Ignorance is bliss... for whom? An M&A update

If you have purchased a company with the protection of standard accounting warranties, do you expect to be able to recover under those warranties if you subsequently discover a liability which was unknown to the Seller at the time of sale?

As a Buyer, you might reasonably answer "yes" given that, in most cases, you would expect protection from liabilities incurred pre-completion; however, the recent case of Macquarie International Investments Limited v Glencore UK Limited suggests otherwise - Buyers are not protected against unknown and reasonably undiscoverable liabilities through standard accounts warranties.

The Macquarie case

Macquarie ('the Buyer') purchased a group of companies ('the Group') from Glencore in September 2006. The transaction is fairly unremarkable except for the fact that only a few months after acquiring the Group, the Buyer had to pay a liability of £2.4m in respect of an accounting charge which ought to have been paid by one subsidiary. Both the parent and the subsidiary were unaware of the liability because of a data entry error that was made by a third party. Group accounts were prepared in early 2006 omitting the charge entirely.
 
This case examined the wording and liability resulting from accounts and management accounts warranties included in a share purchase agreement ("SPA"). The SPA contained a warranty that the accounts gave a "true and fair view" and made appropriate provision for all material actual and contingent liabilities "of which the Group and/or Company or Subsidiary to which they relate was aware". The management accounts were warranted as fairly reflecting the Group's financial position and not being misleading in any material respect.

The Buyer argued that there had been a breach of both the accounts and the management accounts warranty, in particular that the Accounts did not give a true and fair view of the assets and liabilities of the group or the relevant subsidiary and the management accounts did not fairly reflect the financial position of the group and were misleading in a material respect. The Sellers admitted that if the liability been known, it would have been included in both the accounts and the management accounts, which would have undoubtedly resulted in a reduction in the purchase price.

Result

The Court of Appeal considered that both the management accounts and the draft audited accounts gave a true and fair view. The Seller did not know and could not reasonably have discovered the missed charge at the relevant time, and there was no evidence of the missed charge available before the draft audited accounts were signed off which would have enabled the charge to be included in the accounts. Furthermore, it could not be said that the Group or its accountants made an "error" within the meaning of accounting policy FRS 3 paragraph 63 (an error of such significance as to destroy a true and fair view) which required or permitted the accounts to be reopened or restated. In this case, therefore, ignorance was indeed bliss for the Seller.

So what can be done to protect a Buyer?

Following this case, Buyers cannot just rely on common accounts and management accounts warranties (or even post-completion price adjustment mechanisms such as a completion accounts process) to cover them for liabilities which were not known to or reasonably discoverable by a seller prior to completion.   Buyers should now, where possible, ensure that sellers give an unqualified warranty regarding the amount of the target company's liabilities.

The issue is really one of balancing commercial risk vs. getting the deal over the line.  As a Seller, you would argue that you cannot be expected to make provision in audited or management accounts for liabilities of which you are not and could not reasonably be aware (a position supported by the decisions in this case). A Buyer will make the counter argument that if it is buying the target based on certain financial criteria and if such criteria subsequently turn out to be incorrect, the purchase price should be adjusted, notwithstanding the fact that the seller had no reason to believe (and no way of knowing) that such criteria was incorrect at the time. Whether sellers will be able to resist calls for specific unqualified warranties as to liabilities will depend on their bargaining position.

At the least, however, this case provides comfort to sellers that if an unknown liability is discovered by a buyer post completion, it will be difficult for the buyer to bring a claim under typical accounts warranties where the accounts include all known or reasonably discoverable liabilities and have been prepared in accordance with published professional standards.

Angelique de Lafontaine is a solicitor in our Corporate Finance team, which acts for corporates, banks and private equity firms on often complex and innovative M&A transactions. The team, which is ranked No1 in both Chambers and Legal 500 guides, advises on the full range of deal structures and draws on the expertise of a wide range of other expert lawyers across the Firm, including lawyers from the employment, property, TMC, company commercial and financial services teams.

For further information, contact Angelique at angelique.de-lafontaine@michelmores.com or on 01392 688688.