Buyers’ best defence against M&A fraud requires rigorous, pre-closing due diligence — when fraud is suspected, deal teams should seek legal advice and proceed with caution.
Recent high-profile fraud cases gravely illustrate how a failure to detect fraudulent activity can cause lasting damage to corporate value. In January 2019, publicly listed bakery chain Patisserie Valerie collapsed following allegations of a £40 million accounting fraud.
In our view, instances of fraud in the context of acquisitions are more common than is often thought. There can be (or have been) allegations of artificial inflation of reported revenues, revenue growth, and gross margins or other distortions — underlining the high stakes and public nature of M&A fraud allegations.
The best protection against fraud comes from specialist due diligence and an early emphasis on fraud detection pre-closing. Where concerns arise post-closing, English law provides some innate protections, but deal teams should seek legal advice early on to help navigate this complex area without causing further damage.
The First Lines of Defence for Buyers and Deal Teams
English law imposes a very limited duty on sellers to disclose information — buyers must beware. Whilst a seller can be liable if it gives specific warranties that are incorrect, non-disclosure or silence alone is generally not enough to amount to fraud. Due diligence is therefore hugely important as the first line of defence.
If a target’s business is opaque, access to information is unnecessarily restricted, or unusual practices or patterns emerge, deal teams should seek advice. Concerned deal teams will need to make a concerted effort to discover fraud. Instructing forensic accountants, while often thorough, can be expensive and may not be practicable in the context of a competitive deal process.
Often, the best line of defence for acquirer due diligence teams is to look beyond the data room and, if possible, seek to engage with target management to better understand how the business operates in practice and to informally verify what appears in the paper trail. This approach to due diligence could also reveal issues around bribery, money laundering, or compliance, which can undermine corporate value and attract large fines.
Why Now? Mind the Audit Expectation Gap
The role of accountants and auditors in detecting fraud is a hot topic. Recent government reports indicate an expectation gap, when prospective purchasers wrongly believe that audited accounts provide the necessary levels of diligence in an M&A context.
The Patisserie Valerie fraud was discovered through forensic accounting, an exercise with a very different standard from that of an audit (which, at least in Patisserie Valerie’s case, did not uncover fraud). For deal teams, relying solely on existing accounts (of any nature) is not sufficient. If such accounts are not prepared specifically for the benefit of potential acquirers, the potential acquirers will have a few options to directly pursue compensation.
What if Fraud Slips Under the Radar?
If fraud is suspected, buyers should contact legal counsel before approaching the seller or other parties involved in the deal. Bringing fraud claims is challenging, and if claims are not carefully addressed from the outset, there is a strong risk of exacerbating the damage.
The discovery of fraud between signing and closing usually gives rise to a right to terminate the SPA, if it is sufficiently material. If wrongdoing is discovered after a deal has closed, a key reason to claim fraud rather than breach of warranty is that a seller cannot contractually exclude or limit liability for fraud via exclusion or limitation clauses (and attempts to do so are ineffective as a matter of English law). “Fraud unravels all”, as the saying goes.
If irregularities are detected before an escrow payment is made, asserting a claim at that stage may improve prospects of recovery — either by settlement, or by seeking a court-ordered preservation of the funds pending the outcome of any dispute. Contracts also often allow a purchaser to withhold deferred consideration in the event they claim fraud, which can provide added protection for pursuing a claim, or assist in leveraging a settlement. Deal teams should note that the approach taken to fraud varies by jurisdiction. Delaware and New York allow for non-reliance clauses to exclude liability for fraud, if drafted with a sufficient degree of explicitness, although case law remains fluid and fact-specific.
English courts take a robust approach to dealing with fraud claims, including by making orders for a defendant’s premises to be searched, and for assets to be frozen.
Directors can be found personally liable for false statements that they made or authorised, or where they have conspired with another party. English courts are also more willing to find substantial loss in fraud cases, in contrast to the general rule that losses should be a foreseeable consequence of the wrong. Additionally, defendants cannot argue that claimants “contributed” to their own loss (e.g., by not checking the fraudulent statement).
Fraud in Public M&A deals
Risks relating to fraud need particular attention in public M&A deals. Although listed companies have ongoing disclosure and audit requirements, there are many instances of fraudulent practices at public companies which have only been uncovered years later. Due diligence in public M&A deals often needs to be carried out in an accelerated timeframe and target companies are frequently sensitive to providing non-public information. Deal teams must carry out focused due diligence, that looks beyond the numbers in the accounts and examines the strength of the target’s internal financial reporting procedures.
Bidders also face the issue that they usually will not have the benefit of any warranties from the selling shareholders of a public company. If fraud is discovered after a public M&A deal closes, the only course of action for a buyer may be a claim for misrepresentation or fraud against the directors or management team of the target on the basis of information provided or statements made in due diligence or public documents. Of course, the level of damages likely to be recovered through personal claims against the directors or management could be considerably less than the financial and reputational damage suffered by the company.
Fraud is difficult to spot and even more difficult to prove — and it can have a rapid and detrimental impact on the value of an M&A deal, with fines and penalties for associated wrongdoing. Deal teams must balance targeted due diligence with the commercial deal realities, remaining alert to risks and seeking legal advice to aid discovery of wrongdoing and recovery of lost value.
WHAT IS FRAUD?
Fraud falls into two broad categories:
- Criminal claims under the Fraud Act 2006 — brought by the Crown Prosecution Service
- Civil claims for damages — brought by affected parties
Broadly speaking, both categories require:
- An individual to make a false statement
- Which they know to be false or are reckless as to whether it is false
- Which causes loss to another (or for criminal cases, which they intend will make a gain for themselves)
- Similar civil claims can be brought in conspiracy (broadly, fraud involving two or more persons),and are often run alongside claims with a lower standard of proof such as breach of duty, breach of trust, dishonest assistance and knowing receipt, breach of contract, or misrepresentation
- Choosing which claim to advance will depend on the strength of the evidence available, the identity of the prospective defendant, and any claims bars(g., exclusion or limitation clauses)
- Corporates should engage with lawyers as soon as any material irregularity is discovered