Due diligence – a cautionary tale (for all parties)

A recent decision from the High Court in Christchurch in Bradfields Ltd v Brookwater Investments Ltd contains some harsh lessons (for purchasers and their advisers) about due diligence.

The judgment arose out of the purchase, in 2014, by Bradfields from the vendor (Brookwater) of a business which comprised two divisions in New Zealand and Australia – the first selling ‘natural’ pet care products and the second manufacturing air freshener products.  The purchaser also claimed against the director of the vendor and the purchaser’s (then) lawyers – who advised on the acquisition.

In 2016, some 18 months after settlement of the purchase, the purchaser was told by the Australian regulators that most of the pet care products were required to be registered before they could be legally sold in Australia.  At around the same time, the New Zealand regulator gave similar advice in respect of the sale of some of the pet care products before they could be legally sold in New Zealand.  The purchaser took advice and stopped selling all of the pet care products in Australia and most of the pet care products in New Zealand.  It then brought a claim against the vendor and its director for the losses suffered.

A total of five claims were made against the vendor and its director, for breach of the Sale and Purchase Agreement (SPA), for misrepresentation, for breaches of the Fair Trading Act 1986.  The claim against its own lawyers was based in negligence.

It was clear that the registration status of the pet care products was crucial to the success of the business and therefore was of vital significance to any due diligence.  As a result, independent enquiries were required to verify the accuracy of the representations made by the vendor – and it is apparent that no such enquiries were made either by the purchaser or its lawyers.

Breach of warranty

The central claim under the SPA was that of a breach of warranty that the Vendor had not received any notice or demand and had no knowledge of any requisition or outstanding requirement [from any regulatory authority] which adversely affects the business and which has not been disclosed in writing to the Purchaser.

On this issue, the judge found that the director’s knowledge of the registration requirements was substantial and was acquired over a number of years during which he carefully conducted his business.  As a result, the judge was satisfied of two things:

(i)         that the director was on notice that a number of the products, because of their constituent requirements or their labelling or advertising claims, did require either registration with [the Australian regulator] or significant amendment to avoid registration; and

(ii)        that he was required to disclose this to the purchaser in writing (which he did not).

The Court then noted that the SPA was conditional on due diligence.  It is a necessary requirement for liability for breach of contract to establish that the breach (of warranty) caused the purchaser’s loss.  The vendor and its director argued that, because of the due diligence clause, the purchaser did not rely on the warranty.  In this regard, the Court continued that inducement needs to be gauged at the time when the SPA was declared unconditional.  

Whilst, in some cases a purchaser’s independent enquiries may bring reliance to an end (negating, for example, the effect of a misrepresentation) the Court found that the purchaser did rely on the warranty and (as laid out in further findings) misrepresentations made by the vendor and that these induced the purchaser to enter into the SPA and declare it unconditional  – and the due diligence clause neither brought that reliance to an end nor negated the effect of the  warranty (or the misrepresentations).

The Court also held that the SPA would not make any commercial sense if the business as it stood was not able legally to manufacture and sell generally unchanged pet care products.  As a result, a term could be implied into the SPA that all the pet care products were legally able to be manufactured and sold in order to give business efficacy to the contract. 

Misrepresentation

The Court upheld the claim for misrepresentation under what was the Contractual Remedies Act (now the Contracts and Commercial Law Act 2017) and rejected the defence argument that, because the issue was how the regulatory regime applies to the facts (the knowledge of which was common to both parties) and because the vendor genuinely and reasonably held the opinion that registration was not required – there could be no actionable misrepresentation.  This was because the representation was not simply one of law.  It was a representation that the business has acted properly and the products either do not require regulatory compliance or, if they did so, then compliance has been achieved.

This was simply not the case.

The Court also rejected the submission that, because of the due diligence clause, any loss incurred was not caused by the vendor (i.e. independent enquiries were to be made – and they did not rely on the misrepresentation).

Fair Trading Act

Overall, the Court found the totality of the misrepresentations which were made and the conduct of the vendor were found to be misleading and deceptive, and they were not protected by a disclaimer included in the Information Memorandum.

The Court then examine whether the purchaser contributed to the loss or damage suffered.  There were two relevant time periods:

(i)         the leadup to the SPA being declared unconditional (and settlement) – where the judge was satisfied that, even with the presence of the due diligence condition to be undertaken on their part here, it could not be said that the purchaser was blameworthy / careless in the sense of departing from the standards a reasonable person would have taken in such a transaction.

(ii)        post settlement – in which case the judge was satisfied that the purchaser did contribute to the loss in response to the regulator’s ruling that the pet care products were non-compliant – by removing them from the market and not taking remedial action (despite evidence that they had received advice that a number of the pet care products could have been reinstated on the Australian and New Zealand markets by an adjustment to labels, marketing and, in some cases, a change in the ingredients for a particular product).

The judge also rejected the vendor director’s evidence that he did not know the pet care products required registration and, because of the finding that the company was in breach of the Fair Trading Act, then the vendor was liable under the Fair Trading Act (for aiding and abetting).

The role of the purchaser’s lawyers

The judge rejected a defence submission that the lawyers’ role was a limited retainer (and that the purchaser was undertaking its own due diligence – as it had with a previous transaction).  As a result, there was a breach of the implied term in the lawyers’ retainer to use reasonable skill and care in carrying out their work. 

Instead, it accepted evidence that:

• the lawyers erred in respect of the advice provided and work they needed to undertake relating to due diligence matters and especially to legal and regulatory issues concerning continued operation of the business; and
• a red flag was raised over the Australian aspects of the business and particularly veterinary and food technician advice is crucial.

One of the problems for the lawyers’ case was, given the judge’s views about the context and the general background of the normal lawyer/client relationship – the absence of a clear statement (in writing) that their retainer was limited. 

The judge noted that the purchaser accepted they did undertake aspects of the due diligence process themselves – but they engaged the lawyers and instructed them to undertake what they describe as “legal due diligence”.  In the judge’s view, it need hardly be said that this would have included advice and work regarding the ability of the purchaser to acquire and properly operate all aspects of the business in both New Zealand and particularly in Australia (which was represented as having the greatest growth potential).

Ultimately, the judge was satisfied the standard of conduct expected from the lawyers (judged at the time the relevant work was done) was such that there was a breach of the implied term in the lawyers’ retainer to use reasonable skill and care in carrying out their retainer.  This was particularly the case in relation to the red flag over the Australian aspects of the business – and particularly veterinary and food technician advice was crucial.

The judge also devoted some time to the lawyers’ actions in respect of the solicitors’ approval clause in the SPA.  Based on the summary of the evidence – the lawyers treated this as a pro forma approval matter.  It is usually limited to having the legal implications of the transaction explored – and the lawyer would only be entitled to refuse approval if there are genuine legal objections.  Here, the evidence seemed to be that the lawyers gave the approval without (detailed) discussion with the purchaser – and there was no thought given to the lawyers’ responsibility under that approval condition (and whether they were expected to advise on the legal implications of the transaction – and the purchaser’s ability to continue to the pet care business because of regulatory issues).

Contributory negligence

Despite evidence which seems to indicate that the purchaser’s due diligence investigation was a bit of a shambles, but possibly driven by his findings that it was the lawyers who were at fault, the judge concluded that the purchasers acted reasonably in the due diligence enquiries they undertook – and if there was any deficiency in their actions this did not contribute to or cause their loss.  This was said to be particularly the case when compared to the conduct of the vendor relating to the critical matter of product regulatory compliance.

The judge was also satisfied that the presence of a due diligence clause in the SPA does not allow the vendor to simply “wash their hands” of any responsibility in warranting and representing that the business had regulatory compliance.  This, and the business’ ability to properly continue post settlement, were fundamental here.

Mitigation

The judge was satisfied that, to a degree, the purchaser did not take proper steps to mitigate the loss caused by the wrongful acts which emanated from the vendor.  The just and equitable contribution to the scale of the loss was assessed at 50%.

Is there a gap in the judgment?

There are two aspects of the decision that I find puzzling:

• the judge seemed to place a lot of weight on what was clearly a pre-contractual matter (an IM prepared by a broker) and it is difficult to know, without knowing more about the evidence and particularly the SPA, why that was not excluded from the scope of the warranties – either directly or by means of an ‘entire agreement’ clause; and
• why there was no reference to the distinction (in relation to Fair Trading Act claims) identified in Red Eagle between conduct in a business context as between people in business – as opposed to that towards a consumer.

Takeaways

Notwithstanding the comments under the previous heading, this judgment (once again) makes it clear that a would-be buyer and its advisers must assign responsibilities carefully and clearly – and whoever is responsible must undertake a comprehensive due diligence on the intended target.  This is especially the case for issues which are identified as value or mission critical.

Whilst it is always difficult to criticise a judgment without having heard all the evidence and submissions, I find the level of responsibility pinned on the lawyers quite troubling.  There was clearly a red flag issue (about the need to get technical input into the issue of the ability to sell the pet care products in Australia) but it seems that this should have been apparent to the party conducting due diligence.  If (as appears to have been the case) the lawyers were waiting for their client to complete the due diligence investigation and then come back to them – and the client didn’t, it is difficult to lay the blame at their feet.  Or at least such a large chunk of the blame.

On the basis of the judge’s summary of the evidence, it appears that the issue of regulatory compliance was only apparent to the purchaser – at which point they should have ensured that it was investigated (and should have raised it with their lawyers).  As a result, whilst it does seem clear that there should have been a clearer (documented) understanding between the purchaser and its lawyers to confirm “who was doing what” to ensure that due diligence was properly undertaken – the purchaser must shoulder a large part of the blame for failing to clearly define with its lawyers were doing in the due diligence phase.

In an increasingly service-orientated economy, verifying ownership of all (key) IP and developing a deep understanding of any regulatory/compliance issues (and limits) must be seen as mission-critical. 

And, the process element of a due diligence investigation cannot overwhelm the significance of what is being looked at/decide.  Good project management is fundamental.  But so is allocating responsibility not only for investigating an issue but also the decision making process required for determining whether an item requires follow up, deal / value protection or is even a deal killer.

Further information

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