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Accounting Error Leads to Damages for Buyers

PLEASE NOTE: Information in this article is correct at the time of publication, please contact DFA Law for current advice on older articles.

A case has been decided which arose because accounting errors were made by a company which was bought by another company. Some of the management of the company which was sold invested in the buying company, so that the eventual result was a management buy-out (MBO). The errors were not detected by the buying company before the purchase was completed.

The mistakes had the effect of overstating the turnover (but not the profitability) of the company being sold by approximately 4 per cent. The turnover was used as a basis for calculating the price paid for the company’s shares based on projections of turnover growth, which meant that the purchase price paid was more than the buyer thought justified.

The accounting errors were known to the Finance Director (FD) of the company that had been purchased, and also to its auditors. They were not picked up when the ‘due diligence’ exercise was carried out. Crucially, the FD later became a member of the MBO team.

The purchase agreement contained a warranty that the published accounts of the company drawn up prior to the sale gave a ‘true and fair view’. The buyer claimed that this warranty had been breached and also that the seller had misrepresented the true position. The buyer claimed that the misrepresentation was severe enough that had it known the true position, it would not have purchased the company.

The buyer sought repayment of the whole of the purchase price, some £17 million.

The vendor claimed that the buyer must be considered to have known about the error since the FD participated in the MBO. As such, there could be no claim under a warranty. It also claimed that the buyer would have bought the company anyway and had suffered no loss on which to base a claim.

The first issue before the court was whether there was misrepresentation. The court ruled that representations had not been made with regard to the matter in dispute.

The claim therefore proceeded on the basis of warranties having been given. The court decided that just because the MBO team later included the FD of the company that had been bought, it could not be concluded that the buyer knew about the issues: the FD was ‘on the vendor company’s side’ prior to the purchase. Accordingly, the warranties given would apply.

Additionally, the judge accepted that the purchase would not have gone ahead at the same price had the buyer known the true turnover. However, the court could not accept that the correct measure of damages was the entire cost of the acquisition. Damages were awarded based on the difference between the actual price and the price the buyer would have paid had the turnover been correctly disclosed.

Making sure that appropriate warranties are agreed in a purchase of a business is essential. For advice on carrying out legal due diligence on the acquisition of any business, contact John Keeble.

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