The Importance of Due Diligence

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Corporate Article

18 June, 2019

When purchasing a business, whether it is a purchase of its share capital or its assets and liabilities, the buyer of the business will often undertake due diligence (the level of which varies dependent upon the size of the undertaking, the terms of the deal and the level of pre-existing knowledge by the buyer of the business concerned) of the business to ensure that it is successful and performs as portrayed by the seller. In the event that any issues concerning the business are unearthed by the due diligence process, it is highly likely that such issues could be dealt with via a reduction in the purchase price or by the insertion of more stringent warranties and indemnities within the share or asset purchase agreement.

The general principle governing all acquisitions is caveat emptor (buyer beware), meaning that the law generally affords no protection to the buyer regarding the condition of the business that they are acquiring. Therefore, a buyer will seek to rely on warranties and indemnities within the legal documentation itself. Warranties are contractual statements regarding the condition of the target business. Should a warranty be provided that later transpires to be untrue, the buyer will have a potential breach of contract claim against the seller.

During the negotiation process, the degree and amount of warranties can be heavily contested between the parties - should they be breached, the seller will likely have to account to the buyer for the lost value in the business. The potential pitfalls of providing incorrect warranties has recently been demonstrated by the High Court in the case of 116 Cardamon Limited v MacAlister and another [2019] EWHC 1200 (15 May 2019).

Facts

The claimant buyer in this case was 116 Cardamon Limited (Cardamon), an investment company dealing in the insurance sector. The defendant sellers, Mr and Mrs MacAlister, were both shareholders in Motorplus Limited (Motorplus), which itself was a seller of insurance policies to consumers. Cardamon was to purchase the entire issued share capital in Motorplus from the sellers for a purchase price of £2,386,247.90, to be paid partly in cash with the remainder to be offset against a loan owed to Motorplus by the sellers in their capacity as directors.

A key aspect of the deal was that it was to be completed as quickly as possible and, as a result, no material due diligence was carried out by the buyers. The business was, on the face of it, profitable. As an added protection for the buyers, the share purchase agreement contained a series of warranties, including the relatively industry-standard warranty that the accounts were true, accurate and not misleading in any material respect.

However, following the purchase cashflow became an immediate issue for the buyers, which meant that they had to invest significant capital in order to keep the business afloat. As the financial position of the business continued to worsen, Cardamon issued the present claim against Mr and Mrs MacAlastair, claiming the return of the entire purchase price on the basis that the business was insolvent.

The Claim

The basis of the claim was that the accounts provided by the sellers were inaccurate, in that they:

  • Overstated Motorplus's liability to pay claims under a before-the-event legal expenses scheme named FamilyPlus;
  • Listed a significant debt owed to an associated company as an asset, rather than writing it off; and
  • Failed to disclose a change in the method of remunerating insurance brokers, which led to the accounts appearing to be more profitable than they were.

Consequently, it was claimed that the sellers breached the warranty as to the accuracy of the accounts provided prior to completion. Under the SPA, breach of warranty claims were capped at the purchase price, with a de-minimis (minimum) threshold of £500,000 (this was significantly higher than would often be the case due to the apparent "good deal" that the buyers were receiving).

The sellers defended each aspect of the claim on different grounds, relating to limitation and, more importantly, that the alleged inaccuracies had been disclosed by them.

Judgment

In relation to grounds (a) and (c), the Judge found that the seller had breached the warranties provided by them. In determining ground (a), the Judge undertook a forensic analysis of the business accounts provided prior to completion, concluding that they were largely inaccurate. Reserving figures (which are key for forecasting the potential cost of potential insurance claims) were understated within the accounts by over £1,000,000. Had the buyers have known about this error (emphasising the need for due diligence), they likely would not have purchased the business. The Judge similarly found for the claimant in relation to ground (c).

As to ground (b), the business owed over £500,000 to an associated company. Post-completion, it transpired that this was never going to be recovered by the buyers and as such should not have been classified as a good debt for valuation purposes. The sellers argued that the non-recoverability of the loan had been disclosed to the buyers prior to completion, during email correspondence in which it was stated that "it's likely the remaining balance will be written off". The SPA and Disclosure Letter contained further provisions to the effect that all matters disclosed by the sellers could not later be the subject matter of a warranty claim by the buyers. Consequently, the Judge found in favour of the sellers in this regard.

Nonetheless, the breaches of the accounts warranties were adjudged to be so significant that, as a result, the buyers were entitled to recover the full amount paid for the business.

Comment

This case highlights a number of key considerations for both buying and selling parties during the acquisition process. Firstly, had extensive due diligence been carried out by the buyer, then it is likely that the issues regarding the accounts and insurance reserves would have been identified and the buyers could have acted accordingly as a result. The same can be said regarding the apparent bad debt that was owed to the associated company.

Further, as outlined at the beginning of this article, warranties are often highly contested between the parties. In this case, Cardamon was protected as the SPA contained extensive warranties regarding the condition of the business. Comparatively, the sellers fell afoul of the warranties provided by them as they could not be certain as to their truth and accuracy. Upon entering negotiations, the respective parties should be appropriately advised regarding the extent of warranties that they should give and the potential problems should they be inaccurate.

For more information contact Nick Pickup in our Corporate department via email or phone on 0333 207 1132. Alternatively send any question through to Forbes Solicitors via our online Contact Form.

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