Sophie Adshead and Matthew Canfield take a look at the importance of due diligence and providing full and accurate information when selling a company.
It is standard practice in corporate transactions for sellers to provide responses to buyers’ pre-contract due diligence enquiries and for the share or asset purchase agreement to contain warranties that the buyer relies on when deciding whether to proceed with the transaction.
A thorough due diligence exercise should provide the buyer with a good idea of the value of the target company or business and allow it to agree a price based on the knowledge gained from that exercise. It is not unreasonable for a buyer to rely on the responses provided by the seller to those enquiries, and a recent High Court case has demonstrated the importance of ensuring that the responses are accurate.
In the case of MDW Holdings Ltd v Norvill  EWHC 1135 (Ch), the High Court was asked to consider whether false due diligence responses provided by the sellers amounted to fraudulent or negligent misrepresentation.
The target company in question was involved in the disposal of waste, and in particular wet waste, which is heavily regulated. To discharge the waste into a public sewer the target had to hold an environmental permit and meet certain requirements imposed on it by the local water authority. Between 2013 and October 2015 water sampling carried out by the target company and local water authority found that the level of certain contaminants in the discharged waste exceeded the limits imposed. As a result, the local water authority wrote to the target company requiring it to carry out immediate remedial action.
While some remedial action was taken, the waste being discharged continued to include contaminants above the prescribed limits. The results of internal tests carried out by the target company were also falsified to hide the continued breaches.
In late 2014 the sellers entered negotiations with the buyer for the sale of their shares. The buyer carried out a due diligence exercise which included a request for all documentation concerning any investigation, enquiry, prosecution or other enforcement proceedings or process by any governmental, administrative, regulatory or other body or organisation in relation to, or affecting, the target company. Given the nature of the company’s business, the buyer was particularly concerned about any environmental issues. The responses provided to the buyer failed to mention the ongoing breaches of the discharge permit or to provide details of the previous correspondence with the local water authority.
On 14 October 2015, the sellers and the buyer signed the share purchase agreement and completed the sale. On 11 November 2015 the local water authority wrote to the target company warning that consideration was being given about bringing a prosecution for breach of the conditions of the consent. It contained a list of breaches in respect of discharge levels dating back to February 2014.
The buyer notified the sellers that it intended to claim against them for failing to disclose the breaches. The buyer alleged that by breaching environmental laws and unlawfully avoiding the costs associated with environmental compliance, the profit levels were inflated to a level that would not have been achieved if the company had acted lawfully. As a consequence, the buyer alleged that it paid considerably more for the shares than they were worth.
The buyer asked the court to consider awarding damages on the grounds of (1) misrepresentation and (2) breach of warranties in the share purchase agreement (SPA).
1) Claim for misrepresentation
The buyer argued that it had relied on the sellers’ responses to the due diligence enquiries and that these statements amounted to pre-contractual representations that were false. If a misrepresentation is fraudulent then the buyer can recover all losses that arise, whereas a negligent misrepresentation only allows a buyer to recover losses that were reasonably foreseeable.
The court found that the sellers had made fraudulent misrepresentations. Despite the sellers’ corporate finance advisor having prepared the responses and not the sellers themselves, the court said that the advisor was acting as agent and the sellers were ultimately responsible and liable for the responses. On the question of reliance, the judge noted that ‘the buyer’s reason for asking the questions can only have been that it wanted to know the answers and the reason for wanting to know the answers can only have been because they would inform their decision whether to buy the shares’.
The fact that the target company’s CEO (who was also a seller) had known of the breaches and falsified data was considered dishonest and amounted to fraudulent misrepresentation. Despite not having been aware of the facts or involved in the due diligence process, the other sellers were also found to be responsible for the fraudulent misrepresentation.
2) Claim for breach of warranties
Warranties are contractual statements of fact, usually contained in the acquisition agreement, as to the condition of the target company or business. In this case, the court held that the sellers were in breach of the warranties relating to environmental law, compliance with general laws and the accuracy of the company’s accounts, which the buyer argued showed an artificially high level of profit which had only been achieved by the company failing to fulfil its environmental obligations.
It is also typical for the acquisition agreement to include various contractual limitations relating to:
(a) the amount that a seller will be liable to the buyer for, in the event of a breach of any warranties; and
(b) the manner and timeframe within which a buyer must notify a seller of a breach of warranty following completion in order for the buyer to have a valid claim.
The SPA would usually state that such limitations would not apply in the case of dishonesty, fraud, wilful misconduct or wilful concealment on the part of the seller.
Here, the notification of a claim had been brought outside of the contractual time limit set out in the acquisition agreement. However, such limitation was held not to apply on the basis that the breach of warranty stemmed from fraud or dishonesty by the sellers.
The decisions of the court provide a useful and stark reminder to sellers that they should always ensure that the information provided in responses to pre-contractual enquiries are accurate. Full and accurate disclosures must also be made against the warranties where appropriate.
It should go without saying that outright false responses should never be given, nor are there any circumstances where information should be withheld from a buyer. However, responses can also be inaccurate if insufficient detail is provided or there is a lack of context which results in the seller misleading the buyer as to the true position of any particular matter.
The risk to the sellers in MDW Holdings Ltd v Norvill was increased because only one of them was tasked with providing the responses; that role was then passed to an advisor. Sellers should ensure that they are always aware of what information is being shared with a buyer and review all responses thoroughly. As the case demonstrates, it will not be sufficient for a seller’s innocence to exclude them from liability for fraud in circumstances where another seller acted as an agent and that agent acted fraudulently.
As well as fully participating and engaging in the due diligence and disclosure processes, sellers should also seek to include appreciate protections within the SPA to help mitigate the risk of a claim for breach of warranty or misrepresentation being brought against them, such as the inclusion of:
- non-reliance clauses which confirm that the buyer has not relied on any representations in entering into the SPA.
- a no representation statement acknowledging that the sellers have not made any representations in the run-up to entering into the SPA.
- an exclusion of liability for misrepresentation in respect of both pre-contractual statements and any statements that are set out in the SPA.
- a waiver of non-contractual remedies.