The importance of due diligence and the responsibility of investors to conduct a proper investigation of the target businesses is emphasised in this case.  The mere fact of misrepresentation or breaches of contractual warranties may not be a basis for a remedy where there has been a lack of reasonable inquiry. Companies should be mindful of this in ensuring adequate due diligence is carried out on any potential targets.

John Reid sold one of the two shares in David Reid Homes Australia Pty Ltd (DRH Australia) to Stephens Luxury Homes Pty Limited (SLH ) (a company owned by Russell Stephens), with the purchase price to be paid in instalments under a share sale agreement.  The business of DRH Australia was very much dependent on the success of its franchisees who would own and run businesses building homes to the David Reid system.  DRH Australia failed shortly after the sale and the last two instalments of the purchase price were not paid by SLH.

As a defence, Stephens alleged that four pre-contractual representations (including representations about DRH Australia’s future strategy, its business plan and its profit projections) were made in breach of what was then section 52 of the Trade Practices Act 1974.  The Court rejected Stephens’ claims of misrepresentation due to the lack of evidence establishing causal links between the representations and the loss suffered by Stephens and reliance by Stephens on the representations.  The Court was critical of Stephens’ lack of inquiry into DRH Australia’s financial position during the due diligence despite being given unrestricted access to DRH Australia’s business and accounts, especially his deliberate choice not to investigate the businesses of the franchisees (which he considered would have taken unreasonable time and money).

Stephens also alleged a breach of contractual warranties that information disclosed under the due diligence:

  • would be complete, true and accurate and in no way misleading; and
  • was prepared in good faith, after reasonable enquiries, and did not omit anything material (which was separately defined).

Stephens claimed that the failure to disclose that 4 franchisees (from a total of between 13 and 21) were impecunious (and were unable to pay the initial franchise fee without a loan which was personally guaranteed by Reid) breached these warranties, particularly given the dependence of the business on the success of the franchisees.  Agreeing with Stephens, the Court found that the financial capacity of the 4 franchisees fell within the definition of “material” in the contractual warranties and that Reid’s non-disclosure was a breach of those warranties.  However, the breach was found to have an insufficient causal link to Stephens’ loss and the failure of DRH Australia could not, on the balance of probabilities, be attributed to the 4 impecunious franchisees.  The failure occurred during the GFC and there was also evidence of Stephens’ failure to properly resource the business.

In rejecting Stephens’ assertion that had he known about the 4 franchisees, he would have re-negotiated the purchase price, the Court noted Stephens’ naïve approach to the purchase and the fact that while some concerning general information about cashflow of some franchisees and their capacity to continue had been disclosed, Stephens had made no effort to make any follow up enquiries.

See the case.