M&A: Australian decision offers guidance on deal-making

However, staying abreast of recent legal developments is crucial for buyers and sellers when undertaking any transaction as it is contract law and statute that will govern what the commercial outcome is for the buyer and seller in the event of dispute.

The decision of the Federal Court of Australia earlier this year in the case of Optic Security Australia 2 Pty Limited v YC Investments (NT) Pty Ltd emphasises the need for vigilance, informed decision-making, and an understanding of the legal environment in which M&A transactions take place – beyond just the terms of the sale contract itself.

Background

The Optic Security v YC Investments case was a dispute arising from the sale of shares in the STS Group, which operated security businesses in Australia and New Zealand. Optic Security purchased the shares from YC Investments, which partly owned the STS Group. One of the companies in the STS Group had a material contract in place, which was for the construction of security-related facilities at an air force base in the Northern Territory (the Tindal subcontract). The Tindal subcontract was one of the most significant commercial revenue and profit drivers of the STS Group.

The purchase price was determined by reference to a forecast of the EBITDA (earnings before interest, taxes, depreciation, and amortisation) of the STS Group for the financial year ending 30 June 2019. Optic Security alleged that:

• YC Investments breached contractual warranties regarding the accuracy of the information disclosed in the due diligence process (the contractual claim); and
• YC Investments made misleading or deceptive representations in contravention of the Australian Consumer Law (ACL) in relation to the forecast gross margin relating to the Tindal subcontract (the statutory claim).

Optic Security claimed that the forecast EBITDA was overstated by an erroneous forecast of the gross profit margin of the Tindal subcontract. It sought damages or compensation for the difference between the purchase price and the actual value of the STS Group, or alternatively the price that Optic Security would have paid or the opportunity to pay a reduced price if the alleged contraventions had not occurred.

YC Investments denied liability and counterclaimed for an amount alleged to be owed to it by Optic Security as part of the purchase price for the shares.

The decision

The Federal Court rejected all of Optic Security's claims and upheld YC Investments' counterclaim. It held that Optic Security had failed to establish that YC Investments had made any false or misleading representations, or that Optic Security had relied on them in entering into the transaction.

Contractual claim

The court found that the contractual claim was time-barred because Optic Security didn’t notify YC Investments of the potential claim ‘as soon as practicable’ after becoming aware of the circumstances giving rise to the potential claim. The court also found that, in any event, Optic Security had not proved that YC Investments had breached any of the warranties.

Statutory claim

The court rejected Optic Security's allegation that YC Investments engaged in misleading and deceptive conduct in contravention of the ACL by making representations about the gross profit margin of the Tindal subcontract and the EBITDA of the STS Group. The court also found that, to the extent that the representations were about future matters, YC Investments had reasonable grounds for making them and they were not deemed to be misleading under section 4 of the ACL.

The court found that Optic Security was bound by the terms of the sale agreement and side letter to pay that amount into the account nominated by YC Investments. The court ordered Optic Security to pay YC Investments the outstanding instalment plus interest and costs.

What buyers and sellers can take away from the decision

The significance of warranties in disclosures

Warranties play a pivotal role in M&A transactions, providing assurances to buyers about the accuracy and completeness of disclosed information. The case underscores the importance of these warranties, particularly in the context of information that includes forward-looking statements. For sellers who want to minimise the risk of contractual claims relating to forward-looking statements, it would be common to include a specific clause stating that the buyer cannot make any claims based on such statements.

Forward-looking statements

M&A transactions often involve the disclosure of forward-looking information, such as projections, forecasts, and future plans. While such information is valuable for buyers in making informed decisions, it also presents a challenge for sellers in ensuring its accuracy. The court's decision highlights the need for sellers to be careful to ensure that they have a reasonable basis on which to make such forward-looking statements – including, potentially, the need to update material forecasts if circumstances change prior to signing the sale contract.

Scrutinising warranties

For buyers, the case emphasises the critical importance of carefully scrutinising the warranties provided by sellers. When forward-looking information is part of the disclosure, buyers should pay special attention to the specific representations, if any, made by the seller regarding the accuracy of such information.

Ensuring accurate disclosures

Sellers, for their part, should approach the disclosure of forward-looking information with utmost care. The court's decision highlights the seller's duty to ensure that the disclosed information is accurate, based on reasonable grounds, and supported by thorough due diligence.

Time limits on claims

Buyers and sellers should be cognisant of the time limits imposed on statutory claims, as highlighted in the court's decision. The case emphasises the importance of adhering to prescribed timelines for both notifying the other party of, and bringing, claims under contractual and statutory provisions. Failure to comply with these requirements may result in the loss of legal recourse, making it imperative for parties to act swiftly in pursuing their rights. 

It is advisable for both buyers and sellers to seek legal advice promptly if they believe they have a potential claim, ensuring compliance with the stipulated timeframes.

The weight of contractual notice procedures

Contractual notice procedures are not mere formalities; they are vital components of agreements that demand strict adherence. Many commercial parties focus on the specified time limits in the contracts, for example, that a claim must be made within 18 months of completion, but place less weight on another common clause – that a buyer notify the seller promptly upon becoming aware of a potential claim. The case emphasises that both clauses are very relevant.

Earn-outs and forecast claims

The case sheds light on the intricacies surrounding earn-outs and forecast claims in M&A transactions. Sellers often agree to earn-out arrangements based on the future performance of the business. The judgment underscores the need for clarity in defining earn-out metrics and conditions.

Parties entering into such agreements should be meticulous in drafting earn-out provisions, considering potential future contingencies and outlining mechanisms to resolve disputes arising from forecast claims. Clear and precise contractual language is crucial to avoid ambiguity and mitigate the risk of disagreements down the line.

The case also indicates that if an earn-out mechanism is included, this may make it difficult for a buyer to make a claim for damages for breach of warranty / representations as to future matters because the earn-out mechanism itself makes express provision for a reduction in purchase price if those forecasts are not achieved.

Contracting out of consumer law claims

The case involved two claims: one for breach of warranty, i.e. the contractual claim, and one for misleading or deceptive conduct under the ACL, i.e. a statutory claim. In many M&A contracts, a clause will be included seeking to specifically limit the ability to bring a claim not based on the contract itself – i.e. seeking to exclude statutory remedies such as claims for misleading or deceptive conduct. The case is a reminder that these limitations do not remove the risk of a claim for misleading or deceptive conduct under the ACL, and therefore this is something which the sellers should keep in mind, particularly as it relates to forward-looking statements made during the course of a transaction.

Conclusion

The Optic Security v YC Investments case serves as a valuable resource for buyers and sellers, offering insights that can contribute to the success of transactions and mitigate potential legal risks. Focusing on due diligence, drafting precise transaction documents, and understanding earn out clauses, can help buyers and sellers navigate the complexities of M&A transactions successfully.