I think there was misrepresentation to me when I purchased a business. What can I do?

Introduction

Buying a business can be an exciting yet complex process, with many potential pitfalls to navigate. One of the most significant risks when purchasing a business is the possibility of misrepresentation by the seller. Misrepresentation occurs when a seller provides false or misleading information about the business, which induces the buyer to enter into the sale agreement. This can have serious consequences for the buyer, who may find themselves saddled with a business that fails to live up to expectations or, worse yet, is burdened with hidden liabilities or legal issues.

In this article, we’ll explore what constitutes misrepresentation in a business sale, common examples to watch out for, and the steps you can take if you believe you’ve been misled. We’ll also discuss how sellers can avoid engaging in misleading conduct and what remedies may be available to buyers who fall victim to misrepresentation.

What is Misrepresentation When Buying a Business?

Misrepresentation in the context of a business sale refers to a false or misleading statement of fact made by the seller which induces the buyer to enter into the purchase agreement. It’s important to understand exactly what constitutes misrepresentation, as not all inaccurate statements will give rise to legal liability. To establish misrepresentation, the statement must be:

• Untrue or misleading
• Related to a material fact about the business
• Something which the buyer relied upon in deciding to purchase
• Known to be false or made recklessly by the seller

Statements of opinion, sales puff, or projections about the business’s future potential generally won’t amount to actionable misrepresentation. The false statement must relate to a current or past fact.

There are also different types of misrepresentation recognised by the law, each with varying remedies available:

Type #1: Innocent Misrepresentation

Innocent misrepresentation is where the seller genuinely believes the false statement they are making is true, and has reasonable grounds for that belief. While the seller did not intend to mislead, the buyer may still be able to rescind the contract in some circumstances. However, damages are not usually awarded against the seller unless they had the means of knowing the statement was untrue.

Type #2: Negligent Misrepresentation

Negligent misrepresentation occurs where the seller makes a false statement carelessly, without exercising reasonable care to check its accuracy. To be negligent, the seller’s conduct must fall below the standard of care expected from a reasonable person in those circumstances. If negligent misrepresentation is established, the buyer may be able to rescind the contract and also claim damages.

Type #3: Fraudulent Misrepresentation

Fraudulent misrepresentation is the most serious type, where the seller knowingly makes a false statement with the intention of deceiving the buyer. Fraudulent conduct may also include concealing or failing to disclose material facts with the intention to mislead. In these cases, the buyer will be entitled to rescind the contract and claim damages for any losses flowing from the misrepresentation, including potentially punitive damages. The seller may also face criminal charges in some instances of fraud.

Regardless of whether the misrepresentation was innocent, negligent or fraudulent, if it had the effect of inducing the buyer into the sale contract, the buyer may be entitled to a legal remedy. Buyers should be vigilant for any false or deceptive statements made by a seller, and carefully document all information provided during the sale process. If misrepresentation is suspected, seeking prompt legal advice is crucial to protecting your rights and interests.

Common Examples of Misrepresentation in Business Sales

Misrepresentation can occur in relation to various aspects of a business during the sale process. Here are some of the most common examples of misleading conduct to watch out for:

Example #1: Financial Misrepresentations

One of the most frequently encountered types of misrepresentation involves the business’s financial performance and position. The seller may provide inaccurate, incomplete or misleading financial statements which paint a rosier picture of the company’s profitability and value. This could include:

• Overstating revenue by including one-off or extraordinary items as regular income
• Understating expenses by excluding certain costs or liabilities
• Manipulating inventory figures or asset valuations
• Providing outdated or unaudited financial reports
• Misrepresenting the business’s working capital position
• Failing to disclose outstanding debts or tax liabilities

Inflated revenue figures and understated expenses can make the business appear more profitable than it really is, inducing the buyer to pay a higher price. The seller may also misrepresent the company’s growth trends, either by cherry picking successful periods or failing to disclose a recent downturn in sales. Providing incomplete or inaccurate financial disclosure is a major red flag and can result in the buyer significantly overpaying for the business.

Example #2: Misrepresentations About Assets or Stock

Another common area of misrepresentation relates to the condition, value or ownership of the business’s assets and stock. The seller may try to overstate the quality or quantity of assets being sold with the business, or fail to disclose defects or issues with key equipment. For example:

• Misrepresenting the age, condition or maintenance history of plant and equipment
• Exaggerating the size or value of inventory
• Failing to disclose obsolete or damaged stock
• Claiming equipment is owned outright by the business when it is actually leased or encumbered
• Overstating the size or value of the customer database being transferred

The buyer may rely on these representations about assets and stock when valuing the business, only to later discover they are not getting what they paid for. Replacing or repairing assets can involve significant unexpected costs for the buyer down the track.

Example #3: Misrepresenting Legal Matters

Sellers may also make misrepresentations about the legal status or compliance of the business, which can leave the buyer exposed to serious liability or loss. Common examples include:

• Stating that the business holds all necessary licences and permits when it does not
• Failing to disclose disputes with customers, suppliers or employees
• Misrepresenting the terms of key contracts or leases
• Failing to disclose pending or potential legal claims against the business
• Claiming that the business owns certain intellectual property or assets which it does not
• Understating the extent of any outstanding warranty claims or product liability issues

The buyer may unwittingly take on significant legal risks or liabilities if these matters are not accurately disclosed prior to sale. For example, if the lease is not actually transferable or has less favourable terms than represented, the buyer could be left without a premises to operate from. Buyers should insist on comprehensive information about all legal matters during due diligence.

How to Prove Misrepresentation Occurred

If you believe you have been misled during the purchase of a business, you will need to establish certain key elements to succeed with a misrepresentation claim. This can be challenging, as the onus is on the buyer to prove that the seller made a false statement which induced them to enter the contract. Here’s what you need to prove:

1. The Seller Made a False Statement of Fact

Firstly, you must be able to point to a specific false statement made by the seller during the sale process. This could be a verbal statement, or a written statement in the contract, financial documents or other pre-contractual communications. The statement must be objectively untrue or misleading – mere puffery or statements of opinion are insufficient.

Importantly, the false statement must relate to a fact that existed at the time it was made. Statements about the business’s future prospects or potential will generally not amount to misrepresentation, unless the seller had no reasonable grounds for making them. Silence or failure to disclose material information can also constitute misrepresentation in certain circumstances.

2. You Relied on the False Statement

It’s not enough that the seller made a false statement – you must also show that you relied on that statement when deciding to purchase the business. In other words, the misrepresentation must have been a significant factor that induced you to enter into the contract.

If you did not know about the false statement, or if you knew it was untrue at the time of signing the contract, you cannot later claim to have relied on it. Similarly, if you simply got a bad bargain but did not actually rely on any false statements from the seller, misrepresentation will not apply.

3. The False Statement Caused You Loss

Finally, you will need to demonstrate that you suffered loss or damage as a direct result of relying on the seller’s misrepresentation. If the business was worth significantly less than you paid for it, or you incurred unexpected expenses or liabilities due to undisclosed issues, this may be relatively straightforward.

However, you will need to show that your loss was caused by the misrepresentation, and not by other unrelated factors such as poor management or changes in market conditions. The remoteness and quantification of loss can be a complex issue in misrepresentation cases.

The Importance of Due Diligence and Documentation

To have the best chance of proving misrepresentation, it’s crucial that you conduct thorough due diligence before purchasing a business. This includes:

• Carefully reviewing all financial statements, contracts and other documentation provided by the seller
• Physically inspecting the condition of premises, plant and equipment
• Searching public records for undisclosed liabilities or legal issues
• Speaking with employees, suppliers and customers to verify information

Just as importantly, you should document all information and representations made by the seller during the deal. If any statements are made verbally, follow up with an email confirming your understanding. Keep copies of all correspondence, meeting notes and reports provided.

If a dispute arises later down the track, having a clear documentary trail of the seller’s statements will put you in a much stronger position to prove misrepresentation. Conversely, if you don’t have records of the specific statements made, it can devolve into a “he said, she said” situation.

Of course, prevention is always better than cure. Buyers should invest time and resources into comprehensive pre-purchase due diligence wherever possible. Engage the services of experienced advisors such as lawyers, accountants and brokers to help you critically assess all information provided by the seller. While it may involve some upfront cost, it can pale in comparison to the financial and legal headaches of buying a business based on false representations.

Remedies Available for Misrepresentation

If you can establish that the seller engaged in misrepresentation, there are several potential legal remedies available. The specific remedies will depend on the nature and severity of the misrepresentation, as well as the terms of the sale contract. Here are the key remedies to be aware of:

Remedy #1: Contract Rescission

One of the primary remedies for misrepresentation is rescission of the contract. Rescission essentially means unwinding the transaction and restoring the parties to their original positions before the contract was signed. If the court grants rescission, the business and any assets will be returned to the seller, and the buyer will recover the purchase price.

Rescission may be available where the misrepresentation was significant enough to induce the buyer to enter the contract, and where the parties can still be practically restored to their pre-contractual positions. It is a discretionary remedy and will not be granted where the buyer has affirmed the contract or where third party rights have intervened.

Time limits also apply – the buyer must seek rescission within a reasonable period after discovering the misrepresentation. What is considered “reasonable” will depend on the circumstances, but the buyer should not delay in seeking legal advice and communicating with the seller once alerted to a potential misrepresentation.

Remedy #2: Damages

In addition to (or instead of) rescission, the buyer may be entitled to sue the seller for damages. Damages are a monetary remedy designed to compensate the buyer for any losses suffered due to the misrepresentation. Depending on the type of misrepresentation, the buyer may be able to claim:

• The difference between the purchase price and the actual value of the business (i.e., overpayment)
• Costs of rectifying any undisclosed defects or liabilities
• Loss of profits that would have been earned if the business was as represented
• Interest paid on money borrowed to purchase the business
• Consequential losses flowing from the misrepresentation
• In cases of fraud, exemplary or punitive damages to punish the seller’s conduct

The aim of damages is to put the buyer in the financial position they would have been in if the misrepresentation had not occurred. The buyer must prove the loss suffered and that it was caused by the misrepresentation. Calculating the appropriate measure of damages can be complex and often requires expert financial evidence.

It’s important to note that the sale contract may seek to limit the seller’s liability for misrepresentation. For example, the contract may include an “entire agreement” clause stating that the buyer has not relied on any representations outside the contract itself. However, such clauses will not always be effective in excluding liability, particularly in cases of fraud.

The buyer may also have agreed to a cap on the seller’s liability or a time limit for bringing claims. Again, these clauses need to be carefully reviewed as they may be open to challenge depending on the circumstances. If the seller has engaged in blatant misrepresentation, the court may look unfavourably on attempts to avoid responsibility through contractual limitations.

In any case, a buyer who suspects they have been misled should seek urgent legal advice. Strict time limits apply to commencing legal action for misrepresentation, so delays can be costly. An experienced business lawyer can advise you on the strength of your case and the best strategy for achieving a satisfactory outcome, whether through negotiation, mediation or court proceedings.

Avoiding Misrepresentation as a Seller

As a seller, it’s crucial to understand the risks of misrepresentation and take steps to ensure you are providing accurate and complete information to prospective buyers. Engaging in misleading or deceptive conduct, even unintentionally, can result in serious legal consequences down the track. Here are some key strategies to help you avoid misrepresentation when selling your business:

1. Provide Accurate and Up-to-Date Information

One of the most important things you can do as a seller is to ensure that all information you provide about the business is accurate, complete and up-to-date. This includes financial statements, asset registers, employee records, legal documents and any other material relevant to the sale.

Take the time to carefully review all information before providing it to the buyer, and double-check that it is factually correct. If you’re unsure about any aspect of the business, seek advice from your accountant, lawyer or other professional advisors. It’s better to clarify matters upfront than to make assumptions or estimates that could be misleading.

Be particularly cautious about making statements or projections about the business’s future financial performance. While it’s natural to paint your business in the best possible light, any forward-looking statements must be based on reasonable grounds and assumptions. Avoid exaggerating or speculating about potential growth or profitability if you don’t have solid evidence to back it up.

2. Disclose Issues and Risks Upfront

Transparency is key when it comes to avoiding misrepresentation claims. As a seller, you have a duty to disclose any material facts or issues that could impact the buyer’s decision to purchase the business. This includes disclosing:

• Any major customer or supplier disputes
• Legal claims or regulatory investigations
• Issues with key assets, equipment or inventory
• Underperforming products or divisions
• Declining sales or market trends
• Expiring patents or trademarks
• Difficulties obtaining finance or credit

While it may be tempting to downplay negative aspects of the business, failing to disclose important issues can come back to bite you later. If the buyer discovers something you should have disclosed, they may accuse you of misrepresentation and seek legal recourse.

It’s far better to be upfront about any potential risks or problems, even if it means a lower sale price. The buyer will appreciate your honesty and you can negotiate appropriate warranties or indemnities to allocate risk. Trying to sweep issues under the rug will only damage trust and increase the likelihood of a dispute down the line.

3. Use Clear and Qualified Language

When making any statements or representations about the business, use clear, precise language that accurately reflects the facts. Avoid exaggerations, superlatives or emotive language that could mislead the buyer. For example, instead of saying “this is the best café in town”, say “the café has won local business awards in 2020 and 2021”.

Be specific about the basis for any statements you make, and qualify them where appropriate. For instance, if you say that your business has a “market leading product”, clarify what you mean by this and provide evidence to substantiate it. Use phrases like “based on our internal sales data” or “according to independent industry reports” to show that your claims are supported.

If you’re making financial or numerical representations, ensure they are accurate and not open to misinterpretation. Avoid rounding up figures or omitting key details. For projections or estimates, make sure you clearly explain the assumptions and methodology behind them.

4. Include Appropriate Disclaimers and Limitations of Liability

Finally, you can help protect yourself from misrepresentation claims by including appropriate disclaimers and limitations of liability in the sale contract. While these clauses won’t always absolve you of responsibility, they can help signal to the buyer that they need to conduct their own due diligence and not simply rely on your representations.

Some common contract clauses to consider include:

• Entire agreement clause: States that the written contract contains the entire agreement between the parties and supersedes any prior representations or negotiations.
• Non-reliance clause: The buyer acknowledges they have not relied on any representations made by the seller other than those expressly set out in the contract.
• Disclaimer of warranties: Excludes any warranties about the condition or performance of the business, except those specifically provided in the contract.
• Cap on liability: Places a financial cap on the seller’s liability for any breach of contract or misrepresentation (e.g. limiting to the purchase price).
• Time limit for claims: Requires the buyer to notify any claims within a set period after completion (e.g. 12 months).

Of course, the enforceability of these clauses will depend on the specific circumstances and the type of misrepresentation involved. Limitations may not be effective in cases of fraudulent misrepresentation or where the seller has fundamentally breached the contract.

To ensure any disclaimers or limitations are appropriate and legally valid, it’s essential to have an experienced business lawyer draft and review your sale contract. They can advise you on the risks and help negotiate terms that provide a fair balance between the interests of both parties.

Steps to Take if You Suspect Misrepresentation

If you believe you have been the victim of misrepresentation when buying a business, it’s crucial to act quickly and strategically to protect your rights and interests. The longer you delay, the harder it may be to unwind the transaction or recover any losses. Here are the key steps to take if you suspect misrepresentation:

1. Gather Evidence and Document Everything

The first step is to gather as much evidence as possible to support your misrepresentation claim. This includes:

• The contract of sale and any related documents (e.g. disclosure statements, due diligence reports)
• Financial statements, projections and other accounting records provided by the seller
• Emails, letters or other correspondence with the seller or their representatives
• Notes from any meetings or phone calls where representations were made
• Documents or information that contradicts the seller’s representations (e.g. asset registers, customer contracts)
• Evidence of the losses you have suffered as a result of the misrepresentation (e.g. rectification costs, lost profits)

Create a timeline of events leading up to the sale, including key dates and details of any representations made. The more concrete evidence you have, the stronger your case will be. Keep detailed records of any steps you take moving forward, including any discussions with the seller or your advisors.

2. Seek Prompt Legal Advice From Experienced Professionals

Misrepresentation claims can be legally complex and time-sensitive, so it’s essential to seek advice from an experienced business lawyer as soon as possible. Look for a lawyer who specialises in commercial disputes and has a track record of successful misrepresentation claims.

Your lawyer can advise you on the strength of your case, the available remedies and the best strategy for achieving a positive outcome. They can also help you navigate any contractual notice or dispute resolution procedures that may apply.

Depending on the complexity of the matter, you may also need advice from other professionals such as accountants, valuers or industry experts. Choose advisors who have experience in business sales and can provide objective, evidence-based opinions to support your claim.

3. Notify the Seller of the Misrepresentation

Once you have gathered evidence and obtained legal advice, you will typically need to notify the seller of the alleged misrepresentation. Your lawyer can help you draft an appropriate letter outlining:

• The specific representations that were made
• How those representations were false or misleading
• The evidence you have to support your claim
• The losses you have suffered as a result
• The remedy you are seeking (e.g. rescission of the contract, compensation)

The letter should be carefully worded to avoid any admissions or statements that could prejudice your case. It should also put the seller on notice of their obligation to mitigate any further losses and preserve relevant evidence.

In some cases, it may be appropriate to propose a settlement or mediation to resolve the matter without litigation. However, this will depend on the severity of the misrepresentation and the seller’s willingness to engage in good faith negotiations.

If the seller disputes your claim or refuses to cooperate, you may need to commence formal legal proceedings. This could involve filing a statement of claim in court or initiating an alternative dispute resolution process (e.g. arbitration).

Litigation can be costly and time-consuming, so it’s important to weigh the potential risks and benefits before taking this step. Your lawyer can advise you on the likely costs, timeframes and outcomes of any legal action.

Mitigate Your Losses and Consider Your Options

While pursuing a misrepresentation claim, it’s important to take reasonable steps to mitigate your losses. This could include:

• Seeking alternative suppliers or customers to replace any lost business
• Implementing cost-saving measures to minimise the impact of any financial losses
• Taking steps to rectify any undisclosed defects or compliance issues with the business

You should keep detailed records of any expenses incurred in mitigating your losses, as you may be able to recover these as part of your claim.

At the same time, consider your options for moving forward with the business. Depending on the severity of the misrepresentation and the stage of the sale process, you may wish to:

• Rescind the contract and unwind the transaction completely
• Seek compensation from the seller while continuing to operate the business
• Negotiate a reduction in the purchase price or other concessions from the seller
• On-sell the business to another buyer (although any misrepresentation issues will need to be disclosed)

There is no one-size-fits-all approach, and the best option will depend on your individual circumstances and risk appetite. Your lawyer and advisors can help you assess the pros and cons of each approach and make an informed decision.

Case Study: Misleading Financial Statements Lead to Business Sale Dispute

To illustrate the real-world consequences of misrepresentation in a business sale, let’s take a closer look at a recent case from the Supreme Court of New South Wales. This case highlights the importance of accurate financial disclosure and the remedies available to buyers who are misled.

Background

In the 2022 case of QVB Pharmacy Pty Ltd v Le, the parties entered into a contract for the sale of a pharmacy business located in Sydney’s Queen Victoria Building. During the pre-sale negotiations, the seller provided various financial documents to the buyer, including profit and loss statements and business activity statements (BAS).

The buyer relied on these financial statements to obtain a valuation of the business and make an offer to purchase, which included a substantial sum for goodwill. However, after the sale was completed and the buyer took over operations, it quickly became apparent that the actual turnover and profitability of the business was significantly lower than what the financial statements had indicated.

Discovery of Misrepresentation

Upon further investigation, the buyer discovered that the seller had manipulated the financial statements in several ways:

• Inflating revenue by recording false Medicare claims
• Injecting cash into the business to create the illusion of higher turnover
• Understating expenses and misrepresenting the cost of goods sold

The discrepancies were so substantial that the business was actually worth hundreds of thousands of dollars less than the purchase price. The buyer sued the seller for misleading and deceptive conduct, arguing they would never have purchased the business if they knew its true financial position.

Court Proceedings

In court, the seller tried to argue that the financial statements were prepared by his accountant, and he was not aware of any inaccuracies. He also pointed to various clauses in the sale contract where the buyer had acknowledged they were purchasing the business based on their own inquiries and due diligence.

However, the court rejected these arguments and found that the seller had knowingly engaged in misleading conduct. The judge noted that the seller had a legal obligation to ensure any financial information provided was accurate, and could not simply blame his accountant. The court also held that the general disclaimers in the contract did not absolve the seller of liability for specific misrepresentations.

Outcome and Damages

As a result, the court ordered the seller to pay significant damages to the buyer, including:

• Compensation for the difference between the purchase price and the actual value of the business (over $700,000)
• Interest on the loan the buyer had taken out to finance the purchase (over $200,000)
• Legal costs incurred by the buyer in bringing the claim

Key Takeaways

For Sellers

The total damages awarded exceeded $1 million, underscoring the serious financial consequences of misrepresentation for both parties.

This case serves as a cautionary tale for sellers about the dangers of providing inaccurate or misleading financial information, even if the misrepresentation is not deliberate. It also demonstrates the importance of buyers conducting thorough due diligence and carefully documenting any representations made by the seller.

While general contract disclaimers may offer some protection, they will not always shield a seller from liability for specific misrepresentations. If a seller makes a clear and unambiguous statement about the financial position of the business, they cannot simply rely on broad exclusion clauses to avoid responsibility.

For Buyers

For buyers, the case highlights the value of obtaining independent legal and financial advice when purchasing a business. Relying solely on the seller’s representations can be risky, and buyers should always verify key information through their own due diligence processes.

If a misrepresentation is discovered after the sale, it’s crucial to seek legal advice promptly. As this case shows, the financial stakes can be high, and delays in bringing a claim can potentially compromise the buyer’s ability to recover their losses.

Conclusion

Misrepresentation in business sales can have serious financial and legal consequences for both buyers and sellers. Buyers should conduct thorough due diligence, seek expert advice, and ensure important seller representations are included in the contract. If misrepresentation is discovered after the sale, buyers should act quickly and seek legal guidance. Sellers must ensure all information provided is accurate, complete, and transparent.

Honesty and transparency are key to reducing misrepresentation risks and achieving a successful business sale. With the right approach and professional advice, parties can navigate the complexities and move forward with confidence.