Due Diligence and Real Estate Transactions: Always Know What You’re Getting Into

Published on: December 2021 | What's Trending

businessman analyzing a contract through a magnifying glass

This column was originally published on the Real Estate News Exchange (renx.ca).

When purchasing a business through a real estate transaction, buyers should do careful due diligence to ensure that they understand what they’re buying. This may sound obvious to some, but buyers do not always take this step and instead rely on representations from sellers instead of doing their own homework. This, in turn, leads to conflicts and often results in buyers finding themselves on the wrong end of a bad deal which they cannot get out of.

This is what happened in two recent Ontario Court decisions, where real estate transactions involving the sale of businesses went sideways after the sellers allegedly misrepresented them. Although both decisions reinforce the buyer’s responsibility to do its own due diligence, the court went both directions in assigning blame.

In Wen v. Gu, two parties entered into an agreement of purchase and sale for the purchase of a commercial property and the accompanying business. While the parties were negotiating the sale, the seller made certain representations about the income generated by the business, which the buyer relied on. Before the agreement was signed, the seller provided financial records for the business. The buyer therefore had the opportunity to verify the representations that were made before the agreement was entered into.

The buyer later refused to close the sale and alleged that the seller induced her into the agreement by misrepresenting the income of the business. The buyer then sued and alleged that the seller had made fraudulent misrepresentations regarding the business and claimed that the agreement of purchase and sale was frustrated as a result.

At trial, the judge agreed with the seller and ruled that the buyer had an opportunity to verify the representations about the income generated by the business and could not blame the seller for its own lack of due diligence. It was therefore held that the buyer breached the agreement by failing to close the transaction.

The buyer appealed and the court of appeal overturned the trial judge’s decision on the basis that, at trial, the seller admitted that it did, in fact, misrepresent the income of the business while the deal was being negotiated. Given that there was a confirmed misrepresentation, it was deemed to be unfair to blame the buyer, despite the lack of due diligence.

More recently, in 10443204 Canada Inc v. 2701835 Ontario Inc., two parties found themselves in a similar dispute over the purchase of a business through a real estate transaction, which ended in a very different result.

In that case, the business was listed for sale on Multiple Listing Services (“MLS”) and the buyer found out about it in May 2019 through an MLS search.  A meeting was then arranged with the buyer and seller through the listing agent, who was also present. The buyer claimed that, during the meeting, the seller alleged that the business was profitable and made a certain amount of gross income per month.  In reliance on those representations, the buyer made an offer to purchase the business.

A conditional agreement of purchase and sale was executed, in which the seller made a written covenant which stated that “the Business has been carried on in the ordinary course and all financial statements and other information provided to Buyer are true, accurate and correct in all material respects”. The agreement also gave the buyer the right to independently verify the income generated from the business before closing the transaction.

The buyer did not actually review any of the financial statements, it just looked at a one-page financial summary that the listing agent prepared with information from the seller. The statement also contained a term which stated that the Buyer (or its agent) “must verify” the information. The buyer did not hire its own agent and instead relied on representations from the listing agent. Nor did the buyer request any more financial information or take any steps to have the income verified independently in accordance with its rights under the agreement of purchase and sale.

When the transaction closed, the buyer paid the purchase price through a lump sum payment upfront and agreed to a vendor take-back mortgage (“VTB”). The Buyer also gave the seller a promissory note and personal guarantee for the remainder of the purchase price owing.

Soon after the closing, the buyer learned that the monthly income generated by the business was significantly less than the amounts represented by the seller. After finding out about this, the buyer immediately defaulted under the VTB payments. The Seller then sued for unpaid amounts owing under the VTB, the promissory note and the personal guarantee.

At trial, the court held that, regardless of whether or not the seller misrepresented the income of the business during the initial meeting, the buyer could not be deemed to have relied on any such representations in the legal sense. According to the agreement of purchase and sale, the buyer had the right to verify the income independently and the agreement also had an “entire agreement clause”, which stated that there were no external representations or agreements which formed part of the transaction. It was also noted that the buyer had an opportunity to use its own agent and conduct its own due diligence before the deal closed and it opted not to do so.

In the end, the court sided entirely with the seller and the buyer was ordered to pay the amount owing from the purchase price and had to repossess the business.

Given that these decisions are rather at odds with each other, it begs the question as to which reasoning is more correct. On the one hand, these decisions would seem to suggest that, if a seller admits to misrepresenting the income of a business, the buyer may be able to get out of the transaction on that basis. On the other hand, if the seller sufficiently protects itself by obligating the buyer to do its own due diligence, the seller will not be held responsible even if it may have misrepresented the business beforehand.

These decisions demonstrate that due diligence is essential when purchasing a business through a real estate transaction. Buyers should also give themselves the option to get out of the deal if the numbers don’t add up. Sellers, on the other hand, can protect themselves from liability by putting an entire agreement clause in the agreement of purchase and sale. If either side skips those steps, both buyers and sellers may find themselves on the wrong end of a failed deal.

Author: Daniel Waldman, Lawyer