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Conducting a rigorous due diligence process is an essential part of any buyer's assessment of the viability of a prospective acquisition. For the seller or target business, however, it may be a frustrating exercise because it can be time-consuming, labour-intensive and costly. Often the exercise can also reveal a problem that the seller or target business would prefer not to disclose or address. But staying silent about known issues can carry significant risks, as a recent case highlights.
A case in point 1
A UK plc (Seller) decided to seek a buyer for its wholly owned subsidiary, which was a manufacturing company (Target). An information memorandum was prepared which described the products manufactured by the Target, listed its main customers and provided figures for actual and forecasted income. The prospective buyer (Buyer) received the information memorandum and a due diligence exercise began.
During that process, one of the Target's main customers (Key Customer), which was forecasted to account for a substantial part of the Target's turnover, informed the Seller's CEO that it would be terminating all business with the Target. The Seller's CEO, who was also a director of the Target, failed to disclose this fact to the Buyer and failed to update the Target's forecasted income projections. The Buyer only became aware of the issue shortly after the Buyer had become the Target's owner, following completion of the relevant sale and purchase agreement (SPA).
The Buyer brought a claim against the Seller for rescission of the SPA (i.e. for the SPA to be set aside and the Buyer returned to the position it was in before the SPA was completed) and damages, on the basis that it was induced to acquire the Target by a fraudulent misrepresentation. Fraudulent misrepresentation occurs when a false statement is knowingly made or is made recklessly (i.e. carelessly as to whether or not it is true or false).
The High Court agreed with the Buyer's claim. It decided that:
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Although the forecasts were statements of opinion, they carried an implied representation of fact – namely that the Seller had reasonable grounds (or knew of facts) that justified them.
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The Buyer had relied on the forecasts to buy the Target.
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The Seller's CEO failed to communicate any updates to the forecasts to the Buyer knowing that they had become misleading well before completion of the SPA, intending that the Buyer would rely on them, and also knowing the impact of the Key Customer's decision on the Target's future revenues and the Target's saleability.
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As a result, the Buyer's completion of the SPA was induced by a fraudulent misrepresentation, and the Buyer was entitled to rescind the SPA and to damages.
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The liability risks with disclosure failures
In the context of acquisitions, failing to disclose a material issue to a buyer can carry a number of risks for a seller:
Misrepresentation: If a seller makes a positive representation, for example by disclosing information such as prepared forecasts during due diligence, then staying silent about a known problem that contradicts or distorts that representation can result in liability for the seller to pay damages. If that representation was fraudulently made, the buyer's remedies will be rescission of the contract and damages. In sale and purchase transactions, rescission can be an awkward remedy to pursue in practice, because it is generally difficult for the parties to be restored to their pre-contractual position – either because the buyer will have already started to run the target company or business concerned, or because it is practically difficult to re-vest the shares or business back to the seller. The more usual remedy for the buyer in relation to a seller's misrepresentation is damages.
Breach of warranty: If a seller gives a warranty in an SPA, and then fails to disclose any necessary qualifications to it, the seller will have liability to the buyer for a contractual claim for damages for breach of warranty.
Misleading statements: In the case of a share purchase, a seller can commit a criminal offence if he makes a statement, promise or forecast which he knows to be misleading, false or deceptive in any material way, or dishonestly conceals any material facts, in order to induce the buyer to enter into an investment agreement, which includes an agreement to buy shares (Financial Services and Markets Act 2000, section 397(1)). The offence carries an unlimited fine and/or seven years' imprisonment.
Fraud by false representation: A seller could also have liability under the Fraud Act if he makes a representation or gives a warranty which is false, and is not corrected, whether by providing updated information or by disclosure, and the seller does so dishonestly and with the intention of making a gain or causing the buyer loss (Fraud Act 2006, section 2). The offence carries an unlimited fine and/or ten years' imprisonment.
What does this mean for sellers?
As a general rule, it is rarely advisable for a seller to try to conceal important information from a buyer in the context of a sale and purchase transaction.
While the seller might obtain a higher sale price by not disclosing the relevant problem, there are real risks at stake – including liability for damages, rescission of the SPA and, if a seller dishonestly conceals material facts, criminal liability.
In addition, if the seller discloses the problem before completion, then the seller will retain control over the way in which it is managed and potentially minimised or remedied. That is likely to be preferable to being pursued by an angry buyer after completion and dealing with the inherent risks and costs associated with litigation.
If you would like help with a due diligence process or would like more information on these issues, please contact Caroline Copeland.
1 Erlson Precision Holdings Ltd (formerly GG 132 Ltd) v Hampson Industries plc [2011] EWHC 1137 (Comm).
Caroline Copeland
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Simkins' early warning bulletins are for general guidance only. Legal advice should be sought before taking action in relation to specific matters. Where reference is made to Court decisions facts referred to are those reported as found by the Court. Please note that past bulletins included in the Archive have not been updated by any subsequent changes in statute or case law.
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