Home Knowledge Unknown Unknowns – Buyer Beware

Unknown Unknowns - Buyer Beware

October 4, 2010

The extent of pre-completion liabilities, and who should bear that risk, is always a matter of contention in the sale or purchase of a business.  A recent UK Court of Appeal decision has confirmed that it is the purchaser who takes the risk of “undiscoverable” and “unknown” liabilities unless they have negotiated specific warranties to cover these.  This is the case even if the target company has incurred a significant liability before completion, provided that the accounts comply with the relevant accounting standards and that the liability was unknown to, and not reasonably discoverable by, the seller at the relevant time.

In the recent case, the purchaser acquired a group of companies from the seller.  It was discovered that a group company had incurred a significant liability prior to completion, which neither the purchaser nor the seller was aware of.  The seller had given typical accounting warranties in the share purchase agreement, effectively stating that the accounts had been prepared in accordance with the relevant accounting standards, gave a “true and fair view” and fairly reflected the group’s financial position, not being misleading in any material respect.

The Court of Appeal decided that there will not be a breach of accounting warranty where accounts do not disclose a liability which was unknown to, and not reasonably discoverable by, the seller at the relevant time.  In addition, the Court of Appeal commented that compliance with professional standards will be strong evidence that accounts present a true and accurate view and that the wording “not misleading” did not mean that the accounts represented the actual financial position.  Instead, it meant the accounts contained the information which someone would expect management accounts prepared on the stated basis to contain.

This decision highlights the balancing act of allocating commercial risk and the importance of dealing with the risk in the purchase/sale contract.  Who bears these risks will depend on the bargaining power of the respective parties.  A buyer will want to exclude unknown and undiscoverable risks because the costs associated with them won’t have been factored into the purchase price.  Equally, a seller will assert that it should not be responsible for risks it is and could not have been aware of.  

This case gives sellers comfort that they should be better protected against claims under typical accounting warranties that accounts do not give a true and fair view where unknown and undiscoverable liabilities subsequently emerge, provided that the seller’s accounts have been prepared in accordance with the relevant professional standards.  

Buyers need to take account of this case so that the risk of undiscoverable and unknown pre-completion liabilities is transferred to the sellers by additional warranties or otherwise covering off such risks in the purchase/sale contract.