Private Company M&A: Warranties and the Disclosure Process

A case that has recently taken place in the English High Court emphasizes how important disclosure is as well as the challenges that may occur during a fast-tracked sale process.

Background

Motorplus Limited, which is governed by the Financial Conduct Authority in England, concerned the sale of insurance policies. In April - May 2014, a deal of purchase was concluded and Motorplus was sold to Cardamon.

During an expedited sale process the following unusual deviations from standard practice occurred:

• There was no due diligence demonstrated by the Buyer out of fear of giving heads up to the management team, who were formulating an MBO.
• The warranties were given negligently, without identifying exceptions to the warranties.
• The offered price of £2,300,000, reduced from the original asking price of £5,000,000, was accepted under the condition of finalizing the purchase promptly.
• There was an unusual minimal arrangement on the sellers’ obligations, which made the first £500,000 of any claim non-recoverable.

The share purchase agreement (SPA) included warranties related to the content and preparation of Motorplus’ financial accounts. In one of these warranties it was indicated that the annual accounts did not understate any obligations and adequately determined bad debts.

After completing the deal, the Buyer detected substantial errors in the accounts, and its auditors advised to revise the prior year accounts, as a result the Buyer believed that Motorplus was insolvent at the time of the purchase.

One Successful and Two Dismissed Claims

The Buyer made three claims with regard to (1) an underprovision in the accounts, (2) a failure to clear a debt, and (3) a failure to report a change in broker remuneration practices.

(1)  It was detected that the 2013 financial accounts only made provision for claims informed before 31st of August 2013, and not before 19th of February 2014 as it was mutually agreed. The Court found the significant shortage of funds put the sellers in violation of warranty.

Although the undeprovision in the accounts made the Court’s task of calculating damages significantly complicated, it determined the damages flowing from such error exceeded £2.8 million. The sellers’ liability under the SPA was limited to the purchase price of £2.3 million. Hence, the Court discovered that the Buyer’s claim succeeded in the amount of the full purchase price, which means the Buyer was eligible to recovering the full purchase price. 

It is worth mentioning that the Court revealed that the sellers’ limit of liability was not reduced by the de minimal threshold. The Court verified and discovered that the Buyer was not eligible to the first £500,000 of a claim as a result of the minimal threshold, but it was eligible to recover the remainder of the claim up to an amount equal to the seller’s limit of liability. 

(2)  It was found on the facts of the case that the bad debt in question had been fairly disclosed to the Buyer, and therefore this claim was dismissed.  The SPA standard for fair disclosure was that a matter be “fairly disclosed … (with sufficient details to identify the nature and scope of the matter disclosed)”.

There was also general disclosure of all communications between the transacting parties and their advisers.  Email correspondence between the parties showed the financial controller of Motorplus stating that “it’s likely the remaining balance will be written off”, and also showed the Buyer’s finance director seeking a reduction in the consideration by way of response.

Though it was recognised that general disclosure of all communications between the sellers and the buyers is quite unusual in typical transactions, the Court found that the standard of fair disclosure was clearly met as evidenced by the disclosed correspondence in this instance.

(3)  This claim was dismissed because the only notice of claim served in respect of this claim by the cut-off date had failed to “summarise the nature” of the claim. 

The SPA required that any claim must be notified in writing “summarising the nature of the [claim] (in so far as it is known to the Buyer) and, as far as reasonably practicable, the amount claimed”.

The written notice served by the Buyer asserted a claim relating to a change in broker remuneration that made the Management Accounts misleading. However, the written notice did not state a claim in relation to the statutory accounts or relating to unusual or non-recurring items. By the time the claim was formulated in this way, the cut-off date for claims had passed and the Court found that the claim lapsed.

Relevance

This case demonstrates the consequences of neglecting the warranties and disclosures when selling a business. The sellers' failure to conduct a proper disclosure exercise resulted in occurrence of the following issues:

1. The sellers guaranteed accounting matters that they apparently were not familiar with and they did not attempt to inform themselves. The error was so serious in this instance that the sellers had to repay the total purchase price.
2. Despite the fact that the sellers had clearly updated the Buyer regarding certain doubtful debts in the financial accounts, it is uncertain as to whether the specific disclosure itself would have been sufficient on its own to meet the standard of fair disclosure in disclosing that the entirety of the relevant debt was unrecoverable. In this case, the Court considered the specific disclosure alongside the generally disclosed email correspondence, and based on that detected that the standard of fair disclosure was met. Nevertheless, it would be uncommon for a disclosure letter to consider all correspondence between the Buyer and sellers as being generally disclosed.

This case also demonstrates that it is vital to present all relevant claims in the notice of claim, as failure to do so may result in a claim lapsing. Other case law has also recently demonstrated this point.

Although this is a judgment of the High Court in the UK, its findings are very likely to be convincing in the Irish Courts.