Buyer’s responsibility in mergers & acquisitions: Superior Court clarifies the extent of a buyer’s duty to inquire into a company’s financial condition

• Sales at Tubes and Jujubes Family Fun Center Inc. were in decline in the months preceding the acquisition of the company’s shares by the buyer;

• The share purchase agreement contained a warranty regarding the stability of the company’s financial position since the date of its most recent financial statements;

• The buyer claimed $316,100 from the sellers, alleging misleading statements concerning the profitability of the business;

• The Court held a joint responsibility between the buyer, who was negligent in its verifications, and the sellers, who guaranteed the stability of the company’s financial position and breached their duty to disclose information during the sale of the business. 

When a business is sold, it is customary for the seller to include, in the share purchase agreement, certain representations and warranties to the buyer regarding the financial position of the company being acquired. These warranties allow the buyer to assume, among other things, that business activity has been in the normal course since the date of the company’s last financial statements. However, as the Superior Court of Québec pointed out in Tubes et Jujubes centre d’amusement familial inc. v. Nemry¹ (the “T&J Case”), the presence of these representations and warranties in the purchase agreement is not sufficient to exempt buyers from their duty to inquire into the financial condition of a company before proceeding with a purchase. 

The T&J Case

Rendered on February 25, 2020, the T&J Case is a rare decision within the context of claims made against the sellers and former shareholders of a company that has been sold. In this case, the Court had to decide, among other things, whether the sellers (the “Sellers”) of the shares of Tubes and Jujubes Family Fun Center Inc. (“T&J”) had made false representations to the buyer and new shareholder (the “Buyer”²) regarding the profitability and financial position of T&J, and more specifically the fact that T&J’s sales were declining in the months preceding the close of the transaction. 

In this case, the evidence revealed that T&J’s sales had indeed been declining over the last few financial years and that this had directly impacted the company’s net income from operations. However, the Buyer did not review T&J’s monthly sales data before the acquisition, despite having access to this data. 

In this regard, the Buyer relied solely on the representations and warranties set out in the share purchase agreement, which included the following warranty concerning T&J’s financial position: 

“9.5 The sellers warrant [sic] that the financial position of the Corporation is at least as good and has not changed since the financial statements of 30 September 2013 and interim financial statements of 30 May 2014, its assets and liabilities being the same and having undergone no adverse change, except for the transfer of property described in Section 9.14 herein.” ³

The Sellers were found liable for implying and guaranteeing to the Buyer, through this warranty, that T&J’s financial position was stable while sales and profits were declining.⁴ However, the Court limited the scope of this liability to no more than a quarter of the loss suffered, in light of the negligence and failure of the Buyer to comply with its duty to inquire into T&J’s financial position. The Court observed that the warranty contained in a share purchase agreement is not sufficient to exempt a buyer from his or her duty to inquire into the financial condition of a company before proceeding with its purchase. Accordingly, both the Buyer and Sellers were found liable in this case.

The duty to inquire and the obligation to disclose 

The T&J Case illustrates the importance of the duty to inquire and the obligation to disclose, which affect the respective parties to a contract. Both of these obligations arise from the obligation of good faith provided for in Section 1375 of the Civil Code of Quebec. 

When a company is acquired, a buyer can satisfy his or her duty to inquire by conducting reasonable due diligence on the main components of the business, its activities and its financial performance. Among other things, this process allows the buyer to verify the accuracy of the information provided by the seller, to evaluate the risk associated with the planned purchase and to assess the reasonableness of the agreed price. 

However, the extent of this responsibility is not absolute. It can be subjectively determined, based on the buyer’s level of experience and training. Moreover, as the Court points out in the T&J Case, there comes a point at which a party to a contract can no longer be held accountable for not pursuing information further due to the relationship of trust developing between the contracting parties and the representations and warranties made by the other party. 

On the other hand, the obligation to disclose implies that the seller has a duty to disclose information of a decisive nature, of which the seller was aware or presumed to be aware, and which the buyer did not obtain either because of an inability to access the information independently or because of the buyer’s legitimate trust in the seller. 

As demonstrated in the T&J Case, the obligation to disclose is independent of the duty to inquire. Indeed, a buyer’s failure to inquire cannot release a seller from his or her obligation to disclose information and will not protect the seller from sanction for his or her reluctance or silence, even in the presence of a prudent co-contracting party.

In conclusion, following this decision, we underline the importance for diligent buyers to avoid relying solely on the representations and warranties of the seller. So far as is reasonably practicable, buyers must fulfill their duty to inquire. Since representations and warranties similar to those in the T&J case are found in most share purchase agreements, we encourage both buyers and sellers to exercise caution and conduct due diligence to properly assess the target company’s financial performance and revenue mix before the conclusion of a transaction.