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Liability in Civil Fraud for Breach of a Warranty in an SPA

Author: Nicola Sharp  9 October 2023
3 min read

What constitutes a ‘dishonest and fraudulent’ breach of warranty?

The warranties in share purchase agreements (SPAs) tend to be fairly similar in most transactions. Among other things, a buyer typically wants to see assurances that the accounts were prepared correctly and that they give a true and accurate reflection of the financial position of the target company.

The leading case on the meaning of “true and fair” accounts is Macquarie Internationale Investments Ltd v Glencore UK Ltd [2010] EWCA Civ 697. In exceptional circumstances, accounts prepared in accordance with relevant accounting standards might not give a true and fair view.

The purpose of this sort of warranty though is not necessarily to envisage all the possible exceptional circumstances. It is primarily designed to protect the buyer from unscrupulous sellers who are “cooking the books” to make the business look more profitable and therefore achieve a higher purchase price.

When to frame a breach of warranty claim as a claim in fraud

A breach of warranty claim can be framed as a breach of contract claim, without pleading fraud.

What benefit is there to pleading fraudulent breach of warranty?

The reason for pleading fraudulent breach of warranty is usually a limitation issue. The SPA will normally contain a clause which caps the value of a claim and imposes a time limit by which a claim must be brought (within one year for example). The parties agree to these limitations to effectively draw a line under the transaction. The seller wants to be able to sell the business, without the possibility of claims arising during the course of the next six years (the statutory limitation period for breach of contract claims).

However, it’s normal practice to include a clause that waives the application of these limitation where liability arises as a result of, or in connection with any fraud of the seller.

This was one of the issues at play in the recent case of Next Generation Holdings Limited & Anor v Alex Finch & Ors [2023] EWHC 2383 (Ch)

Relevant facts

The defendants submitted that the claim for breach of warranty had been “dressed up” as civil fraud in order to avoid the contractual time bar in the SPA.

While HHJ Johns KC (sitting as a judge of the High Court) considered that possibility, he found that a fraud had indeed been carried out by the defendants. One of the reasons was the evidence of the accountant of the seller, who gave evidence that the accounting practices were conducted “to make it look like [the company] was a profitable and successful business to potential buyers and investors, and disguise that it was, in actual fact, balance sheet insolvent and operating at a loss.”

HHJ Johns KC found that the dishonest and fraudulent behaviour was:

  • Accruals were made which had no proper basis. These were not merely honest overestimates.
  • D1 and D2 knew that the accruals had no proper basis.
  • D1 and D2 knew of a client money hole (to the value of around £3.5m) which these accruals were causing.
  • D1 and D2 were prepared to act dishonestly by in relation to these accruals. They had fraudulently misrepresented that they were real and recent debts. In fact they were accruals for which no corresponding debt had fallen due.
  • D1 and D2 attempted to provide some false justification for the accruals.

Was the accountant liable?

While it was accepted that the accountant (D3) for the seller company was liable to the claimants in respect of the same damage as D1 an D2, she was found to owe nothing in terms of a contribution.

The reasons for that lies in section 2 of the Civil Liability (Contribution) Act 1978. The contributions should be “just and equitable, having regard to the extend of that person’s responsibility for the damage” and the court has the power to “exempt any person from liability to make a contribution.”

The court exercised those powers in this case because:

  • D1 and D2 were ultimately responsible for client money compliance.
  • D1 and D2 were the FCA approved persons for the company’s authorised business.
  • D1 and D2 were directors and shareholders, whereas D3 was a salaried employee.
  • D1 and D2 benefitted from the wrongdoing by securing the sale at an inflated price. D3 did not.
  • The moral blameworthiness of D3 was reduced by her “coming clean” and helping the claimants obtain the redress to which they were entitled.

Conclusions

Pleading fraud in a breach of warranty claim can be a risk. It raises the temperature of the litigation from the outset, and the court will usually consider what is inherently probable having regard to the particular circumstances of the case (Otkritie International Investment Management Ltd v Urumov [2014] EWHC 191 (Comm)  In general, dishonesty and fraud are less likely explanation for events than negligence or imprudence.

But if the evidence points to fraud it may be a successful way to seek redress, even after the contractual time limits for bringing a claim have expired.

 

Nicola Sharp C 09983

Nicola Sharp

Partner

nicola.sharp@rahmanravelli.co.uk
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Nicola is known for her fraud, civil recovery, arbitration and business crime expertise, her experience of leading the largest financial disputes and multinational investigations and her skills in devising preventative measures and conducting internal investigations for corporates.

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