Fraudulent misrepresentation and rescission of a share purchase agreement
The case earlier this year of Erlson Precision Holdings Ltd v Hampson Industries plc highlighted a key issue for sellers in relation to disclosure and the temptation to conceal bad news from a buyer.
Erlson Precision Holdings Ltd (the "Buyer") entered into a share purchase agreement with the Hampson Industries plc (the "Seller") under which it agreed to acquire a subsidiary of the Seller (the "Target"). The sale was negotiated by the Seller’s finance director and the interim managing director of the Target and, as part of its due diligence, income and customer forecasts were provided to the Buyer. These forecasts included anticipated growth in demand from a major customer of the Target (the "Key Customer") who represented between 34% and 40% of the Target’s annual turnover. The sale process started in summer 2009 with the circulation of an information memorandum and, over time, additional information (including customer forecasts) was provided to the Buyer. In April 2010, just after the parties agreed the final terms for the sale of the Target, the Key Customer informed the CEO of the Seller that it was terminating its supply arrangement with the Target. This information was not passed on to the team negotiating the sale who continued to provide the Buyer with forecasts and other information reflecting an on-going relationship with the Key Customer. Formal written notice terminating the supply agreement was given by the Key Customer on 22 June 2010. The sale completed on 23 June following which the team negotiating the transaction learnt of the Key Customer’s written termination and promptly informed the Buyer.
The sale and purchase documentation did not include warranties concerning forecasts or customers hence the false statement in the forecasts and related documents did not amount to a breach of warranty. Equally, the agreement included a standard boilerplate exclusion (or entire agreement clause) concerning actions based on innocent or negligent misrepresentation. This meant the Buyer’s principal remedy was to bring an action for rescission on the grounds of fraudulent misrepresentation.
It is a well-established principle of English law that where a person has been induced to enter into a contract as a result of the fraudulent misrepresentation of the other party, the first party may rescind that contract, claim damages or both. Equally, under English law, fraud requires an intention to deceive. Rescission is the retrospective avoidance of a contract with the result that the contract is deemed never to have been made. Accordingly, the shares would re-vest in the Seller who is obliged to repay the consideration paid for those shares. Certain actions may annul the right to rescind, for example if the party claiming misrepresentation affirms the contract/acts in a way which is inconsistent with its intention to rescind (for example, it tries to sell the asset it acquired as a result of the fraudulent misrepresentation) or it is not possible to restore the parties to their original position (for example, the company has entered into new contracts or undergone a reorganisation). Delay in rescinding a contract after discovery of the misrepresentation can also negate the right to rescind.
The judge concluded that, while the CEO had not himself given the erroneous forecasts to the Buyer or instructed anyone else to provide them to the Buyer, he knew (i) the forecasts had been provided to the Buyer and (ii) they were wrong and contained misleading information. Effectively, he kept silent about the termination notwithstanding the fact that he knew the Buyer would reply on the erroneous forecasts.
Accordingly, the judge ruled that the Buyer was entitled to rescind the sale and purchase agreement for fraudulent misrepresentation.
Rescission of an agreement to transfer shares or a business following completion is rare and, given the unique nature of this case, namely the fact that the misrepresentation came to light within hours of the agreement completing and, within a week, the right to rescind had been exercised, this is unlikely to change. However, it highlights the fact that there is a positive obligation on key individuals within a firm to correct misleading information which a third party acquirer is relying on even where the person who has such information is not directly involved in the sale process. The "Nelsonian blind eye" is not a defence in such a scenario.
Interestingly, the matter ended with the Seller appealing and the parties subsequently settling on terms whereby the Buyer retained the Target but was paid a lump sum by the Seller. In effect the fraudulent misrepresentation claim gave the Buyer a negotiating position from which it could agree a settlement for breach of warranty, notwithstanding the fact that the forecasts fell outside the contractual warranties.
A final point for sellers to be aware of is that making an incorrect pre-contractual representation may amount to a criminal offence under section 397 of the Financial Services and Markets Act 2000, notwithstanding any contractual provision in the sale documentation which excludes liability for misrepresentation.