Business Sale Disputes: Misleading or Deceptive Conduct

0:00
You're listening to Explain That by Velocity Legal, the podcast that keeps business owners and professional advisers ahead of the curve in an ever-changing legal landscape.

Business sales are often negotiated based on optimism and future opportunity.

0:17
However, what happens when a purchaser discovers that the business wasn't all it appeared to be? Or perhaps economic circumstances change?

This episode explores misleading or deceptive conduct in business sales. To unpack this topic, I'm joined by Jess Hill and Leo Crnogorcevic from Velocity Legal.

0:36
Welcome, guys.

Thanks, Andrew.

Thank you.

Leo, there's a bit to unpack in this topic. As a disputes lawyer, I know this has come across your desk many times, disputes between a purchaser and a vendor for a business, and the purchaser essentially claiming that they were deceived.

0:57
Yeah, correct. It's quite a common manifestation of misleading or deceptive conduct, which is a type of conduct that's prohibited by section 18 of the Australian Consumer Law, or the ACL, which states that a person must not, in trade or commerce, engage in conduct that is misleading or deceptive, or is likely to mislead or deceive.

1:19
So it's a broad section. I remember learning it in university back when it was the Trade Practices Act.

Correct.

But essentially, it's a prohibition on misleading and deceptive conduct in commerce.

Yeah. In any sort of supply of goods or services, and it sort of acts with two limbs.

1:41
Section 18 prohibits that conduct, and then section 236 provides that a person who has suffered loss or damage by reason of that conduct is able to recover that by an action for damages.

There's a limitation period of six years for such claims, and there are some important provisions and court authorities that provide guidance about how some of these tests are applied.

2:13
But I'm sure we'll get into that throughout the episode.

It's an interesting one for me because, as a commercial lawyer, I think, okay, well, if someone has a claim when selling a business, I'd start with the contract of sale and the contractual claims.

2:31
But Jess, I'm sure those are important as well. Why misleading or deceptive conduct? Why not breach of contract?

It's an interesting question, and you raise an interesting point. Often, it's a claim that's both for misleading or deceptive conduct and also some kind of breach of contract, typically a warranty.

2:52
So these claims often run side by side with, okay, I've got this misrepresentation, I was misled in some way and that's had a consequence for me as the purchaser. Then alongside that, you've breached this warranty.

So warranties are effectively contractual promises.

3:09
They're very common in a sale of business, where the vendor usually provides a whole series of warranties around the business, that it's not in litigation, that it doesn't have any claims, that it's profitable, that it's running within compliance of laws, all of those typical things.

3:27
And when there's been some form of misleading or deceptive conduct, it's usually the case that there's also been a breach of warranty. So they often get run side by side.

Yeah. Leo, Jess has talked about breach of warranties, some statement in the contract that something's true or not true, and it turns out not to be that way.

3:50
But what are the kinds of things, in the context of a dispute where a purchaser has bought a business and they're disputing something with the vendors, that would be in this realm of misleading or deceptive conduct?

There are a number of aspects that may constitute misleading or deceptive conduct in the context of a sale of business.

4:26
There could be undisclosed liabilities on the part of the vendor, for example, trade creditors who have not been disclosed.

It's also possible that business revenues, profits or prospects for growth in the future have been overstated. Financial statements could be inaccurate in general, which will also likely be misleading or deceptive conduct.

4:43
But broadly as well, it's important to note that certain strategic issues, for example, a loss of a key supplier or a key client to a business, if an issue like that is not disclosed, that could also be misleading or deceptive conduct.

5:01
So as will become apparent from our discussion today, there's a requirement not to give positive instances of misleading or deceptive conduct, but there's also a negative obligation there as well.

5:18
You can't withhold information that's important.

Well, let's run with that example, Leo. Let's say all financial statements are correct and there's no warranty on this point. But perhaps we know that some key supplier or key customer has said, look, I'm going to take my business elsewhere or something of that nature.

5:42
It hasn't been picked up. So let's run with that example.

I guess the concept of caveat emptor, I think that's the Latin term for it. If it's not, I'm going to run with it anyway. But buyer beware. To what extent, Jess, can we rely on that principle of buyer beware versus a positive obligation? Where is the intersection between the two?

6:11
It's a fine line, and it's often difficult to find exactly where that is.

Obviously, from the vendor's perspective, you want to sell the business at the best value you can get and on the best terms you can get. From the purchaser's perspective, there is an obligation on you to do your homework, to do your due diligence and ask the right questions.

6:31
The issues arise often where the question has perhaps been asked in some form but not interrogated, or the question just hasn't been asked at all, and the vendor is aware of something that would materially impact the business.

6:48
So it typically is about big things. You know, one of your key customers, maybe they're 20% of the business, and you know they're going to leave once settlement goes ahead. Do you have an obligation to positively tell the purchaser that?

And it's difficult, because obviously it may well mean that your business is worth less, and you don't want to get less value for that business.

7:13
You think that you would be able to make it up with other clients, and so you don't think that maybe it's going to have as material an impact, but you think the purchaser is going to be worried about it. So you don't tell them about it.

Have you been misleading or deceptive by omission, effectively?

You then have to go back to, okay, what representations were made by the vendor?

7:37
Did you say, these are all our customers, and this one is 20%, and this is all the work that we get from them, and they're locked into a contract until the end of June? Then you left out, well, they've already told me actually that they're not going to continue on.

7:56
Then you probably do have a positive obligation to tell the purchaser that you know something that is materially going to make the representations you've made, or lack of representations, untrue.

If you don't know that, if you just know that you've got this customer that's 20%, you have no idea what their plan is and you haven't asked the question, do you then have an obligation as the vendor to go and make enquiries about it?

8:21
No, you don't.

So it's that fine line between if you've got knowledge that's going to impact the person's decision and you're choosing not to share that knowledge because it's going to impact you, usually financially, then it's a difficult question.

8:39
The reason most people get around it is by doing due diligence and putting together usually a data room or something along those lines, where all of the information can be shared.

Now, that can have its own risks and we'll maybe talk about that in a minute, but that's often the way that people get around it, to give all the information you can possibly give to the purchaser and then say, okay, you sort it out, you go through it, it's all there.

9:06
Everything you want is available for you, and you've got to do your own homework. If you ask me some specific questions, I'm not going to tell you anything that's untrue, but equally, you've got to go through your own due diligence.

The fine line that Jess speaks to is reflective of this tension that's inherent to this intersection between business sales and misleading or deceptive conduct.

9:30
Because on the one hand, the courts recognise that private parties have entered into a contract, and vendors are not required to explain every conceivable business risk, which is the wording used in Whittall and Philaria.

9:47
But there's also, on the other hand, the protective regime that the ACL creates that safeguards the public interest.

So the courts look at a number of factors to determine whether this was a case of one party not doing their homework and not carrying out their due diligence in the way that they should have, or whether it was something more sinister on the part of the vendor.

Usually, have they not disclosed something they should have, or have they provided false information as part of the transaction?

10:18
Yeah, I sort of contrast it to the property experience, where I don't have the sections in front of me, but if you sell a property, you've got all this stuff you've got to fill in about anything you know about the property. Basically, it has to be disclosed.

Whereas I guess in the sale of business context, it's probably a bit more nuanced than that.

10:40
Leo, a question I wanted to ask you. Does it matter if it's a small business transaction or a larger business transaction? Do you think that's a factor that is relevant in this discussion of how much do we need to disclose versus letting them ask the questions?

10:57
Yeah, I think it is a good question through which to analyse this type of claim.

In one aspect, the courts perhaps may give a bit more leeway to smaller businesses in terms of information that's provided.

11:17
They may expect, in a larger sale, more sophistication. There's more of an expectation that that business is across its financials.

But equally, it could have the opposite effect in terms of this type of claim.

11:38
If we go back to that major client leaving example that we talked about a little earlier, a major client for a small business, their departure could be a much more significant event for a smaller business compared to a larger one.

11:58
So the quantity or threshold of things happening to that business that may have to be disclosed perhaps could be much larger for smaller businesses compared to larger ones.

So again, these factors are nuanced and could cut either way.

12:16
I think that's a good segue into what I was going to ask you about. Okay, well, let's say there is some misleading or deceptive conduct or alleged misleading or deceptive conduct. What then?

12:32
My rudimentary understanding of disputes is that generally then you need to go to, okay, well, what's my loss from it?

But Jess, how do the courts consider loss and reliance?

It's always an interesting one in terms of misleading or deceptive conduct because you end up effectively working through often what we call the counterfactual.

12:58
So often loss is determined by, well, if I'd known this information, what would I have done differently?

It can be quite challenging to work through that exercise in terms of a business sale, because is it that I wouldn't have bought this business at all, or I would have paid less for it, or I would have negotiated different terms within the contract that protected me against these things?

13:24
It's often really easy to work through that exercise when it's something like financials.

There was a case last year where there was some information that was really pertinent to calculating the EBITDA. That information was put into the data room, but no attention was called to it.

13:44
So it was in the data room, it was available for the purchaser, but it wasn't called to their attention. And it was directly tied to value, to how much someone is paying for this business.

So in those circumstances, it's very easy to say, okay, well, we had a formula, a multiple, this information means that what I should have paid was less.

14:05
I want the balance between them.

That's quite an easy exercise. But if it's a question of that customer leaving, what is that loss? It can be a more challenging exercise because would I have bought the business?

14:21
Maybe I would have anyway. Would I have put some other safeguards around customers and some warranties around that? Perhaps that would have been the answer. Could I have just paid a little bit less?

And then, of course, you've got the mitigation point. You've always got to mitigate your loss.

14:37
Could I pick up other customers, which means that in fact that gap is not as big and I haven't actually suffered as much loss?

So the counterfactual can often be quite a challenging exercise in misleading or deceptive conduct. It's not always as simple as I've been misled, there's loss, I'm entitled to it.

You may well be misled, but there's no loss.

14:58
And so, you really need to work through what that counterfactual is.

I presume for a purchaser they're probably saying this is the game-changing issue. They wouldn't have bought the business, they would have paid $1.00 for it, etcetera.

Correct.

15:13
And parallel to the question that arises from this consideration of loss is also the question of reliance.

How definitively can we say that the purchaser actually relied on these misleading or deceptive representations, for example, in purchasing the business?

15:35
Can we say that this is what caused them to purchase the business?

Perhaps there were 10 representations, none of which were accurate about the profitability of the business, but one of them was misleading or deceptive. It's again tricky for the court to work out to what extent the prohibited conduct caused the loss.

15:58
So essentially you're saying if you're the vendor in that type of situation and a claim comes along, one of the questions will be, okay, even if there's something that's arguably misleading or deceptive, and even if it's arguable that it might have affected the bottom line, did you even rely on it in the first place?

16:15
Correct.

Yeah. And that can also be a challenging exercise for both parties to work through. How much reliance was there on it?

From the vendor's perspective, they might say, well, you've never mentioned this before. It wasn't an issue.

16:30
You weren't asking a whole lot of questions around it. It wasn't critical to your decision-making. You were going to buy the business anyway. You were going to pay that amount anyway.

You've now come up with this because maybe the business isn't doing as well as you thought it was going to be, or it's not as profitable as you thought it was going to be.

16:45
And so now you've come up with this and said, well, there's this one point that's misleading. I'm entitled to my damages. But how much reliance was there really?

From the purchaser's perspective, you're going to say it was the critical issue, and I never would have bought the business in the first place if not for this, or I would have paid a lot less for this business because it's worth a lot less.

17:09
It's often an issue that we see where there might be some form of earn out. So the purchaser is still involved in the business, the vendor is still involved in the business, and there's a handover period where everyone is involved, but the vendor's not driving the ship anymore.

17:28
It's being driven by the purchaser.

They don't want to.

Well, and maybe the business isn't doing as well as it was under the vendor.

Then it gets into this really nuanced conversation around, well, okay, maybe this thing was misleading, but also, how have you managed the business?

17:43
Have you been mismanaging it? Have you put on all these costs? And then what is your loss really?

So it's an area of a lot of tension, and it's often not a straightforward exercise to work through.

Yeah. Leo, from a practical perspective, what can vendors do when they're selling a business to potentially reduce their risk of a purchaser later coming along and saying, you know, you've misled me?

18:13
It sounds really obvious, but ensure that all the financial statements and other information you provide to the purchaser is accurate.

If you feel as though your books and records might not be in the best shape, speak to an accountant to audit them or to have a look if there's a way to clean up those records so when they are provided to the other side, they're accurate.

18:40
Vendors should also consider whether any representations that have been made during the course of negotiations need to be qualified, or whether any disclaimers need to be made.

This is a factor that courts consider when engaging in that exercise of determining whether something is indeed misleading or deceptive conduct.

19:04
Is it a case of the vendor making a really bold statement, or is it one that was nuanced and qualified, which put the purchaser on notice that there may be risk as part of the transaction?

19:21
Yep. Jess, what about from a contractual drafting perspective?

There's always a tension, and you certainly can't contract out of the ACL. That's not something that you can do, although many people have tried.

But there are certain disclaimers and things that you can put in there that try to limit your risk from both perspectives.

19:44
From a vendor's perspective, you would want to have in there some statements around things that are in the data room. You are understood, from a purchaser's perspective, to have read and understood them. You've had access to all of the relevant information.

20:01
The warranties that we're providing are subject to that data room, subject to what is in there.

Now, of course, you still need to be calling those things out for the purchaser, but if you can put it all into a data room and then say, well, everything is in there.

20:19
You're aware of it, you've read it, and you're giving some positive confirmations that both parties are acknowledging that. That can really help.

Making sure that you go through your warranties from a vendor's perspective and really go through them with a fine-tooth comb, and make sure that there's nothing in there that is untrue.

20:35
And if you have warranties in there that are too strong, that you can't say quite that definitively, qualifying that at that point in time and again calling it out. Why are you qualifying it? You're qualifying it because you've got this concern or that concern.

The more information you provide as a vendor, the more protected you are.

20:57
For example, if your financials are in pretty bad shape and you know that, well, you can say, these are the financials, but they're not prepared in accordance with the accounting standards. They're only prepared in accordance with my standards.

21:14
And I know that they're not compliant. Then it's on the purchaser to say, okay, well, I want to do my own exercise to work through that, or I'm comfortable with it, I can live with it.

From the purchaser's perspective, you want to make sure that there are warranties.

21:31
The warranties are as robust as possible, but also you typically want to have a clause in there that says any representations that have been made to me throughout the process are captured.

So there's no disclaimer that says something that's happened prior gets extinguished by signing the contract.

21:52
You want to keep that in.

So there's always that natural tension between the purchaser and the vendor. This is where we as commercial lawyers spend a lot of our time going back and forth and trying to find that balance of, okay, has everyone got enough certainty?

Does everyone know what they're buying, but also that you're not exposed to an unpalatable level of risk on either side?

22:15
Leo, we've been talking about business sale disputes and misleading or deceptive conduct. If I could go to you for one takeaway from this discussion, what would your number one takeaway be?

My number one takeaway would be the fact that silence can also constitute misleading or deceptive conduct.

22:34
It need not be a positive representation that was made, but rather a lack of disclosure about something.

The Court has very clearly said that mere silence, without more, is unlikely to constitute misleading or deceptive conduct.

22:51
However, if a person remains silent and the circumstances are such as to give rise to a reasonable expectation that something be disclosed, then that lack of disclosure can be misleading or deceptive.

23:08
Don't assume silence is okay, and maybe get some advice at that point.

Correct.

Jess, one takeaway from you?

Typically, when we see these kinds of disputes arising, it is around the financials and the value of the business.

There are other things that agitate purchasers, but it typically is around the value of the business, and is the business really worth what the vendor is saying it is worth?

23:35
And so, if you're going to invest time as a vendor in making sure that the information you're disclosing to the purchaser is accurate and fulsome, and to the extent that you know anything that might make any of that inaccurate, putting that to them.

There are some other things that you might be able to sort of skirt around and not talk about.

23:58
And if the question doesn't get asked, you maybe don't need to answer it. But when it comes to financials, and particularly if those financials are tied to some kind of metric for value, like an EBITDA metric or an EBIT metric or something like that, that's the number one area that people are going to dispute.

24:14
If they've bought a business that's not worth what they think it's worth, that's where they're really going to go hard on potentially a claim.

So it's important from a vendor perspective to make sure that is all accurate. Even if the purchaser is making the assessment about what the multiple is or how the value is determined, at least they're working off a base of accurate financial information.

24:41
From a purchaser perspective, do your homework. Just don't sit back and say, well, the vendor's told me this, therefore it must be. Do your own homework. Get your own accountant and get them to run the numbers.

Make sure it all stacks up. Yes, okay, you might have a claim for misleading or deceptive conduct, but it's going to cost you a lot more time and stress.

You don't want to be running through the court system if you don't have to, when you could have just done your homework in the first place.

25:06
Better off just aborting the business sale at that point rather than going down that path.

Correct.

Jess and Leo, I wanted to thank you so much for being part of this episode.

I encourage any listeners, if they have any questions, particularly regarding a business sale dispute, contractual breach, misleading or deceptive conduct, to reach out to either Leo or Jess.

25:27
Thanks once again.

Thanks, Andrew.

Thanks, Andrew.