ‘representations’ may obviate the conceptual difficulty. He did not make clear how it would do so and it is perhaps difficult to see how that is consistent with the Court of Appeal decision in AXA Life. As the conceptual problem is one of timing, the label used in the agreement itself ought not to be decisive. It may be that he had in mind a ‘commercial’ approach to construction of the risk allocation provisions which would, if statements were described both as warranties and representations, contemplate the coexistence of contractual and tortious remedies. If that is correct, it will be important that the liability allocation provisions properly and expressly address both potential remedies. A simpler reason why drafts ought not to amount to representations is that they are not statements of fact by the vendor at all but rather an indication of the statements the vendor would be prepared to make in the contract when it is made.
It is heartening to see the adoption of this commercial approach to due diligence claims. Where the parties have negotiated a specific regime precisely to cover liability for inaccuracy of warranties, there is much to be said for holding the parties to that bargain. However, it is important to note:
- The approach taken in 2012 will not be binding upon later judges and could be overruled in the Court of Appeal. Indeed, it could be said to be inconsistent with the existing AXA Life Court of Appeal decision.
- In particular, where a qualification to the entire agreement clause in the form discussed above is included, it remains an open question whether a statement made in the agreement itself can be the foundation of a misrepresentation claim, either because the statement had been circulated in earlier drafts or if it is described as a ‘representation’ as well as a ‘warranty’.
- Where the parties agree that there should only be contractual liability for inaccuracies in the due diligence process, it remains important to ensure that all parts of the liability allocation provisions adequately reflect that objective. If the parties intend to exclude a right to claim misrepresentation, the more clearly that can be expressed the more likely it is the court will enforce that bargain.
- Provisions of this type provide no defence against a claim based on fraudulent misrepresentation by the vendor.