An issue that frequently exercises the minds of buyers and sellers of companies and businesses is the possibility of a previously unknown pre-completion liability that comes to light after completion of the transaction, particularly where provision for the liability, if known, would have been made in the audited or management accounts of the target. This issue was the subject of a recent English Court of Appeal decision (Macquarie Internationale Investments Limited v Glencore UK Limited [2010] EWCA Civ 697).

The Macquarie case examined the wording and liability resulting from accounts and management accounts warranties included in a share purchase agreement. The share purchase agreement entered into between the parties defined "Accounts" as the draft audited consolidated balance sheet and profit and loss account in respect of the financial year ended on 31 December 2005 and "Management Accounts" as the unaudited consolidated management accounts for the period from January to June 2006. The share purchase agreement 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 target group's business involved the supply of gas to commercial customers in the UK. The gas was transported by distribution companies one of whom undercharged one of the target's subsidiaries in respect of certain charges over a period. It then issued an invoice to the relevant subsidiary for the amount of the shortfall, which was Stg£2.4 million. The liability was not included in the Accounts or Management Accounts but if it had been the price paid would have been Stg£2.4 million less. The claimants argued that 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. It was admitted by the defendants that had the liability been known it would have been included in both the Accounts (at the then accrued figure of £566,000) and the Management Accounts, with a resulting reduction in the purchase price.

In the High Court, the trial judge held that there was no breach of warranty as the defendants were not aware of, and could not have reasonably discovered the existence of, the liability. The claimants appealed against the ruling on the Management Accounts only.

Although there was no appeal on the audited Accounts, the Court of Appeal nevertheless confirmed that there was no breach of the Accounts warranty and that the Accounts presented a true and fair view of the assets and liabilities of the group for the year ended 31 December 2005 as the Company did not know about, and could not reasonably have discovered, the liability in question at the relevant time.

The Court of Appeal held that the same process of reasoning applied to the Management Accounts and held that a seller would not be in breach of a management accounts warranty where those management accounts did not disclose a liability which was unknown to, and not reasonably discoverable by, the seller at the relevant time. The Management Accounts were prepared in accordance with relevant accounting standards and did in fact give a true and fair view of the group's financial position (although this was not actually warranted in the share purchase agreement at issue). The Court of Appeal held that the warranty in respect of the Management Accounts had to be construed as a warranty about the manner of preparation and the degree of accuracy of the Management Accounts and did not purport to warrant anything about unknown or undiscoverable liabilities no matter the size of such liabilities.

Furthermore the Court held that the phrase "not misleading" did not mean that the Management Accounts represented the target group's actual financial position rather it meant that the Management Accounts contained information which one would expect management accounts prepared on the relevant basis to contain. The fact that these were management accounts and the reference to their purpose (which the court found to be internal management) warned the reader that they would be of a lesser standard of accuracy than one would expect from audited accounts. On the facts, the Management Accounts had been prepared in the manner required by the warranty and consequently there was no breach.

It remains to be seen if the Macquarie case is followed in this jurisdiction but it is reasonably likely that it would be given the similarity between accounting practices in the two jurisdictions. The management accounts warranty included in the share purchase agreement was fairly standard but did not provide protection to the buyer in respect of a liability that both parties accept would have impacted on the purchase price had it been known. The issue is really one of the splitting of commercial risk. While a seller may argue that it cannot be expected to make provision in audited or management accounts for liabilities of which it is not and could not reasonably be aware (a position supported by the decisions in this case) a buyer will make the counter argument (depending on the specific circumstances of the relevant transaction) that if it is buying the target based on certain financial criteria (such as a particular level of net assets) 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 were incorrect at the time when the initial calculation was done.

In light of this decision, it would be prudent for buyers to seek enhanced warranty protection to cover liabilities of this nature. It is difficult to see how the position could be adequately covered in warranties on accounts or management accounts, as by their nature such warranties can really only deal with the standard of preparation of such accounts, and extending them to deal with unknown liabilities would be likely to create problems in the negotiation of such warranties. Interestingly, in the Court of Appeal decision, it was suggested that the claim which the claimant was seeking to advance could have been covered by warranties as to assets and liabilities but in this case such warranties were not drafted in sufficiently broad terms to cover the undiscovered errors.

For sellers, the judgment will give the comfort of knowing that once the target's accounts are prepared in accordance with published professional standards and include all known and reasonably discoverable liabilities, they should be able to avoid a claim that the accounts do not present a true and fair view should an additional liability come to light post completion. The case did not discuss the lengths to which a seller must go to in order to satisfy itself that there are no reasonably discoverable liabilities.

For further information please contact Jennifer McGuire or Gerry Halpenny.

September 2010.