Effective disclosure for warranty claims

When buying or selling shares or businesses, what is effective disclosure for the purposes of a warranty claim? The Court of Appeal has unsettled some key assumptions by reversing the trend of a series of cases.

Disclosure

In a share or asset purchase transaction, the law provides little protection as to the nature of what is being bought. It has therefore become the norm for the documentation to contain extensive contractual statements (known as warranties) about the subject matter. Warranties provide the buyer with a remedy if any of them turn out to be untrue or misleading, and also direct the seller’s mind to specific areas in order to draw out information. This is especially important in share transactions, where the buyer will often be taking on the company warts and all (unlike an assets purchase, where there is more scope to cherry-pick and leave liabilities with the seller).

UK practice is rather idiosyncratic, in that, on their face, the warranties typically describe an ideal state of affairs (sometimes modified by “so far as the seller is aware”). But everything is to be understood as being subject to disclosures to the contrary made by the seller in a formal disclosure letter (usually accompanied by voluminous appendices in the form of a CD-rom or a bundle of documents). This method puts the onus on the seller to make sure that it has disclosed effectively: to the extent that it has not done so, it is taken to have given the warranty as stated. The question of what is (or is not) effective disclosure is therefore critical to the process. A series of cases over the last 25 years had established a consensus largely in favour of buyers, but in Infiniteland Ltd v Artisan Contracting Ltd the Court of Appeal has bucked the trend.

The established position

There is no precise formula for disclosure in transactional documents: some agreements say that the warranties are given “except as disclosed” or “except as fairly disclosed”. Some require disclosures to be specific, full or accurate, and there are various permutations of these and other terms.

Until Infiniteland, it was generally thought that all the variations were really distinctions without a difference. The courts tended not to place emphasis on the precise subtleties and shades of meaning in disclosure provisions. The lack of elaborate wording was no impediment to the buyer in a case in 1978, for example, where the seller had warranted that, “save as disclosed”, there had been no adverse change in the net assets of the business since the year-end. The buyer was given carte blanche to review all aspects of the business (and, indeed, appeared to have been involved in its affairs prior to exchange of contracts). He had certainly known that the business was loss-making, and had been given clear indications of the rate of the losses and that the negative impact on net assets was inevitable. Yet the court upheld his warranty claim, and said that “a protection by disclosure will not normally be achieved merely by making known the means of knowledge which may or do enable the other party to work out certain facts and conclusions.” In other words, it was not enough that the buyer could have worked it out for himself: the precise amount of the reduction in net assets should have been disclosed.

Similarly, in a case in 1996, the court said that it was not enough merely to refer to a source of information where a diligent inquirer might find the relevant information. The judge condemned what he called the “repetitive and omnibus approach” of the seller deeming a whole series of documents to have been disclosed and seeking to rely on information contained in them as effective disclosures. But what has not received enough attention until now is that the agreement expressly required disclosures to be made “with sufficient details to identify the nature and scope of the matter disclosed.”

The Infiniteland case

Artisan sold three companies to Infiniteland. The year-end accounts of one of the companies showed a profit of almost £600,000. The sale and purchase agreement contained a warranty that the accounts showed a true and fair view of the financial position of the company, and the seller accepted that in fact they did not. This was due to an exceptional item of just over £1 million that had been incorrectly offset against the cost of sales, with the result that the profit and loss account was overstated. The company had in fact made a loss of just over £500,000.

The agreement qualified the warranties by the phrase, “save as set out in the disclosure letter”, and the disclosure letter in turn was deemed to include all information supplied to the reporting accountants. It was through a bundle of files sent to the accountants that the seller sought to pin the disclosures on the buyer. The files do not appear by any means to have contained a full explanation of the accounting irregularity or its artificial effect on profits, but there was enough information to alert the reporting accountants. One of them did unearth the issue, raised a query with the seller and was told the true position. But this material fact was not reported to the buyer in the accountants’ due diligence report.

The Court of Appeal – reversing the High Court – found that there had been valid disclosure and therefore no breach of warranty. In the leading judgment, Lord Justice Chadwick emphasised the need to focus on the precise language of the agreement. In doing so, he neatly turned the 1996 case, which had previously been seen as confirming the buyer-friendly trend, to his purpose, pointing out that it had been decided not on a general principle of what proper disclosure meant but because the agreement had stipulated sufficient details to identify the nature and scope of the matter disclosed. He said that, if the Infiniteland agreement had expressly required disclosures to be full, clear and accurate (which was the standard the High Court had applied, regardless of the actual wording), he may well have agreed that there had not been valid disclosure. The clear sign is that it is largely up to the parties to write their own rules, and that negotiating the wording is likely to be the subject of more intense focus between them.

So what is the standard where the agreement provides for nothing more than bare disclosure? Lord Justice Chadwick said:

“the disclosure requirement was satisfied in relation to such matters as might fairly be expected to come to the knowledge of the reporting accountants from an examination (in the ordinary course of carrying out a due diligence exercise for which they were engaged) of the documents and written information supplied to them.”

The standard may differ depending on the recipient of the information: here, the test refers to the expected knowledge of reporting accountants, but that is because the agreement provided that everything supplied to the accountants was to be treated as disclosed. The buyer could have refused to accept this, but must be presumed to have chosen freely not to do so. If the agreement had been silent on the point, it is possible that the buyer’s engagement of professional advisers would have led to the same standard being imposed. Conversely, if no experts are involved (or known to be involved), the standard of disclosure is presumably higher.

Relevance of the buyer’s knowledge

The case also touches on another important issue: can the buyer make a warranty claim on the basis of information that was not formally disclosed by the seller but was nevertheless known to the buyer when it entered into the agreement? What if the agreement says that it can? Since 1991, when the Court of Appeal suggested (without deciding the matter) in a case known as Eurocopy that such a provision might not stand up, lawyers acting for buyers have continued to include these clauses but have warned their clients that they might not work.

The Infiniteland agreement provided that the buyer’s rights and remedies in respect of any breach of the warranties were not to be affected by any investigation made by it or on its behalf into the affairs of the companies. But the clause contained a carve-out: the buyer’s rights were not to be affected except to the extent that any such investigation gave the buyer actual knowledge of the relevant facts.

Most lawyers who routinely negotiate sale and purchase documentation were probably not surprised at the interpretation taken by the High Court: the clause might seem to be included principally for the buyer’s benefit, but the effect of the carve-out was to flip it over, so that where any investigation gave the buyer actual knowledge of the relevant facts the buyer had no claim. The Court of Appeal disagreed: the clause was there to protect the buyer, and happened to include a carve-out for actual knowledge. That was not the same as an additional protection for the benefit of the seller enabling it to avoid liability where the buyer had actual knowledge. It is not clear, however, what the carve-out means in the Court of Appeal’s reading, or what effect it would have in the context of a warranty claim. One possible interpretation is that, while the seller is agreeing not to invoke the buyer’s investigations in defending a warranty claim, it is not agreeing to hold back where the investigation resulted in actual knowledge. In that event, the buyer is free to take proceedings, but the seller is free to argue that the quantum of damages should reflect the fact that the buyer was willing to buy at the agreed price despite knowing the relevant facts, and ought not to be allowed to try to improve the bargain.

Having already decided that disclosure had been effective, the Court of Appeal did not have to decide whether, as a matter of law, a buyer with actual knowledge is precluded from claiming for breach of warranty notwithstanding a clause expressly preserving such rights, or where the agreement is silent on the issue. The High Court believed that there was no such principle of law. Although the Court of Appeal left the matter open, it does seem likely that parties can agree that knowledge is irrelevant to the right to claim. But it is also likely that any buyer hoping to do so will encounter strong arguments along the lines referred to in Eurocopy: that it might be dishonest – even fraudulent – for the buyer to claim, or that the buyer’s knowledge goes to the quantum of loss. It is therefore inadvisable for a buyer to “sign and sue”. The matter should be raised before exchange and either factored into the price or covered specifically by an indemnity.

Imputed knowledge

On the question of the actual knowledge carve-out, the High Court thought that the knowledge of the reporting accountants could be imputed to the buyer (this was not relevant to the disclosure issue, as the agreement provided that what was supplied to the accountants counted as disclosed to the buyer).

The Court of Appeal disagreed, and said that the carve-out would have expressly referred to imputed knowledge had the parties intended the accountants’ knowledge to be covered. This was dealt with fairly briefly in the leading judgment and does seem a slightly curious result. One of the judges, dissenting on this point, put it cogently: can the parties, who knew the information was being sent to the buyer’s accountants for due diligence and expected them to report to the buyer, really have intended the seller to bear the risk that the buyer’s accountants would be in default?

Practical measures

If acting for the buyer:

• Expressly provide for as high a standard of disclosure as possible in the agreement (for example, by requiring sufficient details to identify the nature and scope of the matter disclosed).
• Be cautious of general disclosures. Sellers will go on seeking deemed disclosure of all due diligence or everything contained (or, even, referred to) in disclosure documents, particularly where the documents have been available for a prolonged period. If the buyer concedes, it is all the more important to insist that deemed disclosures provide sufficient details to identify the nature and scope of the relevant matters.
• Be ever more alert to last-minute disclosures. There may simply not be enough time or the will to assess the full implications of the disclosure. Time can be even tighter if the information is being supplied directly to advisers (who may even have signed off their reports by then).
• Include a clause asserting that the buyer can claim (not merely that its rights and remedies are not affected) notwithstanding its knowledge (actual or imputed, or what it might reasonably be expected to discover), and consider providing that – in the absence of fraud on the buyer’s part - the quantum of damages will not be affected by any such knowledge. But stress to the buyer that these provisions may not work in all situations. If the buyer knows about something prior to exchange, seek an indemnity or a reduction in the price.

If acting for the seller:

• Maximise the scope of disclosure by resisting any formula more rigorous than “disclosed” or “fairly disclosed”.
• Include an acknowledgment in the disclosure letter that specialist advisers of the buyer have been supplied with the information, in case the court infers a greater onus on the seller to bring out the issues.
• As always, sellers should reduce the risk of failing to make a disclosure stick. Ensure that disclosures are as specific as possible and adequately bring the matter to the buyer’s attention in the disclosure letter, giving the buyer and its advisers as much time as possible to consider the information.
• Address the effect of the buyer’s knowledge on warranty claims: for example, by a cross warranty that the buyer is not aware of any breach of warranty. Spell out that the buyer is not entitled to make a claim based on its actual knowledge of the relevant facts before the agreement was exchanged. Specify whose knowledge in the buyer’s organisation counts as the buyer’s knowledge, and whether the advisers’ knowledge is included (bearing in mind that the courts appear to be slow to impute advisers’ knowledge to the buyer in the absence of express provision).

This article first appeared in our Clearly Corporate Bullitin April 2006. To view this publication, please click here to open it as a pdf in a new window.