Rescission – When is a contract not a contract?

When there is a serious misrepresentation – Caroline Graham tells the cautionary tale of Erlson Precision Holdings Limited v Hampson Industries plc.

Background

In any business sale there is always much discussion between the seller and the buyer as to what risks the buyer will bear and how much protection the seller will afford the buyer. However, once the contract is signed few would expect that the entire transaction could be retrospectively cancelled by the courts. This is exactly what happened in the case of Erlson Precision Holdings Limited v Hampson Industries and sellers should take note.

Facts of the case

In June 2010, Hampson Industries plc sold the shares in its subsidiary HPA Limited to Erlson Precision Holdings Limited. The share purchase agreement excluded the buyer’s right to bring claims for negligent misrepresentation, but not for fraudulent misrepresentation.

A matter of hours after the share purchase was completed, Erlson became aware that a key customer of HPA Ltd had notified the company some months previously of its intention to terminate their business relationship and to place no further orders with the company. This information rendered substantially incorrect various income and customer forecasts which had been provided to Erlson over a period of some 10 months prior to the transaction. In fact, Hampson Industries had gone to some trouble to ensure that Erlson did not learn of these developments, including requesting the relevant customer to keep the information confidential.Hampson’s CEO did not inform Erlson, despite having numerous opportunities to do so.

Upon becoming aware of the relevant facts, and realising that the income and customer forecasts upon which it had relied were incorrect, Erlson very quickly notified Hampson that it wished to rescind the contract. Speed was of the essence here, since the buyer’s rapid communication prevented Hampson from asserting that Erlson had affirmed the contract after becoming aware of the misrepresentation.

The matter came to court and Erlson’s right to rescind the contract was confirmed. Hampson sought leave to appeal, but the parties settled soon afterwards.

While it is fair to say that the case turns on rather particular facts, and that the buyer’s quick reactions were key to the success of its claim for rescission, the principles set out in the case have a wider relevance in the mergers and acquisitions context.

What does this mean for those involved in mergers and acquisitions?

When negotiating the terms of a share purchase agreement, a seller’s advisers should seek, so far as possible, to minimise the protection it gives the buyer and in particular to exclude liability for misrepresentation. Whereas a claim brought by the buyer for breach of a contractual warranty, or under a specific indemnity in the share purchase agreement, will be for financial damages, a successful claim of misrepresentation may entitle the buyer to require the rescission of the contract, as happened in this case.

Most sellers will be unwilling to risk this on-going level of uncertainty. In the case of most share transactions, many conversations will have taken place, both formal and informal, between the parties, before the buyer commits to the transaction. Unless the share purchase agreement specifically excludes claims for misrepresentation, such a claim may be brought in relation to any statement made prior to entering into the contract, upon which the other party relied.

For this reason, share purchase agreements often include a term precluding the buyer from bringing a claim for misrepresentation against the seller, but such a clause is ineffective where the misrepresentation is fraudulent.

However, this case suggests that sellers’ advisers should also seek the inclusion in share purchase agreements of a clause confirming that the purchaser has entered into the contract in reliance solely on the warranties set out therein, and has relied on no other representation made by the seller. It would also be wise to for sellers to ensure they track any representations made to the buyer, especially as the buyer might not accept a seller’s request to include such an exclusion, either from the off or shortly before signing.

Conclusion

The seller will be treated as one corporate entity and so it is imperative that the seller’s deal team has access to all relevant information, even if that is traditionally held only by senior management.

In addition, although a misrepresentation can in certain circumstances give rise to a claim for rescission, the making of misleading pre-contractual statements may also support a claim for monetary damages for deceit. It is clearly important to most sellers, therefore, that there should be clarity as to which statements have been relied upon by the buyer; extensive negotiations usually precede the agreement of the final suite of warranties and indemnities in any share purchase agreement and it is unacceptable to most sellers that, in effect, every pre-contractual statement may be treated as an additional warranty.

For this reason a clause excluding rescission as a remedy is insufficient. The share purchase agreement should clearly state that the buyer is entering into the contract in reliance on the warranties and on no other representation made by the seller, whether prior to or at the time of the agreement.

There are other reasons besides the risk of a claim for rescission why sellers should be cautious about making pre-contractual representations which may not be correct. Under section 397 of the Financial Services and Markets Act 2000, making such a representation may be a criminal offence. Even where the clauses we recommend above are included in the agreement, this serious risk remains.