Unknown Liability Not Actionable

One of the prime objectives of the due diligence process carried out by the prospective buyer of a business is to ensure that there are no skeletons in the cupboard of the business being bought. Warranties and indemnities are important safeguards, of course, but it is far better to identify any potential problems at the outset.

Typically, the vendor of the business will supply accounts for it and will warrant that these show a 'true and fair view' of its position. In a recent case, a purchaser of a business relied on audited accounts and more recent management accounts, which were provided on this basis. Subsequently, however, an undisclosed liability of more then £2 million was discovered.

The purchaser sought to rely on the warranty that the accounts showed a true and fair view and claimed damages from the vendor. However, the vendor claimed that it had been completely unaware of the potential liability, the omission of which was due to a third-party error. The accounts did, therefore, show a true and fair view as far as the vendor understood the situation to be at the time these were signed off and also when they were disclosed to the purchaser.

The Court of Appeal firstly considered whether the accounts had been properly audited in accordance with accepted auditing standards. It concluded that they had. It then went on to find that because the accounts had been properly audited and the vendor was completely unaware of the liability at the date the accounts were signed off and on the date of sale, the accounts did show a true and fair view and there was no breach of the warranty.

One way of seeking to minimise risks of this sort is to put a 'ratchet' clause in the sale agreement such that any significant undisclosed liability that exists (whether known about or not) at the date of sale, and which becomes manifest within a specified period, will lead to a repayment. In some circumstances, a proportion of the purchase proceeds may be held in escrow for the specified term.

For advice please contact Roger Sands on 01752 292316.