Key takeaways

• M&A buyers should:
  • When negotiating the sale and purchase agreement – ensure that any requirements for giving the seller notice of a claim are practical, not unduly onerous, and unlikely to result in claims being barred due to procedural irregularities.
  • After completion of the sale – ensure that any claims made against the seller strictly comply with all timing and other procedural requirements specified in the sale agreement.
• M&A sellers should, when negotiating the sale and purchase agreement:
  • Be aware that contractual time limits on claims are unlikely to be effective against statutory claims for misleading or deceptive conduct.
  • Exercise caution in giving warranties regarding the accuracy of information disclosed to the buyer, particularly if the information includes forward-looking information.
  • Consider the merits of including an earn-out component in the sale price as a means of sharing earnings risk between the parties, which (i) can give the seller upside exposure to post-completion business performance and (ii) can potentially limit the exposure of the seller to a buyer claim for breach of warranty or misleading or deceptive conduct relating to such performance.

In depth

The decision

On 19 May 2023, the Federal Court of Australia published the judgment of Justice Charlesworth in Optic Security Australia 2 Pty Limited v YC Investments (NT) Pty Ltd [2023] FCA 495.

The proceedings arose from Optic Security's acquisition of the STS Group from YC Investments (and others) in late 2018. The buyer had calculated its price for the acquisition by reference to the target group's forecast earnings, which included the forecast profit margin under a significant contract held by the target. In 2020, alleging that this forecast profit margin was incorrect, the buyer claimed the seller had breached an accuracy of information warranty in the sale agreement and engaged in misleading or deceptive conduct in breach of the Australian Consumer Law.

The Court rejected the buyer's claims due largely to (i) the buyer's failure to comply with the procedural requirements in the sale agreement for giving notice of warranty claims, and (ii) insufficient evidence that the forecast was in fact inaccurate and had caused the loss claimed by the buyer. The evidentiary issues will be of interest to parties and their advisers involved in future proceedings; this alert focuses on the learnings for M&A parties at the negotiation stage or the early stages when a potential claim emerges.

Lessons for buyers

The buyer notified the seller of its claim within 18 months of the sale, and commenced proceedings within a further six months, in accordance with the specific time limits prescribed by the sale agreement. However, the Court held that the buyer had failed to comply with a separate obligation to notify the seller of any claim "as soon as practicable after it becomes aware of it".

Given the broad definition of "claim" in the sale agreement (which included "allegations"), the Court held that the buyer was aware of its claim long before it notified the seller, i.e., when a senior representative of the buyer group believed there was a basis for a warranty claim. It was relevant that the senior representative was legally qualified and highly experienced in business and that, given his position, his state of mind could be attributed to the buyer entity. The Court held that "the obligation to notify of a "Claim" does not arise when the Buyer forms the view that it would succeed in a suit for breach … [but] 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."

As a result of this failure to give notice as soon as practicable, another provision imposing a bar on proceedings became effective, preventing enforcement of the buyer's claim. The drafting of the relevant clause demonstrates how careful buyers need to be in this situation (emphasis added):

13.5    Notice and time limits on Claims

(a)    The Buyer must notify the Sellers’ Representative in writing of any Claim it has against the Sellers under this agreement (including any breach of any Seller Warranty of Claim under an indemnity), setting out reasonable details of the facts, matters or circumstances giving rise to the breach and the nature of the breach as soon as practicable after it becomes aware of it.

(b)    The Buyer may not make any Claim for a breach of a Seller Warranty or under an indemnity unless reasonable details of the Claim have been notified to the Seller.

(i)    in the case of the Seller Warranties … within 18 months after the Completion Date; and

…

(c)    A Claim … will not be enforceable against the Sellers and is to be taken for all purposes to have been withdrawn unless legal proceedings in connection with the Claim are commenced within six months after written notice of the Claim is served on the Sellers in accordance with clause 13.5(a).

On the Court's reading, if notice of the breach was not given as soon as practicable after the buyer became aware of it, "then notice will not have been given "in accordance with clause 13.5(a)" and the time bar in clause 13.5(c) will operate to preclude the enforcement of the claim."

Although the drafting is arguably open to an interpretation more favourable to the buyer, the Court's reading should serve as a reminder to buyers that courts generally require strict compliance with contractual notice procedures. Accordingly, buyers should:

• When negotiating a sale and purchase agreement – ensure that any requirements for giving the seller notice of a claim are practical, not unduly onerous, and unlikely to result in claims being barred due to procedural irregularities, particularly if these requirements can be triggered by a very broad range of "claims" such as mere allegations (as is common in M&A definitions of "claim"). Preferably for buyers, the sale agreement should expressly provide that claims are not precluded by minor procedural non-compliance.
• After completion of the sale – ensure that any claims made against the seller strictly comply with all timing and other procedural requirements specified in the sale agreement. Again, buyers should have regard to the specific meaning of "claim" in their agreement and consider whether a requirement for notice is triggered merely because their officers or other key persons are aware of circumstances amounting to a potential breach – this could occur even before the buyer has, for example, completed relevant enquiries, obtained legal advice and/or complied with any governance requirements regarding contemplated litigation.

In this case, this strict compliance with the contractual notice procedures was required regardless of whether the seller suffered a detriment as a result of the non-compliance – that is, it was a matter of contractual compliance by the buyer rather than an assessment of any detriment suffered by the seller.

Lessons for sellers

Although the seller successfully defended the buyer's claims in this case, the decision also provides some lessons for sellers in negotiating a sale and purchase agreement:

• Time limits on statutory claims: The time limit that barred the buyer's contractual claim for breach of warranty did not also preclude the buyer's statutory claim for misleading conduct under the Australian Consumer Law (ACL). Although this statutory claim failed primarily due to a lack of evidence, and the Court therefore did not need to rule on the time limit, Charlesworth J noted that she was obliged to follow existing authority that contractual time limits do not apply to remedies under the ACL (on the basis that this would be contrary to public policy).

Sellers should remember that keenly negotiated contractual limits on buyer claims are unlikely to block claims for statutory misleading conduct. However, sellers can also take some comfort that there is still an evidentiary hurdle for buyers to show that they have suffered loss caused by the alleged conduct.

• Information warranties: The sale agreement contained a warranty as to the accuracy of the material disclosed to the buyer during its pre-sale due diligence review of the target. This material included financial information containing representations about the forecast profit margin of the significant contract in question.

Although the seller was not found liable for breach of this warranty, the case highlights that sellers should be careful regarding the drafting of information warranties and the scope of the information being warranted – if the information includes forward-looking information such as financial modelling, sellers should seek to limit any information warranty to factual and historical information and ideally include an express carve-out from the warranty for forward-looking information.

• Earn-outs and forecast claims: The sale price included an "earn-out" component, under which the seller would later receive a further payment which varied depending on whether the target group's actual earnings in a given year were greater or less than forecast. The Court held that this provision weighed significantly against a finding that the buyer had overpaid for the target due to any inflation of that forecast: "In the circumstances of a contract making express provision for a payment in the event that the forecast was for any reason inaccurate, I am not prepared to draw an inference that [the buyer] relied on any misrepresented forecast to its detriment."

Although discussed in the context of the buyer's statutory claim, the same argument would likely apply in relation to contractual warranties. This is an interesting illustration that an agreement to share economic risk through an earn-out arrangement may, in practice, supersede any allocation of the same risk through financial representations or warranties. On this basis, sellers may argue that including an earn-out component in the sale price should remove the need for any earnings-related warranties, and otherwise may take some comfort that the earn-out will present challenges for a buyer arguing it has suffered loss caused by a missed forecast.

Conclusion

M&A sale and purchase agreements should always be negotiated with a clear view of the possibility of enforcement. When a potential claim arises, buyers should carefully consider their notification obligations and seek legal advice as early as possible.