Those who have been involved in negotiating the sale or purchase of a business will be well aware of the careful attention paid to warranties. Warranties are a mainstay of merger and acquisition (M&A) transactions, however, due to their technical meaning under Australian common law, there can be a lack of clarity over the consequences that arise from a breach of these contractual promises. In particular, does a failed warranty gives rise to a right for the purchaser to rescind the agreement entirely? In this first of a two-part series, we look at what happens when a warranty in a business sale turns out to be false.
In modern Australian contracts, a warranty is a contractual statement of a fact by one party to another, asserting that a specific state of affairs is true. A warranty can be given in relation to current affairs or past conduct, as well as future conduct and/or facts.
The vendor of the business is asked to stand behind the truth of these statements, in the knowledge that the purchaser is placing trust in their veracity. If the warranties turn out to be false or misleading, whether maliciously so or by oversight or incompetence, the purchaser may sustain loss.
A typical sale and purchase contract for an M&A transaction includes warranties by the vendor in the form of contractual statements with respect to the health of the business. For example, a vendor may provide warranties such as:
The warranties above are simply stated. In practice, these kinds of promises can often be highly detailed in nature and run to over 100 individual statements of fact.
Warranties moderate the level of risk which may accompany buying business assets or shares in the company which holds those assets. Far-reaching and comprehensive warranties are often sought by a purchaser to protect them from both foreseen, unforeseen, and unforeseeable, liabilities. As former US Secretary of Defence, Donald Rumsfeld, famously remarked:
“…there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.”
As part of the sale process, the purchaser will almost always carry out some form of due diligence before the transaction is finalised. M&A market practice is such that the purchaser will expect the vendor to provide relevant information via a data room about the business, then via warranties written into the sale agreement. The warranties are often shaped around what has been discovered during due diligence, and any information gaps identified in the process.
Damages
If a warranty is breached, the primary remedy is a right for the purchaser to claim financial restitution for loss sustained.[1] These damages are intended to put the purchaser in the position they would have been in had the warranty been true.
Beyond financial restitution, alternative rights and remedies include termination and rescission. Depending on the terms of the contract and the specific circumstances, careful consideration must be given to the distinction between these concepts, and their implications, under the law.
The Contractual Right of Termination
Termination discharges the parties from their future obligations under the contract, but any accrued obligations remain intact.[2]
Unless expressly stated in the contract, in order for the purchaser to have the ability to rescind the agreement and get their money back, they will need to prove that the warranty is an ‘essential term’ of the contract. Otherwise, they may be obliged to complete the transaction, and then rely on the right to claim damages for the false promise of the breached warranty.
The Common Law Right of Termination
Under Australian common law, in circumstances where a warranty meets the test of being an ‘essential term’ of a contract, the recipient of the warranty will have a right to ‘escape the bargain’ and terminate the contract. This is the case even where the sale and purchase agreement does not say so expressly.
The High Court adopted the test of essentiality in Tramways Advertising Pty Ltd v Luna Park (NSW) Ltd (1938)[3] (Tramways Case), looking at the common intention of the parties when forming the contract. Jordan CJ stated:
‘The test of essentiality is whether it appears from general nature of the contract considered as a whole…that the promise is of such importance to the contract that he would not have entered into the contract unless he had been assured of a strict or a substantial performance of the promise….he may in general treat himself as discharged upon any breach of the promise, however slight.’ (bold added)
Based on the Tramways Case and succeeding judgments, a term is likely to be an essential term, if:
However, unless expressly stated, the risk arises for the party relying on the warranty that it may not meet the Tramways Case test of essentiality, and result in confusion as to what the appropriate remedy is. Therefore, it is a better practice to expressly state that the right of termination arises on breach of the warranty prior to completion occurring.
In contrast to termination, rescission means that the contract will be considered void ab initio (from the beginning), allowing the purchaser to set aside the contract and be restored to their original position had they never got into the bargain.[5]
Rescission is like a magic wand or the fantastical machine from the Jim Carrey film, Eternal Sunshine of the Spotless Mind, that means the relationship never happened from the “victim’s” point of view.
Under Australian M&A agreements, a practice has developed of identifying certain warranties as ‘essential’ or ‘fundamental’ terms of the agreement. It follows that the breach of a warranty identified as ‘essential’ or ‘fundamental’, such as by a fraudulent misrepresentation, should give the party relying on the warranty the right of restitutio in integram – i.e. to rescind the agreement and be restored to their original position.
However, in such a case the transaction must be practically capable of being unwound so that both parties are restored to their original position. As NSW barrister and legal author Edmund Finnane described:
‘Money must be repaid and property returned. If that cannot be done precisely, the contract cannot be rescinded at common law.’[6]
In the context of the sale of a business, it is practically difficult to restore the parties to their original position, particularly if the assets have been transferred from one party to another. For this reason, rescission may not be an appropriate remedy in many M&A deals.
Unwinding an M&A deal after it has been completed can be akin to unscrambling an omelette. In the real world, rescission of a completed agreement and restitutio in integram may not be possible.
Careful attention should be paid to how warranties are drafted in business sale and purchase agreements. If the purchaser wishes to preserve the right to terminate the agreement and walk away entirely, it would be prudent to:
Stay tuned for Part 2 of this deep dive on warranties. In the meantime, for advice on M&A deals or corporate law generally, please contact us below.
[1] https://classic.austlii.edu.au/au/journals/SydLawRw/1977/3.pdf 33, 41 (‘Conditions and Warranties’)
[2] Johnson v Agnew [1980] AC 367 at 392.
[3] 38 SR 632.
[4] Hongkong Fir Shipping Co Ltd v Kawasaki Kisen Kaisha Ltd [1962] 1 All ER 474.
[5] Nyuk Yin Nahan, ‘Rescission: A Case for Rejecting the Classical Model?’ (1997) The University of Western Australia Law Review 27(66).
[6] Edmund Finnane, ‘Rescission’ 13 Wentworth Selborne Chambers (13 March 2008).
