Sellers’ false due diligence responses amounted to fraudulent misrepresentations

The High Court has examined whether false responses given by sellers to a buyer’s due diligence enquiries amounted to fraudulent misrepresentations.

The court also had to decide whether the responses amounted to breaches of warranty in the relevant share sale agreement (SPA). We will look at this in next week’s update.

What happened?

MDW Holdings Ltd v Norvill [2021] EWHC 1135 (Ch) concerned the sale of a waste management company whose business included the processing and disposal of dry and wet waste.

The company’s business was heavily regulated. In particular, it required an environmental permit to operate a regulated facility and consent from the relevant water company to discharge trade effluent into public sewers. The permit and the discharge consent were subject to various conditions. In particular, the discharge consent set limits on the level of contaminants permitted in the effluent and required the company to keep detailed records of all effluent it discharged.

Between 2013 and October 2015, sampling showed that certain contaminants in the effluent exceeded the permitted limits in the discharge consent. The water company wrote to the business requiring remedial action. The parties agreed an improvement plan, but the effluent continued to include at least one contaminant above prescribed limits.

The water company subsequently made several requests for the company’s internal test results. In response, the company’s general manager provided figures for copper and lead levels that had been falsified. The company also asked the water company to increase the permitted limit for ammonia under the discharge consent, but the water company declined to do so.

From late 2014, the sellers entered negotiations with an interested buyer to sell their shares in the company. The buyer carried out environmental due diligence, which included sending the sellers a legal due diligence questionnaire.

Among other things, the questionnaire asked for details of “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 company]”. The company’s response failed to mention the ongoing breaches of the discharge consent or to provide details of the communications between the company and the water company concerning the discharge consent breaches.

On 14 October 2015, the sellers and the buyer signed the SPA and completed the sale.

Among other things, the SPA contained an “entire agreement clause”, which stated:

This agreement constitutes the entire agreement between the parties and supersedes and extinguishes all previous discussions, correspondence, negotiations, drafts, agreements, promises, assurances, warranties, representations and understandings between them, whether written or oral, relating to its subject matter.

What did the buyer claim?

Following the sale, the water company sent an email to the company alerting it to further breaches of the discharge consent in respect of ammonia levels and warning it that a prosecution for historic breaches was being considered.

The buyer subsequently notified the sellers that it intended to claim against them for failing to disclose the breaches of the discharge consent and on the basis that the company had been systematically breaching environmental law.

The buyer’s claim was based on two separate actions:

  • Breach of contract on the basis that several of the warranties which the sellers had given in the SPA were inaccurate.
  • Misrepresentation, on the basis that the sellers had made several pre-contractual statements that were inaccurate or false.

Below, we discuss the buyer’s claims in misrepresentation. We will look at its claims for breach of warranty next week.

What did the buyer claim?

The buyer claimed that it had relied on written statements in the sellers’ responses to the due diligence questionnaire when deciding whether to enter into the SPA. It argued that these statements amounted to pre-contractual representations and had been false.

The buyer claimed in both negligent misrepresentation under the Misrepresentation Act 1967 and fraudulent misrepresentation (or “deceit”) at common law. The key distinction between these actions is the level of damages the court will award (although there are others). Broadly, if a misrepresentation is fraudulent, the buyer can recover all losses arising from it, whereas if it is merely negligent, the buyer can recover only losses that were reasonably foreseeable.

The sellers denied that they had made any misrepresentations at all. However, they also argued that, if they had made misrepresentations, their liability was excluded by the entire agreement clause.

What did the court say?

The court found that the sellers had made fraudulent misrepresentations.

In assessing the buyer’s claim, the judge addressed several interesting points.

  • The sellers’ corporate finance adviser had provided the responses to the buyer’s due diligence questionnaire, not the sellers themselves. However, the court said the corporate finance advisor had been acting as the sellers’ agent and so the sellers were liable for its responses.
  • The buyer had relied on the responses to the questionnaire when entering into the SPA. The judge noted that “[the buyer’s] reason for asking the questions can only have been that it wanted to know the answers, and its reason for wanting to know the answers can only have been because they would inform its decision whether to buy the shares.
  • Several of the responses to the questionnaire had been inaccurate, including, in some cases, because the sellers had omitted information that was relevant to the context of those statements. However, there was no evidence that the sellers had made oral or implied representations.
  • One of the sellers (who was also the company’s CEO) had known of the relevant matters, including the falsified data that had been provided to the water company. His statements were therefore dishonest and amounted to fraudulent misrepresentations.
  • The other sellers were also liable for the fraudulent misrepresentations, even though they had not acted dishonestly, because they had left the negotiation and handling of the sale to the CEO. He had therefore been acting as their agent and so they were responsible for his fraud.
  • The entire agreement clause did not exclude liability for misrepresentation. The purpose of the clause was to clarify that nothing said, written or done before signing the SPA created any contractual obligations or liabilities. The SPA contained nothing to the effect that the buyer had not relied on any pre-contractual statements or that liability for misrepresentation had been excluded.

Interestingly, the judge did not feel that the water company’s concerns over the persistent breaches of the discharge consent and its ongoing monitoring of the company’s activities amounted to an “investigation, enquiry or enforcement action”. As a result, the response that there were no investigations, enquiries or enforcement action had not amounted to a misrepresentation.

What does this mean for me?

This is a useful reminder of the importance of taking steps to ensure that responses to pre-contractual enquiries are accurate. In this case, the question arose on the sale of a business, but this could apply equally on the sale of some other kind of property.

Here, the risk to the sellers was exacerbated by the negotiations being left to only one of the sellers, and responses to the buyer’s enquiries being further delegated to a professional adviser. Even though most of the sellers were not involved in responding to enquiries, they nonetheless found themselves liable for the misrepresentations.

There are, however, various steps sellers can take to minimise the risk of liability for misrepresentation when responding to enquiries from a buyer:

  • Ensure your responses are complete and accurate. Clearly responses must not be outright false. However, a response can be inaccurate for a variety of reasons, including if it lacks key context or information and so gives a misleading impression.
  • Even if not preparing or compiling responses to a buyer’s enquiries, ensure that you have oversight of what is being said. Review any written responses to enquiries and ask for a summary or minutes of any meetings or telephone calls.
  • Include appropriate protections and limitations in the SPA. As this case shows, an entire agreement clause of the kind in this case, whilst seemingly broad, will not prevent a claim for misrepresentation. The courts will insist on clear wording if the parties are to exclude any remedies provided for by the law.
  • Appropriate protections could include a non-reliance clause, which confirms that the buyer had not relied on any pre-contractual statements when entering into the SPA. Better yet is an express exclusion of liability for misrepresentation. This can be coupled with a waiver of any non-contractual damages, such as rescission or damages calculated on a tortious basis.

The decision is also a useful reminder that the question of misrepresentation is still relevant on a share or business sale. Recent cases, such as Idemitsu Kosan Co Ltd v Sumitomo Co Corp [2016] EWHC 1909 (Comm), have confirmed that a contractual warranty cannot also amount to a pre-contractual representation, significantly cutting back the scope for a buyer to bring a claim in misrepresentation.

However, this does not mean that a misrepresentation claim is not possible. The buyer will need to show, as it did in this case, that there was in fact an inaccurate pre-contractual statement and that the buyer relied on it when deciding whether to enter into the sale.