CONTRACT INTERPRETATION BASICS: BEWARE WHAT YOU WARRANT
Contracts define and control most business transactions. Therefore, clarity about what has been agreed in them is critical. This does not mean being able to explain what you thought you agreed to or intended to agree to. It means understanding how the words of your contract will be interpreted by a court or an arbitrator if a dispute about their meaning arises. That understanding at the outset can save much angst and litigation expense later.
The courts have developed rules of contract interpretation that sound fairly straight forward. The words chosen by contracting parties to express their bargain are to be given meaning if at all possible. They are to be given their plain, literal and grammatical meaning (unless absurdity would result), construed in the context of the entire contract and taking into account the factual circumstances in play when the contract was made. Except in specific circumstances, evidence of how the parties have performed the contract and of their subjective intention is not admissible to inform the court’s interpretation of the contract. To many business people it may be counter-intuitive that in a contract dispute contracting parties are not usually permitted to explain to the decision-maker what they intended. In fact, evidence of what they intended is not admissible unless the disputed provision is found to be ambiguous. If a court decides that a provision is not ambiguous, then the starting point (and sometimes the end point) for interpreting that provision is the words used by the parties.
Even a cursory review of the vast body of legal decisions on contract interpretation reveals that, despite the apparent certainty about the rules of contract interpretation, there is wide variation among judges in the way those rules are applied, and therefore in the results reached. Particularly problematic are the rules about ambiguity and the admissibility of extrinsic evidence (evidence beyond the words of the contract themselves). One judge may find that a term of a contract is ambiguous, and therefore go beyond the plain words of the contract and consider extrinsic evidence to determine the intention of the contracting parties. But frequently the same term will be found by another court (say on appeal) to be unambiguous, therefore not permitting resort to any evidence other than the contractual words themselves.
A recent decision by the British Columbia Court of Appeal illustrates this pattern. The case involved a contract for the sale of 60 acres of land in Salmon Arm. The purchaser intended to develop the property for retail use, including a ‘big box’ store and residential properties. After the property was transferred but before full payment had been made it became clear that the property could not be developed as planned. There were three critical problems: (1) a third of the property could not be developed because of legislation restricting development for environmental/riparian reasons; (2) the city had not re-zoned the property as expected; and (3) there was strong public opposition to the development of a ‘big box’.
The purchaser claimed damages from the vendor. The case was decided based on whether the vendor had breached its contractual warranties. That turned on the courts’ interpretations of their wording. The determinative issue was whether the vendor’s contractual warranties about disclosure of material information were limited to information actually known to the vendor.
As is common in commercial contracts, the purchase and sale agreement set out vendor’s warranties. The critical wording was as follows (emphasis added):
3.1 Representations of the Vendor. The vendor covenants, represents and warrants to and in favour of the Purchaser that, as of the date of this Agreement, or such other date as may be specified: …
(i) Full Disclosure. So far as the Vendor is aware, the Vendor has disclosed to the Purchaser all material information pertaining to the Purchased Lands, whether solicited by the Purchaser or not. Neither this Agreement nor any other document referred to in this Agreement or any Schedule to this Agreement nor any statement, schedule or certificate furnished or to be furnished to the Purchaser pursuant to this Agreement contains or will contain any untrue statement or omits or will omit to state a material fact. All material information pertaining to the Purchased Lands is set out in this Agreement or contained in the Property Documents.
The essence of the dispute was whether the vendor had breached its warranty by not informing the purchaser of the three problems set out above, even though the vendor did not actually know that information.
This case is a very clear example of the attention that must be paid to the wording of contractual warranties and the importance of understanding what you are warranting. Once there is a dispute about breach of warranty, the rules of contract interpretation may prevent you from explaining to a court the scope of the warranty you intended to give.
In this case, the Supreme Court judge found that the warranty was ambiguous. It was uncertain whether the opening words “So far as the Vendor is aware” modified only the remainder of the first sentence or the entire warranty. The second sentence was the critical one, because it required the vendor to disclose all material facts. The purchaser alleged that the proper interpretation of the agreement was that whether or not the vendor knew those facts was irrelevant. The purchaser alleged that the vendor omitted information about the three critical issues.
The judge found that a warranty by a vendor that it had disclosed all material facts, including those outside its knowledge, would be “extremely far reaching” and of an “extraordinary nature”. Given the magnitude of the risk to the vendor, the judge reasoned that the agreement should have clearly confirmed its undertaking of that risk. As there was no such confirmation, the judge found that there was ambiguity in the warranty, allowing him to look at extrinsic evidence to determine the parties’ intention. He ruled that the second sentence of the warranty was also limited by the opening words of the clause. The vendor only warranted that it had disclosed all material information within its knowledge. The vendor had not breached that warranty.
But the Court of Appeal found that the judge had been too quick to refer to extrinsic evidence. Unlike the judge, the Court found that the warranty was not ambiguous at all. The clause was found to have two essential parts: the statement by the vendor that it had disclosed all material information known to it at the time of making the statement (the first sentence), and the statements that all material facts were contained in the vendor’s disclosures and that these facts were true (the second sentence). Contrary to the judge’s finding, the Court ruled that only the first sentence of the warranty was qualified by the phrase “So far as the vendor is aware”. Therefore, the second sentence obligated the vendor to disclose all material facts, whether or not they were known to it.
The Court of Appeal observed that, although such a provision might be harsh, contractual warranties are used to allocate risk and parties are free to do that as they see fit. Despite the judge’s finding, the Court questioned whether the provision was extraordinary, and found that, even if it was, that did not mean it was ambiguous, so as to allow resort to extrinsic evidence. It is perhaps strange that the Court did not see any ambiguity in the two parts to the warranty. Why was the first sentence necessary if the second was unqualified and required the vendor to disclose to the purchaser all material information, whether or not known to the vendor?
This decision emphasizes that courts may look to extrinsic evidence to determine what agreement the parties actually made only where there is ambiguity. But courts may not look to extrinsic evidence to resolve an uncertainty about the legal consequences of the agreement made by the parties.
Having found no ambiguity in the warranty provision, the Court’s reading of the warranty made it irrelevant whether the vendor knew of the undisclosed facts. The vendor’s failure to disclose was a breach of warranty, even though the vendor had not known of them. The court accepted that the vendor had not been willfully blind or recklessly disregarded facts that were there to be known.
It simply did not know about the problems. But, because they were material, the failure to disclose them was a breach of warranty, entitling the purchaser to damages.
Is there anything surprising in this case? Arguably not, if you accept that the warranty was not ambiguous and, though onerous, simply represented an allocation of risk between the contracting parties. But the result confirms that parties should be cautious when agreeing to warranties (or other contractual provisions).
This case also illustrates that you can obligate yourself to communicate to the opposite party information of which you are not even aware. If you do, it is not enough to be honest about your actual state of knowledge. If you agree to a warranty of this nature, then you are obligating yourself to conduct due diligence to discover all material facts (even though you are the vendor), to monitor any developments involving those material facts, and to report accurately, truthfully, and comprehensively to the purchaser. Not everyone would take on this type of obligation. If you do, you certainly want to understand what you are doing.
The best protection against unexpected outcomes is careful, effective contract drafting, and a clear understanding of what obligations and rights are created by the agreed contractual wording.
SHARE VALUATION BASICS
The necessity to determine the value of shares in a corporation can arise in several ways, including:
- a negotiated purchase;
- a shareholder dying or ceasing to be an employee of the company, or another triggering event under a shareholders’ agreement;
- the exercise of a “shotgun” clause in a shareholders’ agreement;
- the court ordering the company or another shareholder to buy the shares to remedy oppressive or unfairly prejudicial conduct, or as an alternative to liquidating and dissolving the company; and
- the exercise of a right of dissent under corporate legislation.
In all of these situations the buyer and seller can agree on the value of the shares. But what if they cannot? In those situations where the sale is compulsory, litigation or arbitration will be required to determine share value. That will almost certainly require expert opinion evidence. This article explores the legal and business valuation issues involved in such proceedings.
The Court of Appeal for British Columbia has taken pains to emphasize that the fair value of shares is a special problem in every case. Each case must be examined on its own facts. Factors which may be critically important in one case may be meaningless in another. Calculations which may be accurate guides for the value of shares in one company may be entirely flawed when applied to shares in another.
The one true rule is to consider all the evidence that might be helpful and to exercise the best judgment that can be brought to bear. No method of determining value which might provide guidance should be rejected.
It is generally not appropriate to apply a minority discount in determining the fair value of shares when they will be purchased as a remedy for oppression or after a right of dissent from corporate action has been exercised. It would be inappropriate to penalize a shareholder who has been the victim of oppressive conduct or exercised a statutory right of dissent.
Minority discounts may or may not be appropriate in other situations. For example, when a sale occurs under a shareholders’ agreement, the agreement may address whether a minority discount will be applied. If not, then the valuator will have to consider the issue, in light of the percentage of shares held, the share rights and restrictions, the history and pattern of dividends, any right to appoint directors, the shareholder’s general ability to influence the company and other factors.
Generally speaking, shares ordered purchased as a remedy for oppression are valued as of the date of the filing of the petition seeking relief. Shares purchased as a result of the exercise of a right of dissent are valued as of the date of the resolution approving or adopting the corporate action dissented from. A well-drafted shareholders’ agreement will address the valuation date for a purchase of shares as a result of a triggering event or shotgun clause. If not, then the court or arbitral tribunal is likely to select the date the right to sell and/or purchase arose.
Fair Value but for Oppression
If shares are purchased as remedy for oppression, the price must make allowance for any negative effect caused by the oppression itself. The price paid will be the fair value as of the valuation date, but for the oppression complained of. For instance, if the oppression included the majority shareholder appropriating some of the company’s assets, those assets would be notionally brought back into the company for valuation purposes.
BUSINESS VALUATION ISSUES
Chartered Business Valuators
A business (and so its shares) can be valued by anyone; the law does not specify who is qualified to perform valuations. A number of court cases have, however, recognized the distinction between expert evidence provided by a Chartered Business Valuator and that provided by a person without the same level of education and professional expertise.
The Canadian Institute of Chartered Business Valuators is the recognized professional organization for business valuation in Canada. The Institute has established practice standards, as well as a code of ethics, to set out the minimum requirements for report disclosure, scope of work and file documentation in the preparation of a business valuation.
Types of reports
The Institute has established three levels of business valuation reports, distinguished by the scope of review, amount of disclosure and level of assurance provided in their conclusions. The three levels are Calculation, Estimate and Comprehensive valuations. A Comprehensive valuation provides the most assurance.
In preparing a valuation of shares, assets or an interest in a business, the valuator generally considers, among other information, financial information (including, if available, the financial statements for the last five years), the most recent corporate tax return, the current budget or business plan, the operations of the business, market and transaction comparables, and industry research.
When determining the value of a particular business, an assessment must first be made of whether a going concern or liquidation methodology should be the primary method of valuation. The primary method should be the one that yields the greatest net contribution to the equity owners.
A going concern valuation can be based on one or more approaches, including asset-based, income-based and market-based approaches. Asset-based approaches are typically used for businesses where the going concern outlook may be uncertain, and for real estate or investment holding companies whose value is in their tangible assets.
Income-based approaches are appropriate when the business is a viable going concern
and provides investors with a reasonable rate of return on investment, and where purchasers would value it on the basis of its stream of earnings/cash flows.
Where the entity is an active operating business, the determination of going concern value is normally best developed with an earnings and/or cash flow based approach.
These generally require:
- An assessment of the future prospects of the business. This normally is the amount of discretionary cash flows or maintainable earnings which the business prospectively is expected to generate, based on its historical operating results and perceived prospects.
- An assessment of the risk of achieving those prospects. That is, what is the appropriate discount or capitalization rate which is applied to the estimated discretionary cash flows or maintainable earnings? Generally, the greater the risk, the higher the required rate of return demanded by a purchaser.
- That redundant assets be identified and segregated. Redundant assets are those not required to generate the prospective discretionary cash flows or earnings of the business. Their net realizable value is added to the income-based value determined for the business.
A common asset-based approach is ‘adjusted net book value’, a measure of the value of the tangible assets subject to purchase, net of all outstanding liabilities. The adjusted net book value is the composite of the fair market values of the individual tangible assets employed in the business, less liabilities, assuming the business continues as a going concern. Where shares are valued (as opposed to net assets), a further adjustment is made for the tax shield difference between the market values of the assets and their cost base for income tax purposes.
The adjusted net book value (or a variant - the tangible asset backing) is also used to measure the risk associated with conclusions reached under an earnings or cash flow based valuation methodology. For example, when the earnings or cash flow value of a business exceeds its adjusted net book value, the difference is ascribed to goodwill and/or other intangible assets.
Valuing shares is rarely straightforward. There are a number of legal and valuation issues to be considered. If you are faced with the need to do so, you should obtain appropriate advice from qualified professionals.
NEW BRITISH COLUMBIA LIMITATION ACT NOW IN FORCE
On June 1, 2013 the significantly revamped Limitation Act came into effect in British Columbia. The Act imposes a two-year limitation period on bringing most legal claims, after which all claims (whether through a lawsuit or other means) are barred. This greatly shortens the deadline for claims from the previous six years for most business disputes. All companies or persons with business ties to British Columbia should closely monitor projects and contracts where litigation may be necessary, and review all contractual provisions concerning potential litigation, to make sure that potential claims are not statute-barred by the new Act. If in doubt, sue.
BASIC TWO-YEAR LIMITATION PERIOD
Under the new Act, in most circumstances, claimants must sue within two years after they “discover” they have a claim. A claim is “discovered” when the claimant knows that harm has been suffered as a result of the defendant’s actions, and that a court proceeding would be an appropriate way to remedy that harm. A claimant cannot be complacent, and must be reasonably diligent in investigating, discovering and starting the lawsuit.
For most claims, such as personal injury and contract claims, the claimant will know right away that they have been harmed and that they have a potential lawsuit, so the limitation clock will start to tick immediately. For other claims, such as latent construction defects and fraud claims, the wrong may go undetected for years. There, the clock will start to tick at that later date.
ULTIMATE LIMITATION PERIOD REDUCED TO 15 YEARS
Even if the two-year limitation period is extended through late discovery, a claim must still be made within the “ultimate limitation period”. The new Act sets this period at 15 years (cutting in half the 30 years under the old Act).
There are important exceptions. First, if the defendant confirms the claimant has a claim, the limitation clock is reset. This often occurs when a person acknowledges that a debt is owed or makes a payment on it. Second, neither the basic nor the ultimate limitation period runs while the claimant is under a physical or mental disability, is under 19 years of age or is the victim of a fraud.
DOES THE OLD ACT OR THE NEW ACT APPLY?
The new Act is not grandfathered. Generally, if the wrong occurred and was discovered before the new Act came into force on June 1, 2013, the old Act applies. If the wrong occurred before the new Act came into force, but was not discovered until after June 1, the new Act applies.
REVIEW CONTRACTUAL REMEDIES
When a limitation period expires, the claimant is not only barred from beginning a lawsuit. All remedies are extinguished. Not only can the claimant not sue, but they also cannot (for example) demand payment, carry out rent distress, repossess vehicles or other secured goods, or start an arbitration. Many contracts, such as joint-venture agreements, set out processes for dealing with disputes. If those processes take longer than two years, the aggrieved party may be out of luck in pursuing a remedy. It is crucial to review all contracts with dispute-resolution provisions in light of the new Act.
IS IT POSSIBLE TO CONTRACT OUT OF THE NEW ACT?
The new Limitation Act does not expressly allow parties to contract out. Private agreements to shorten or lengthen limitation periods may or may not be accepted by courts. It is not likely that agreements to shorten limitation periods will be allowed, particularly in consumer transactions where one party is more financially sophisticated than the other.
- Claimants can no longer take a leisurely wait-and-see approach. Review all potential claims in all past and ongoing projects and transactions. Anticipate, monitor, investigate and swiftly act on potential problem areas in ongoing projects and transactions.
- Start calculating potential limitation periods from the moment of potential harm, not actual harm.
- Review all potential claims well in advance of the two-year deadline.
- Review all systems for limitation period alerts and starting litigation on all files.
- The new Act may present new opportunities for arguing limitation defences and striking unmeritorious claims at early stage, thus saving money and resources.
- If in doubt, file a claim and preserve your rights.