India: Promoters And Sellers Beware: Wrongful Representation And Warranties

Last Updated: 13 February 2017
Article by Bharat Anand and Satish Padhi

Introduction

Representation and warranties are intensely debated during negotiation of M&A contracts. Serious consequences can arise due to a poorly negotiated representation and warranties package. In the context of a typical M&A transaction, representations and warranties contain statements made by the seller as to the quality, condition, value or nature of the business/ entity that the buyer is acquiring from the seller. Furthermore, these representations and warranties are generally backed by the seller's acknowledgment that the buyer is entering into the transaction in reliance of such provisions. This ensures that a buyer can claim breach of the acquisition agreement and seek a remedy against the seller for its losses if the representations and warranties turn out to be not true. This buyer/seller dynamic raises several interesting questions. For example:

  • Is a duty cast upon the seller to disclose all material facts to the buyer?
  • Is there any difference between the consequence of breach of representation and breach of warranty?
  • What kind of losses can a buyer recover under Indian law?
  • Importantly, does due diligence of the target company dilute the representations and warranties made by the seller?

This article focuses on answering few of such questions and outlines the approach taken by Indian Courts while interpreting representations and warranties and suggests some key negotiating strategies.

Setting the legal framework

The term representation and warranty is not defined in the Indian Contract Act, 1872 ("Contract Act"). However, through a series of case law, the phrase "representation" has been understood to be a statement made by way of a positive affirmation, based upon knowledge that the facts represented either do or will exist, or a mere declaration of belief or expectation that such facts do or will exist. Whereas, the Sale of Goods Act, 1930 defines a "warranty" as a stipulation collateral to the main purpose of the contract, the breach of which gives rise to a claim for damages but not a right to reject the goods and treat the contract as repudiated.1 The distinction between representation and warranty has been surmised by the Madras High Court in All India General Insurance Co v. S P Maheswari ("All India General Insurance").2 The Court stated that, "Warranties are representations which are made the basis of the contract whereas a representation is not strictly speaking a part of the contract or of the essence of it, but rather something preliminary and in the nature of an inducement to it.".

Does the Seller have a duty to disclose?

The explanation to Section 17 of the Contract Act provides that mere silence is not fraud, unless there is a duty to speak, or unless it is equivalent to speech. Therefore, there is no general duty to disclose facts which are or might be equally within the means of knowledge of both parties. The principle has been aptly stated by Slade J in Banque Financiere de la Cite SA v. Westgate Insurance Co. Ltd3 wherein it has been observed that: "There are countless cases in which one party to a contract has in the course of negotiations failed to disclose a fact known to him which the other party would have regarded as highly material, if it had been revealed. However, the law leaves that other party without a remedy."

However, in transactions involving contracts uberrrima fides or where one party stands in fiduciary relationship with the other, there is a legal and equitable duty on the parties, not only to state whatever is stated, but also disclose with utmost completeness. Other than that, there is no obligation to disclose at all in transactions which do not fall within the recognised class.4

Due Diligence by Buyer: Does it Dilute Representations and Warranties?

Interestingly, the Contract Act states that: "If consent was caused by misrepresentation or by silence, fraudulent within the meaning of Section 17, the contract, nevertheless, is not voidable, if the party whose consent was so caused had the means of discovering the truth with ordinary diligence".

In World Sport Group (India) Pvt. Ltd vs The Board of Control for Cricket in India5 the Bombay High Court observed that the mere placing of a document on record of a company, society or other such organisation does not lead to the conclusion that every officer thereof had the means of discovering the truth merely by virtue of the document being on the records. It was surmised that what constitutes ordinary diligence must depend on the facts of each case.

In Infiniteland Ltd. v. Artisan Contracting Ltd,6 the parties had entered into a share sale agreement for the purchase of three group companies of the seller. It was alleged that the seller has overstated the profits of one of the companies which exaggerated the payment consideration under the agreement. A due diligence was carried out on behalf of the purchaser by a chartered accountant. Clause 7.4 of the transaction document provided that "the purchaser's rights in respect of breach of warranty should not be affected by any investigation made by it or on its behalf into the affairs of any group company (except to the extent that such investigation gives the purchaser actual knowledge of the relevant facts or circumstances)". The Court held that the due diligence carried out by the chartered accountant gave the purchaser actual knowledge of the misrepresentation, which was outside the purview of Clause 7.4, and hence the warranties cannot be considered to have been breached.  Before the decision in Infiniteland, Prior to Infiniteland, it was widely acknowledged that, a seller was required to provide warranties about the company whose shares were being sold, any disclosures that he made to qualify those warranties had to be sufficiently clear and detailed to enable the potential breach of warranty to the attention of the purchaser.7

Further, in New Hearts Ltd v. Cosmopolitan Investments Ltd8, the share purchase agreement incorporated a clause which stated that: "It is hereby agreed and acknowledged by the parties that the Warranties (. . .) are given by the Vendor subject to matters fairly disclosed (with sufficient details to identify the nature and scope of the matter disclosed) in the Disclosure Letter in respect of which matters the Vendor shall have no liability to the Purchaser." It was held that merely providing documents that might bring the purchaser's attention to a matter was insufficient and that the particular breach must be expressly brought to the attention of the purchaser.

Given the above, regardless of whether an extensive due diligence has been undertaken by a buyer, recognition that matters outside the disclosure letter may sometimes qualify the warranties may well weaken the buyer's remedies under the Contract Act.

Losses recoverable for breach of representations and warranties:

The difference in remedies available in case of breach of representations and warranties have been stated by the Madras High Court in All India Insurance. The Court observed that: "In the case of a warranty materiality or immateriality of the fact warranted signifies nothing. Its incorrectness constitutes a defence to an action on the policy, even though it be not material and be made in perfect good faith. But, in the case of a representation, the insurer can avoid the policy only by proving that the statement is false and fraudulent or that it was false and material to the risk. In other words, it is only a material misrepresentation that can avoid a policy if the truth of the facts contained in the representations be not warranted by the policy."9

As per Section 19 of the Contract Act, the contract is voidable at the option of the party who was induced by misrepresentation. Normally, there are two remedies available to a party one being to elect to rescind the contract, or to seek enforcement of representation, and insist upon being placed in the same position as if the contract were performed.10

In a claim for damage, the contract is left intact, and the suit is to enforce it and substitute monetary damages for performance whereas in a suit for rescission, the object is to avoid performance of the contract. Therefore, any order made on rescission has its object in restoration of the parties to their original position; the idea being restitution in integrum and the parties to be restored to status quo ante.11

In rescinding a contract, the courts act on the principle that, as the transaction ought never to have been made, the parties are to be placed, as far as possible, in a situation in which they would have stood, if there had never been any such transaction. The broad principle has been laid down in numerous case laws as being: "No man can at once treat the contract as avoided by him, so as to resume the property which he has parted with under it, and at the same time keep the money or other advantages which he has obtained under it."12 A similar principle has been incorporated under Section 30 and Section 40 of the Specific Relief Act, 1963.

While normally under a claim made due to wrongful inducement through misrepresentation, the courts have awarded damages which are merely restitutory in nature but in instances where the wrongful representation and warranty is linked to the performance of a contract, the court may award compensation as well relying upon Section 75 of the Contract Act which permits a party rightfully rescinding a contract to compensation for any damage which he has sustained through the non-fulfilment of the contract. While awarding the compensation, courts apply the principles laid down in Section 73 of the Contract Act which permits a party to claim for direct and consequential losses sustained during the performance of the contract. Therefore, promoters and sellers have to be very careful before making any representations and warranties as they may be liable for compensation in addition to damages which are merely restitutory in nature.

Footnotes

1. This definition of warranty under the Sale of Goods Act, 1930 specifically applies to an acquisition transaction where there is sale of shares

2. AIR 1960 Mad 484

3. [1989] 2 All ER 952

4. Haji Ahmed Yar Khan v. Abdul Gani Khan, AIR 1937 Nag 270

5. Arbitration Petition No. 978 of 2010 decided on 20-12-2010 (Bom)

6. 2005 EWCA Civ 791

7. See Levison v Farin, [1978] 2 All ER 1149; Daniel Reeds Ltd v EM-ESS Chemists Ltd, [1995] CLC 1405

8. [1997] 2 BCLC 249

9. Supra note 2

10. Sorabshah Pestonji v. Secretary of State (1927) 29 Bom LR 1535. See also Section 19 of the Indian Contract Act, 1872

11. Ibid

12. Clough v. London and North Western Rail Co, (1871) LR 7 Ex 26. See also Mundakath Nathu v. Chalora Illath Sankaran Nambudripad, AIR 1932 Mad 303 and O Sullivan v. Management Agency and Music Limited, [1985] 3 All ER 351

This article was first published in Libertatem magazine dated 15 January 2017.

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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