Practical lessons from an English Court of Appeal case on using outside experts in due diligence exercises

Although this decision turned on the specific wording used in a sale and purchase agreement, it provides a good example of the risks for a purchaser of accepting widely drafted general disclosures against warranties given by a vendor.

In the English case, Infiniteland Ltd v Artisan Contracting Ltd 1, the Court of Appeal addressed the question of what constituted adequate disclosure where a bundle of documents containing information relevant to a sale but not linked to any particular warranty was provided to the purchaser.

The facts

The case arose from the sale by Artisan Contracting Ltd of three subsidiary companies involved in the construction industry to Infiniteland Ltd. In the sale and purchase agreement the vendor gave a warranty that the audited accounts showed a true and fair view of the profits of the subsidiary companies except to the extent set out in the disclosure letter. That letter contained a general disclosure saying that all the information contained in six files and related bundles were disclosed against the accounts warranty. The disclosure letter had been written on the basis that in advance of the letter there had been an investigation of the subsidiary companies by the purchaser's reporting accountants.

As it turned out, the accounts of one of the three subsidiary companies, Bickerton Construction Ltd, showed an accounting error in which a contribution of the parent company to Bickerton had been wrongly recognised as an ordinary trading profit, resulting in a net profit rather than a net operating loss being shown in the profit and loss account. On the due diligence by the purchaser's reporting accountants, the accountants had discovered the parent's contribution but did not pass on the information to the purchaser. Less than six months after the sale Bickerton went into liquidation.

The purchaser claimed damages for breach of the accounts warranty and the vendor defended the claim on the basis that the warranty was given subject to the disclosure letter and, that since the accountants knew about the contribution by the parent company, the knowledge of the accountant (as the purchaser's agent) must be treated as the actual knowledge of the purchaser.

The decision

What constituted adequate disclosure?

The question of whether there had been adequate disclosure on the facts was considered in light of a previous decision New Hearts v Cosmopolitan Investments2 in which it was held that, for a disclosure to be considered to be fairly disclosed against a warranty, full details of the matter to be disclosed would have to be spelt out in the disclosure letter. A mere reference to a generic source of information would not be sufficient.

The Court of Appeal rejected the concept that a standard test had been developed by the New Hearts case to determine whether or not disclosure had been fair. In its view disclosure had to be measured against the requirements of the agreement into which the parties had entered and not against the requirements of a different agreement in another case.

In the New Hearts case, the sale and purchase agreement had qualified the warranties by reference to those matters "fairly disclosed (with sufficient details to identify the nature and scope of the matter disclosed) in the disclosure letter". In Infiniteland there was no comparable requirement. The court highlighted the fact that the purchaser had effectively chosen to accept a lower standard of disclosure and relied instead on the due diligence by the accountant.

In such circumstances the court was of the view that:

"the disclosure requirement was satisfied in relation to such matters as might fairly be expected to come to the knowledge of the reporting accountants from an examination (in the ordinary course of carrying out the due diligence exercise for which they were engaged) of the documents and written information supplied to them".

The Court of Appeal held that the it was reasonable to conclude that the reporting accountants should have become aware of the parent company's contribution to Bickerton and the significance from the documents it had been provided under the general disclosure. As a consequence it held that there had been adequate disclosure and no breach of warranty.

What is meant by actual knowledge?

The question of whether the reporting accountants' knowledge could be relied on as a defence to the warranty claim was raised because of a knowledge-saving provision in the sale and purchase agreement. The purchaser's remedies for breach of the warranties were expressly stated to not be affected by investigations made on its behalf "except to the extent that such investigation gives the purchaser actual knowledge of the relevant facts and circumstances".

Although, it was not necessary for the court to address this question having decided that there had been adequate disclosure on the facts, the court commented on this issue.

Two of the appeal judges were of the view that a vendor cannot assume that a reference to "actual knowledge" includes the knowledge of the purchaser's agents or advisers, even where (as in Infiniteland) the agent had the relevant knowledge but did not pass it on. In their view, since the law was clear on the distinction between 'actual' and 'imputed' knowledge, if parties wished to limit the scope of the knowledge-saving provision, they should include 'imputed knowledge' in the qualification. To do otherwise would have the effect of giving the knowledge qualification a larger meaning than its language required.

But there was no consensus on this point. The dissenting judge was of the view that including a reference to imputed knowledge in the qualifying provision would not have assisted in determining the outcome. In his opinion where, as in this case, the purchaser took the opportunity to investigate and instructed a third party to do so, the vendor should be entitled to assume that the information given to the third party is information given to the purchaser. The unlikelihood of the parties' intention that the agent's failure in his contractual duty to the purchaser should be borne by the vendor was a significant consideration.

1 [2006] 1 BCLC 632

2 [1997] BCLC 249

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