A recent decision of the Federal Court (Optic Security Australia 2 Pty Limited v YC Investments (NT) Pty Ltd [2023] FCA 49) regarding a dispute between a buyer and a seller in a mid-market M&A transaction has attracted widespread interest.
At the centre of the dispute was –unsurprisingly – the purchase price, although the issues before the Court took the form of claims made by Optic Security Australia 2 Pty Limited (Buyer) that the Seller has engaged in misleading or deceptive conduct under the Australian Consumer Law (ACL) and breached contractual warranties in the Share Purchase Agreement (SPA) in respect of forecast earnings of the target entities known as the STS Group.
YC Investment (NT) Pty Ltd (Seller) has counterclaimed for $1.35 million under a side letter relating to a purchase price adjustment amount (Adjustment Amount). Justice Charlesworth found that the Buyer has not discharged the burden of proof in respect of its claims, while the Seller’s cross-claim was allowed with interest and costs.
The case serves as a reminder to both sellers and buyers that warranty claim regimes in M&A agreements deserve close attention during transaction negotiations and post completion warranty enforcement period. Read on below to learn from someone else’s mistakes (which, as they say, is cheaper than learning from one’s own).
Details
Following a M&A due diligence process, the Buyer had acquired from the Seller shares in the STS Group which included Security & Technology Services (NT) Pty Ltd (STS-NT), an entity that had a multimillion-dollar subcontract with a builder in relation to the construction of security-related communications facilities at the Royal Australian Air Force Base Tindal in the Northern Territory (Tindal Subcontract).
The purchase price for the acquisition was calculated with reference to, among other things, the forecast earnings of STS-NT, which in turn depended on the forecast gross profit margin and forecast net profit margin (Forecasts) from the Tindal Subcontract. The Seller had given warranties to the Buyer in respect of the Forecasts and other disclosure materials under the SPA.
The share sale was completed in November 2018, with the payment of the Adjustment Amount deferred. However, in the course of 2019 the profitability of the STS Group in general and the Tindal Subcontract in particular was brought into question. The Buyer failed to pay the second instalment of the Adjustment Amount which had become due and payable on 30 June 2019, and the Seller issued two letters of demand in October 2019. On 17 May 2020, the Buyer served a warranty claim notice on the Seller, commencing the proceedings against the Seller in November 2020.
Misleading or Deceptive Conduct under the ACL
The claim for misleading or deceptive conduct under section 18 of the ACL was based on various representations in respect of the Tindal Subcontract, STS-NT’s and STS Group’s gross profit margin allegedly made by the Seller during the due diligence process. All of these representations were ostensibly with respect to ‘future matters’. Under section 4 of the ACL, a representation is taken to be misleading if:
a person makes the representation with respect to a future matter; and
the person does not have reasonable grounds for making the representation.
While the Buyer alleged that the Seller’s ~31% gross profit margin forecast from the Tindal Contract was made without any reasonable grounds, Charlesworth J repeatedly noted ‘the paucity of evidence’ [132, 299] tendered by the Buyer to support its claims, failure to call critical witnesses and experts (from which adverse inference was drawn), and the finding that the one witness that did get called by the Buyer was ‘careless’ [164] and ‘unimpressive’ [289], among other things.
On the other hand, the Seller not only called the appropriate witnesses, but their evidence was also preferred to the Buyer’s one by the judge and that has of course given the Seller a significant forensic advantage. This suggests that had the Buyer’s case been more carefully run, the outcome of the proceedings may have been very different, i.e., the warranty claims could have succeeded in principle.
Interestingly, there was also a finding that a contractual time bar on the warranty claims in respect of the SPA warranties did not apply to a claim alleging contravention of the ACL, reiterating the decision of Riordan J in Brighton Australia Pty Ltd v Multiplex Constructions Pty Ltd (2019) 56 VR 557 to the effect that ‘any contractual provision that temporarily limited an applicant’s remedy under the ACL would be contrary to public policy and therefore void’ [253].
Breach of Contractual Warranties in an M&A
The Buyer in the M&A process also alleged there was a breach of contractual warranty as the material provided during the due diligence process was in contravention of the warranty in the SPA that the information in the Disclosure Materials so far as the Seller was aware would be ‘true, complete and not misleading or deceptive whether by omission or otherwise’; and where consisting of opinions, expectations or beliefs, would be ‘honestly held and arrived at on a reasonable basis’ [254].
The warranty regime in the SPA contained, among other things:
- an indemnity by the Seller in respect of Loss suffered by the Buyer arising directly from the breach of a Seller warranty; and
- a notice provision in clause 13.5 of the SPA requiring the Buyer to notify the Seller ‘of any Claims’ it had against the Sellers ‘as soon as practicable after it becomes aware of it’, where ‘Claim’ was defined to mean ‘any allegation, debt, cause of action, Liability, claim, proceeding, suit or demand of any nature whether present or future, fixed or unascertained, actual or contingent, whether at law, in equity, under statute or otherwise’ [261] – [262].
In response, the Seller pleaded that the breach of warranties cannot be enforced because of the operation of the time bar in clause 13.5.
Here again, unfortunately for the Buyer and fortunately for the Seller, the testimony of the Buyer’s only witness – Mr Strathdee – contained an admission to the effect that ‘I believed I had a warranty claim well before November 2019’ [290] that the judge later referred to as ‘unguarded evidence’ [293], which should be taken ‘at face value’ [278], while the testimony overall contributed to ‘an impression that Mr Strathdee was at times evasive and carefully rehearsed’ [292]. The time gap between ‘well before November 2019’ and the Buyer’s eventual notice of claim issued in May 2020 suggested that the ‘as soon as practicable’ threshold was not met by the Buyer. Charlesworth J found that:
the obligation to notify of a “Claim” arises when the ‘Buyer comes to believe (rightly or wrongly) in the existence of facts and circumstances that, if true, could properly found an allegation of breach‘ [273]; and
the phrase to ‘as soon as reasonably [sic] practicable’ does not permit delays referable to the Buyer ‘obtaining authorisation to sue or gather sufficient evidence to form a view about prospects of success on [sic] such a suit or any other matter affecting the willingness or ability to commence legal action‘ [295].
Moreover, the fact that Mr Strathdee was ‘legally qualified and a highly experienced businessman’ [277] was also held against the Buyer in this context, especially as there was evidence tendered by the Seller that Mr Strathdee had verbally exerted pressure on the Seller’s representatives in late 2019 or early 2020 saying words to the effect that ‘if Mr Ireland was not prepared to put [$1 million] of capital back into the company, he would personally make Mr Ireland’s life “hell” and that he would take whatever means were necessary to “destroy” Mr Ireland’s future‘ [282].
As a result, the judge held as follows:
‘I do not accept [Mr Strathdee’s] evidence that he could not personally form a view that there existed a proper basis to allege a breach of the warranty claim [277]… he had formed a belief that the facts and circumstances supported a claim that there was a breach of warranties. That was sufficient to enable Optic2 to give notice of the claimed breach and its nature, together with the facts and circumstances said to give rise to it‘ [278].
In respect of the proof of loss, the Buyer included the following statement in its pleadings: ‘The calculation of the applicant’s loss and damage will be the subject of expert evidence’ [83, 230, 259]. However, as the judge wryly commented: “Despite the closing words, no expert was called to give evidence concerning the calculation of the alleged loss” [231]. Such forensic errors may have contributed to the Court’s finding that the Buyer’s claims haven’t been made out.
Conclusions
The case provides an illustration of the importance of paying meticulous attention to the wording of the warranty claim regimes in M&A transactions, especially as the negotiations of such regimes are often viewed by sellers and buyers as not worth their time and the domain of lawyer-to-lawyer discussions.
The Seller side in an M&A, especially, can be affected by a badly negotiated warranty regime, as the paid purchase price may often be clawed back should a warranty claim succeed. The case also emphasises that conduct of the parties in connection with a transaction, even after completion, may become subject to public scrutiny and impact the course of legal proceedings. In other words, while courtesy costs nothing, threats and other unprofessional behaviour, in writing or not, may come at a cost.
Finally, adherence to proper notice of any warranty claim and forensic preparation during an M&A and running of a case are critical to its outcome, as the Court may draw adverse inferences from failure to call witnesses or experts, among other things.
For advice on mergers and acquisitions, contact Nick Miller – [email protected]
