[EP 016] Case Alert! Issues in Entering into a Conditional Business Sale Agreement

Aspect Legal | Joanna Oakey | Business Sale and Purchase | Mergers and Acquisition | Sydney Solicitors

A recent case highlights the underlying risks with termination rights in relation to the right to undertake due diligence for a business sale and purchase transaction. In this episode, we have some really strong warnings for brokers and consultants that help drive these deals, and for vendors and prospective buyers as well, about some of the issues of exchanging on a contract before both parties know for sure that they're going to continue.

CLICK HERE to download the transcript for this episode.

Episode Highlights:

00:50 What is due diligence?

03:58 The crux of the case

06:09 The court’s findings

08:02 Risks and dangers in termination clauses

10:20 Drafting the termination right

14:44 Our sales and acquisitions services

Joanna: Hi it’s Joanna Oakey here and welcome back to The Deal Room Podcast. Today we are talking about entering into a business purchase contract before due diligence has occurred and to talk about this interesting matter and a case that is going to be right on point here, we have the fabulous Elizabeth Lee back to talk to us again. Hi Liz, welcome back to this show!

Liz: Hi Joanna! Thank you for having me back.

 

What is due diligence?

Joanna: Great. OK. Well today we’re going to talk about this case Brotun and BNB Group Investments which is a case that was decided just a few months ago all about due diligence. But maybe let’s start right back from the beginning. Let’s just discuss for our listeners who aren’t across all of this terminology in the mergers and acquisitions space, what is due diligence?

Liz: Due diligence is something that a purchaser undertakes in relation to buying and selling business that can occur before a party had even signed a contract. When you’re interested in buying business you want to do a bit of research and reassurance about the strength and quality of the business. But more importantly, once you’ve entered into a contract to buy a business, you might want to preserve that right to continue to undertake due diligence.

Joanna: Yeah, absolutely. And when we’re talking about due diligence here I think it’s also important for us to be clear that there’s many different types of due diligence. Mostly we think of the accounting due diligence and the legal due diligence. On the accounting side, we are verifying the figures. So we’re looking at the figures of the business. From a legal side, we’re verifying the legal backbone or foundation of the business. So we’re looking at a number of things to ascertain the level of risk a buyer believes is likely to be in a business that they’re buying. And of course we can have all sorts of other due diligence as well. For example technology due diligence, IT and all sorts of other due diligence.

Liz: Yes, that’s correct. Employment related issues too that you might want to check and test to make sure that your assumptions and the information you’ve been given are correct.

Joanna: Absolutely. Now that we’ve established what due diligence is, as you rightly said there’s a number of different times that due diligence can occur and so due diligence can occur before a contract is entered into and sometimes it may even occur before full commercial terms are entered into. But generally speaking due diligence will occur after the parties have agreed on a price and the general commercial terms and sometimes prior to signing a contract and sometimes it will continue after signing the contract. In this particular case we’re looking at, it looked like due diligence was either completely occurring or at least partly occurring after the execution of the contract but before completion of the contract, completion being when all of the business is finally passed over from the seller to the buyer of the business.

Liz: Yes, correct.

 

The crux of the case

Joanna: Liz, tell us about this particular case.

Liz: This contract involved the sale and purchase of a boutique hotel in Melbourne. The parties entered into the contract with a condition precedent that enabled the purchaser to continue to conduct due diligence after they had exchanged the contract. The condition precedent was worded very broadly which enabled the purchaser to basically terminate the contract by giving notice within three days of it completing its due diligence. It did not specify whether or not the purchaser had to find something wrong with it, the degree of the misinformation that it found in its due diligence. It was just a very broad and general right to terminate after it had completed its due diligence.

Joanna: So I guess what we really have here in a commercial sense is a buyer who is saying “Well look how about we exchange on this deal so that you can’t accept any other offers whilst I take a look at the business and if I don’t like it or if I don’t want to continue for any reason I can just say within three days after completion of my due diligence that we don’t want to go ahead.” So effectively the buyer thinks in this situation they’re putting themselves in the position of power as to whether or not they want to continue with the purchase of the business irrespective of the results of the due diligence process.

Liz: Yes, that’s right. In effect, the buyer had an option in relation to this sale and purchase transaction.

 

The court’s findings

Joanna: OK. And certainly we often see buyers wanting to find ways where they can exercise control like this. It’s understandable. So what was the issue and what did the court say?

Liz: There was a series of correspondence regarding the lease for the building as well as financial results. It was quite extensive due diligence on the financials. But what had happened here was that the trial judge found that it was necessary for there to be a link between termination and the unsatisfactory due diligence results even though the contract did not specify it. For that reason the trial judge found in favor of the vendor and concluded that the purchaser breached a contract by terminating their contract even though it was not significantly influenced by the due diligence results.

Joanna: I find this a fascinating result. It was really interesting. If parties come to an agreement together that is set out in writing, it is interesting to have the situation where a court might say “Well, notwithstanding you have clearly agreed one thing we the court believe that that would result in an unfair result. So we’ll be importing some other meaning into the contract or implying other meanings into the contract.”

Liz: Yes. That’s right. Clearly, with the need for the unsatisfactory results to be of a significant nature.

 

Risks and dangers in termination clauses

Joanna: And so I think this has some really important lessons then for advisers, like brokers and accountants and other M&A consultants who are working in the sales and acquisitions space in terms of helping to broker a deal where they intend contracts are going to be exchanged before both parties have absolutely committed to the process. Because obviously in this instance using a condition precedent to give one of the parties a right to get out of the deal can be dangerous. There’s a risk that the court will interpret the contract in a different way.

Liz: Yes, that’s right. The case did go on to the appeal by the purchaser and on appeal the court did find in favor of the purchaser in the end. Well, yes and no in that the court found that there didn’t need to be a significant adverse result for the purchaser to walk away from the contract. But nonetheless, the court still gave it a construction which required there to be a linkage between there being an unsatisfactory result and termination.

Joanna: And it comes back I think to this concept where whenever we are trying to rely on a termination clause you have to be absolutely careful about the way in which you practically go about dealing with the termination. So in this instance the lesson probably was, from a legal perspective, it would have been better to have identified issues that arose or highlighted during the due diligence process because it seems like the courts would have looked more favourably upon termination if those sorts of issues had arisen in this instance or had been highlighted and pointed to.

Liz: Yes.

 

Drafting the termination right

Joanna: So I think here we have issues that relate to accountants and brokers and consultants that are part of that initial deal and negotiation in relation to whether or not they will recommend that their clients get committed before if there is still due diligence that’s continuing and secondly the way that these clauses are drafted. This case certainly suggests that we need to have extremely tight clauses to ensure there is no other interpretation that a court can give if they come under scrutiny.

And I guess thirdly it’s about how we deal with termination if we need to and about making sure that you’re building up the best argument for termination even if you think the contract is very clear on the rights of the parties to terminate and to not continue with completion under the sale and purchase.

Liz: Yes, correct. I mean how you would draft the termination right really would depend on whether you’re acting for the vendor or the purchaser. If you’re the vendor, you would want to make sure that the right to terminate are really limited and that those limited rights are very clearly articulated in the contract. Certainly, from a vendor’s perspective you wouldn’t agree to a broad brush sort of right to terminate without any linkage to specific events.

Joanna: Yeah, absolutely right because I guess for a lot of this episode here we’ve really been talking about the buyer’s perspective but you’re a hundred percent right in that from the seller’s perspective here it sounds like they signed up to a pretty bad deal initially, signing up to a contract where they were bound but effectively on the pure reading of the contract the buyer wasn’t bound. But obviously the court had some sympathy for them along the way. But absolutely from a vendor perspective it’s really important that they’re careful that they’re not caught in a contract that they can’t get out of but that the buyer can.

Liz: Yes. That’s correct.

Joanna: All right. Brilliant! Well look, I think we’ve covered some really useful topics there. I think there’s some really strong warnings here for brokers and consultants that help drive these deals, and certainly for vendors and prospective buyers themselves here about some of the issues of exchanging on a contract before both parties know for sure that they’re going to continue. And if you’re going to exchange whilst still preserving a right for getting out of the contract if DD is completed and there are issues that are highlighted the importance particularly from a vendor perspective of understanding exactly where those measures are that would give the buyer the right to terminate.

Joanna: Excellent! All right, well thank you so much for your time today Liz. Obviously if people have questions about how this particular issue could apply to their business sale or purchase, they can contact you Liz through our website at thedealroompodcast.com or through aspectlegal.com.au. If you would like more information about this topic head over, as I said, to our website at thedealroompodcast.com where you’ll be able to download a transcript of this podcast
episode if you want to read it in more detail and you’ll also there find details on how to contact Liz and the rest of our lawyers at Aspect Legal if you or your clients would like to discuss any legal aspects of sales or acquisitions.

 

Our sales and acquisitions services

Joanna: We have a number of great services that help businesses both prepare for a sale or acquisition to help them prepare in advance and to get transaction ready. And we’ve also got a range of services to help guide businesses through the sale and acquisitions process. We work with clients both big and small and have different types of services depending on size and complexity. So don’t hesitate to book an appointment if you want to find out how we might be able to assist.

Joanna: Thanks a lot for tuning in Liz. Hopefully you’ll come back and join us again very soon as we drill into another issue relating to buyers and sellers of businesses.

Liz: Thanks Joanna! Looking forward to it!

Joanna: Great! OK. And thanks for listening in. See you next time.

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