The documents are signed, you’ve done the deal – congratulations! But some time later things are not as rosy as they seemed: revenues are not what you expected and you’re beginning to question the wisdom of your investment decision. Looking round for someone to blame, the accountants who provided the due diligence reports seem a prime candidate.
Luxury health club deal
In late 2006 Ernst & Young were engaged to provide limited due diligence services on the acquisition of the Esporta group of premium health and fitness clubs. Esporta’s revenues were largely determined by membership so a key part of the accountants’ role was reviewing the forecasts for new member growth in the business plan provided by Esporta’s management. Esporta predicted that the number of new members joining its existing clubs would grow by 2.73% in 2007. Ernst & Young took a more conservative approach: their due diligence report revised this forecast down to 0.8%.
A done deal?
An unusual feature of this deal was that, by the time the accountants were engaged to provide the top up due diligence, the buyer had already signed a sale and purchase agreement agreeing to buy the Esporta clubs for £474 million. If the buyer decided to withdraw from the deal, either because it was unhappy with the contents of its due diligence report or for another reason, it would forfeit the £23 million deposit already paid to the seller.
In fact, the deal went ahead but when post-completion revenues were significantly lower than expected the buyer brought a negligence claim against Ernst & Young. The buyer argued that the accountants should have been even more conservative in their revised forecasts and that the predicted growth rate, based on information available at the time, should actually have been 0%. The buyer argued that “but for” the accountants’ negligence it would not have completed the transaction and would instead have withdrawn from the deal and forfeited the deposit.
The High Court has now dismissed the buyer’s claim. The court found that Ernst & Young had not been negligent at all: their analysis was “entirely reasonable and complete”. In case it was wrong on that point, however, the court also considered whether the alleged negligence by the accountants actually caused the buyer any loss. Here, the court said the alleged failures in the accountant’s reporting made no difference to the buyer’s decision to proceed with the deal: even if they had revised their forecast downwards, as the buyer said they should have done, the buyer would still have acquired Esporta on the agreed terms.
The judge also took a dim view of a late change in the buyer’s case where it emphasised that the accountants’ were aware of the key information several months earlier than previously thought. That was viewed as an “opportunistic and unprincipled attempt” by the buyer to rescue its case which had already been exposed as “lacking in merit”.
Hindsight is a wonderful thing…
Whenever something doesn’t turn out quite as expected, it is probably inevitable that decisions are reconsidered with the benefit of hindsight. The buyer clearly felt that had the forecasted growth been revised down it would not have gone ahead with the deal. But the judge considered the buyer’s decision to proceed only on the basis of the information available to it at the time that decision was made and found that the further £1 million reduction in EBITDA that would have resulted from the buyer’s calculations was immaterial in the context of the deal as a whole.
It also seems likely that the poor joining figures experienced immediately after completion could have been affected by Esporta featuring in the BBC’s “Watchdog” programme which alleged that sales staff had misled prospective members about the terms of membership and that the business had breached those terms by refusing to allow seriously ill members to terminate their membership. Something which presumably Ernst & Young (and the buyer) knew nothing about at the time of the deal.