Failure to Point Out Business Decline Proves Costly

When a business is sold, a 'due diligence' process is normally entered into to make sure that the representations made by the seller to the buyer, on which the buyer's valuation of the business will be based, are true. Failure to be forthright in disclosures can prove costly, as a recent dispute shows.

The case involved the sale of a dental practice. The purchaser paid £650,000, which included £80,000 for the fixtures, fittings and equipment, £245,000 for the premises and £300,000 for the goodwill.

Normally, valuations of premises and fixtures, fittings and equipment are uncontroversial, but goodwill valuations are less so.

In this case, the purchaser alleged that a false claim was made by the vendors that all of the practice's income after April 2006 was for private work, the practice having by that time ceased to do NHS work. The claim was untrue because there was a residue of NHS work which accounted for more than 40 per cent of the turnover in the year in which the sale took place.

The newly managed practice did not go well and the purchaser sought redress, claiming that there had been fraudulent misrepresentation and that the goodwill in the practice was nil. In addition, it was claimed that the practice's consumable stores, which were to have been transferred under the contract for £5,000, had been removed prior to the sale. Lastly, it was claimed that a significant deterioration in the practice trading had not been disclosed.

The vendors claimed that the representations made were not relied upon by the purchaser, who prepared her own forecasts based on the assumption that she would get a contract for NHS work. The vendors also claimed that the valuation of the business was fair and that the purchaser's subsequent losses were the result of her own mismanagement. In addition, the vendors claimed that the amount paid for the freehold had been agreed at an artificially low price in order to avoid stamp duty and that the contract was thus unenforceable for illegality.

Needless to say, the facts of the case were very complex, with differing accounts being given by each side. What stands out from the case report was the lack of contemporaneous documentation of what was done and, in particular, the lack of awareness by the purchaser that the practice unusually continued to carry out NHS work on a reducing scale after the loss of its NHS contract in April 2006.

The judge considered that 'a reasonable person such as the claimant who knew the background of the changes made by introduction of the NHS dental contracts on 1 April 2006 would, unless told that unusual arrangements had been made, be bound to assume that the reply given meant that the practice had no NHS contract and could therefore not do any NHS work after that date'.

Interestingly, the judge did not see that the purchaser's failure to see or request up-to-date management accounts was an indication that the business was bought for its potential, not on the basis of its financial performance. The judge pointed to a warranty that the financial position of the business had not deteriorated since the accounts date. That should have compelled the vendors to inform the purchaser about it expressly by way of disclosure.

In a judgment that ran to more than 150 paragraphs, the judge upheld the misrepresentation claim and awarded the purchaser more than £94,000 in damages.