Beware of Warranties and Representations in a Sale of Business – Vendors may be ordered to repay significant amounts

//Beware of Warranties and Representations in a Sale of Business – Vendors may be ordered to repay significant amounts

In the context of a sale of business, careful consideration must be given to warranties contained in the sale of business agreement, along with any representations made about the present and future performance of the business.  Unwary vendors may find themselves defending Court proceedings for breach of warranty or misleading or deceptive conduct.

General principles of warranties in a sale of business agreement

When a business is being sold, the purchaser will generally insist that a number of warranties are included in the sale of business agreement. A ‘warranty’ is a statement of fact that is incorporated into a sale of business agreement to induce a purchaser to enter into the agreement. For example, a simple warranty could be that the vendor has the authority to sell the business or that there are no security interests affecting the business assets.

From a vendor’s perspective, warranties should be specific and limited to facts that the vendor or its representatives can fully verify. A well drafted sale of business agreement should also exclude any pre-contractual representations, to the extent legally possible, and state that the agreement contains the entire bargain struck by the parties. On the other hand, from a purchaser’s perspective, warranties should be as wide and all-encompassing as possible, and the sale of business agreement should not limit the purchaser’s ability to rely on pre-contractual representations.

Representations about future performance

Vendors should also be extremely wary when making any representations about the future performance of the business being sold.  A common example is the provision of financial forecasts, which may form the basis of negotiations about the purchase price of the business.  Purchasers will be understandably aggrieved when, after completion of the sale, it emerges that such forecasts were exaggerated or inaccurate.

The making of misleading and deceptive representations is prohibited by s 18 of the Australian Consumer Law (ACL), and cannot be excluded by contractImportantly for vendors, s 4(2) of the ACL deems a representation about any future matter to be misleading, if there were no reasonable grounds for making the representation.

Where, for example, financial forecasts are provided prior to the sale of a business and a disgruntled purchaser subsequently makes an allegation of misleading or deceptive conduct in relation to the forecasts, the vendor will, in effect, have to prove to the Court that it had reasonable grounds for making the forecasts.

Should the vendor fail to discharge this reverse onus, the Court will find in favour of the purchaser and assess damages. These damages may be awarded on a “no-transaction” basis, meaning that the purchaser’s loss will be assessed as the purchase price less the true value of the business at the time of the acquisition.

When warranties and representations go wrong

 The issues outlined above arose in the recent case of Evolution Traffic Control v Skerratt [2018] NSWSC 49 (Skerratt). In that case, a purchaser entered into a share purchase agreement for a trade training organisation with a purchase price of $10 million. The price was calculated as five times the sustainable EBIT of the business. In calculating the EBIT, reliance was placed by the purchaser on financial forecasts provided by the vendors.

The financial forecasts provided by the vendors assumed that the business would maintain the fifty additional government-funded student places that had been allocated the previous year.  However, the Western Australian government had imposed a condition for ongoing funding which, by the time of the sale, was effectively impossible to achieve.  The vendors failed to disclose this funding condition during negotiations.

When it transpired after completion that such important information regarding the future performance of the business was withheld during negotiations, the purchaser issued proceedings to recover the difference between the purchase price and the actual value of the business at the time of the sale.

The purchasers sued the vendors for misleading and deceptive conduct under the ACL, for breach of the warranties contained in the share purchase agreement and for indemnity against loss pursuant to a clause of the share purchase agreement.

The purchaser relied on two broad warranties: (i) the accuracy and completeness of all information disclosed in due diligence materials during the course of negotiations leading up to the sale; and (ii) that all information that would be material for disclosure to a prudent purchaser had been disclosed.

The vendors in Skerratt were unable to convince the Court that they had a reasonable basis for making representations about the business’ future financial performance, making consideration of the warranty and indemnity arguments unnecessary.  The vendors were ordered to pay roughly $4 million as the purchasers had, prior to issuing proceedings, sold the business to a third party for $6 million.

Although the Court did not deal with the warranty claims, because it found in favour of the purchaser for misleading or deceptive conduct, it is worth noting that the warranties were broad and clearly favour the purchaser. The warranties capture the forecasts that were provided by the vendors to induce the purchaser to buy the business for $10 million. It would have been advisable for the vendors to limit these warranties to past or present facts or information, and expressly exclude any forecasts, which, by their nature, can be very difficult to justify. These changes alone would not have altered the outcome of the case, but they serve to illustrate the issue of agreeing to broad warranties.

How to proceed when drafting a contract of sale

Careful consideration must be given to the drafting of a sale of business agreement. For vendors in particular, there are a number of methods by which potential liability can be reduced, including:

  • Avoiding representations about the future performance of the business
  • Limiting warranties to matters that the vendor can control or has knowledge of
  • Including a cap on the amount that can be claimed as damages
  • Providing a minimum threshold of damages before a warranty claim can proceed
  • Qualifying all warranties with disclosures made during the due diligence period

For purchasers, such clauses in the sale of business agreement are clearly undesirable. Care should be taken to ensure that there will be appropriate recourse against the vendor for undisclosed issues arising post-completion.

Pointon Partners has extensive experience in advising prospective vendors and purchasers in sales of businesses.  Please contact Laszlo Konya or Ben Drysdale to discuss.

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2019-02-19T11:25:44+11:00February 19th, 2019|Categories: Commercial|