Director liability for non-disclosure during due diligence

There has been something of a nagging question about Sale and Purchase Agreements and due diligence and associated warranty issues.  In part, this arises out of the desire (of most vendors) to ensure that the warranty coverage in the SPA is the full extent of the vendor’s liability for matters arising out of the SPA.  This approach makes sense where the purchaser is a commercial a party that has had an opportunity to conduct a due diligence inspection.

Last week a number of pigeons came home to roost in the shape of a Court of Appeal decision Sullivan v Wellsford Properties Ltd [2019] NZCA 168 – overturning an earlier High Court decision, holding a company director personally liable for the non-disclosure, in due diligence, of some material information.

Background

At the heart of the case was the sale of a commercial property development that included shops and service station. 

The SPA was a modified form of the ADLS Agreement for Sale and Purchase of Real Estate – and included a due diligence condition.

During due diligence, the purchaser made various enquiries including enquiries about OPEX and the extent to which OPEX was recovered from the tenants.  In response, the vendor disclosed a shortfall in the recovery of OPEX from the tenants – which generated a price adjustment.

After the purchaser declared that the due diligence condition in the SPA had been satisfied, but before settlement, the purchaser became aware that the service station had challenged its OPEX allocation for the previous financial year.

The purchaser settled the OPEX dispute with the service station after settlement – on the basis that the service station would pay less OPEX.

And it became clear that the vendor had been aware of the service station’s challenge to the OPEX allocation for some time (i.e. during the sale negotiations).

High Court

The purchaser later claimed against the vendor and its director for the diminution in the value of the property caused by the reduction in the earnings from the property.  That claim was dismissed by the High Court. 

In particular, the High Court judge found that the purchaser had simply not asked the right questions to trigger an obligation on the vendor to disclose the OPEX dispute.

The High Court also dismissed a claim for personal liability on the part of the director under the Fair Trading Act 1986 on the basis that the relevant statements had been made by the vendor (i.e. the company) and its agents and not by the director personally.

Court of Appeal

Overturning the High Court judgment, the Court of Appeal held that the vendor was liable for non-disclosure of the service station’s challenge to the OPEX allocation under the due diligence condition in the SPA (i.e. breach of contract).  In doing so, the Court of Appeal found that the High Court judge had interpreted the due diligence obligation too narrowly and had applied it in a commercially unrealistic manner.

The Court also found the vender company liable for misleading and deceptive conduct under the Fair Trading Act.

Personal liability

Most importantly, the company director was also held to be personally liable under the Fair Trading Act for his role in the failure to disclose the dispute with the service station.

The Court of Appeal stated that its approach to the question of personal liability was on the basis that the director was not acting on his own account – but rather, as a shareholder of the vendor and its sole director, he was acting on its behalf.  That raised the question of whether his conduct was “in trade” for the purposes of the Fair Trading Act. 

Relying on earlier authority, the Court added that this was a matter to be interpreted broadly – and could not be limited just to individuals trading on their own account.  Instead, a company director may be acting “in trade” for the purposes of (section 9) of the Fair Trading Act even if they are only acting as an agent and director of a company.

Again, relying on earlier authority, the factual issue of whether the director’s conduct was “directly and causally” involved in the misleading and deceptive conduct, was answered by the Court of Appeal noting that the director in this case:

• was closely involved in the dispute with the service station about its OPEX allocation – correspondence was sent to him and he had supervised the response;

• was directly involved in the sale process generally and, more particularly in the purchaser’s ongoing efforts to clarify the position relating to the OPEX shortfall; and

• accepted, in cross-examination, that he was responsible for not disclosing during the due diligence the emails that had been received from the service station raising issues with the OPEX allocation – on a number of occasions in his evidence he emphasised his understanding that, because the purchaser had not specifically asked whether the allocation of OPEX had been formally disputed, there was no need to disclose the correspondence (and had also not disclosed that because the service station had not paid its OPEX wash-up invoice – it was in default under its lease).

As a result, the Court held that “By our assessment, that narrative establishes that [the director] was directly and causally involved in [the vendor’s] misleading and deceptive conduct.

The outcome was a damages judgment of $424k (being the capitalisation of the reduction in net earnings caused by the lower recovery of OPEX from the service station).

Concluding comments

The Court of Appeal judgment again demonstrates the reach of the Fair Trading Act as an important add-on for contract claims – and claims against persons who were not a party to a SPA.

Also of note is the warning for directors that:

• liability for misleading and deceptive conduct can be triggered by the failure to disclose relevant information – when there is an obligation to do so (i.e. when providing access for due diligence and/or fielding questions about the due diligence material); and

• the requirement for a section 9 Fair Trading Act claim that the respondent be acting “in trade” can extend to directors acting as agents for a company.

Finally, the Court of Appeal judgment underlines my long held view that an argument about a material matter affecting the prospects of a business being be sold, along the lines of:

“it was hidden in the long grass – but we didn’t think we needed to tell them about it because we don’t think they looked hard enough to find it”

is likely to be deeply unattractive to a New Zealand Court.  This is particularly the case when, despite the fact that the vendor had provided information for due diligence purposes, the vendor had a (very usual) obligation in a SPA to confirm that all information provided by or on behalf of the vendor was true, complete and accurate in all material respects and not materially misleading when given (and continued to be as such at settlement).

Further information

If you would like more information about any of the matters discussed in this note, please contact me.