When is a warranty not a warranty?
GAS was an insurance broking company. Its owners decided to sell it. The business came to the attention of D, a private equity house. D conducted preliminary investigations of historic financial performance and projections for future performance. It then proceeded to full-scale due diligence.
An auction process followed, in which D eventually succeeded against one or more potential trade buyers. A number of GAS directors and managers formed a MBO team to acquire a minority shareholding in the company formed to acquire GAS (the "buyer"). The buyer was a company controlled by D, of which the MBO team members (including GAS' finance director) were directors.
On the basis of the available financial information and projections, D valued GAS at around £16.75 million. A key part of the valuation was based on projected earnings. However, D was unaware that the most recent audited accounts of GAS, together with all financial projections seen by them, contained a material error in the amount of earnings.
The error arose as follows. GAS had an outsourcing contract with a supplier. GAS had experienced significant problems with this arrangement. Several customers had ceased to deal with GAS because of failures on the part of the outsourcing company. GAS had claimed compensation from the outsourcing provider and this had ultimately been settled by the outsourcing provider discounting its monthly fees for all ongoing business.
However, GAS included the full amount of the discount for each year as turnover in its accounting records. There were also other non-recurring items that were wrongly included in producing future turnover projections. Turnover for the year in which the MBO was completed was accordingly overstated by as much as £300,000, or more than four per cent. The figures in the accounts for profit and net asset values were, however, correct.
There was no finding of dishonesty in relation to these errors; they were simply accounting mistakes. GAS' auditors had originally queried the treatment of the discounts in the audited accounts, but had been persuaded that it was correct. The issue was well known to GAS' finance director and members of his team. Those carrying out financial due diligence on behalf of D could easily have discovered the issue had they examined the turnover figures in detail. But there was no note to the accounts explaining the issue.
The acquisition agreement contained the usual warranties that the audited accounts gave a true and fair view and had been prepared in accordance with generally accepted accounting practice. Matters within the actual knowledge of the Buyer were excluded from the warranties.
D claimed for breach of the accounts warranties. D also claimed that the warranties amounted to misrepresentations by the sellers. Damages for breach of warranty are designed to put the claimant in the position it would have been in had the warranty been true. In this case, that amounted to around £4.75 million (which is the amount of the price reduction the court found that D would have demanded had it known about the inflated turnover figures).
However, damages for misrepresentation are designed to restore the claimant to the position it would have been in had the misrepresentation never been made. D claimed that, had it understood the turnover issue, it would not have bought GAS at all. A key attraction of the company as an investment was the high-level of maintainable earnings shown by the turnover projections. D therefore claimed repayment of the whole of the purchase price, almost £17 million.
A key part of the sellers' defence was that the buyer should be taken to have known about the turnover issue because the GAS finance director was a director of the buyer at the time of the acquisition. Such knowledge would have ruled out a warranty claim under the terms of the acquisition agreement. The sellers also claimed that D would have gone ahead with the buyer's acquisition at the same price even if it had known about the turnover issue. On that basis, they claimed that the buyer had suffered no loss and could, therefore, recover nothing.
The High Court ruled as follows:
- The warranties were not representations. The following factors were relevant:
1.1 The acquisition agreement used the language of warranties ("The sellers severally warrant to the buyer...") and not of representation. The only reference to representations was to exclude liability for any representation not set out in the agreement (and that did not mean that the warranties were intended to operate as representations).
1.2 The acquisition agreement contained customary limitations on the sellers' liability under the warranties but contained no express limitation on liability for misrepresentation (other than as set out in 1.1 above). The judge thought it would be "a strange and uncommercial state of affairs" for a seller to negotiate detailed limitations on liability under warranties while remaining liable without limitation for misrepresentation based on the warranty wording.
1.3 There is what the judge described as "a conceptual problem" in treating contractual provisions as representations. In order to give rise to a misrepresentation claim, it is essential that the claimant was induced by the representation to enter into the contract. The classic example involves someone buying a used car because the salesman has said that "It's a nice little runner" or similar. There is therefore what the judge called "a timing problem" because something that is contained in the agreement (and therefore has no effect until the agreement is signed) cannot be said to have caused the agreement to be entered into. However, the judge left open the possibility that contracting parties could provide expressly that certain statements were to be treated as representations.
- There had been breaches of warranty in that the accounts of GAS:
2.1 did not give a true and fair view because of the material overstatement of turnover; and
2.2 failed to comply with accepted accountancy practice because of the way in which the discounts had been treated as turnover.
The judge commented that a breach of this type of warranty could also arise where there were a number of non-material errors which when aggregated produced a material amount.
Even though the profit and net asset figures in the accounts were accurate, the claim for breach of warranty succeeded.
- The buyer was not to be taken to know about the turnover issue just because the GAS finance director, who knew about it, was also a director of the buyer. The members of the MBO team were clearly "on the seller's side of the line" at the point at which the warranties were given. To find otherwise would be largely to defeat the whole purpose of the warranties. English law has never taken the view that the knowledge of a director is automatically treated as knowledge of the company. Only matters within the actual knowledge of members of the D team would have been relevant.
- The judge was not persuaded that D would have gone ahead with the deal at the same price even if it had known the true position. He awarded damages representing the difference between the price paid for GAS and what it was actually worth when acquired.
Sycamore Bidco Ltd v (1) Sean Breslin (2) Andrew Dawson  EWHC 343 (Ch)
This analysis may contain information of general interest about current legal issues, but does not give legal advice.