Deal teams negotiating acquisitions, or considering claims post-acquisition, should be aware of two recent cases relating to breach of warranties in share purchase agreements: The Hut Group Limited v Nobahar-Cookson and another and Augean plc v Hutton and others.
The most significant points relate to the calculation of damages. Although cases often turn on their particular facts, these decisions highlight a number of principles:
- the method of calculation of loss is likely to differ depending on whether the claimant acquires a majority or minority shareholding
- where quantum of loss is established using a multiple of EBITDA, the court may accept an argument that a ‘warranty false’ valuation (i.e. the valuation of the target company as it actually is, not as it is warranted to be) requires both a reduction in EBITDA and a reduction in the multiplier of EBITDA applied
- where a liability is partly recovered through a completion accounts process, this may jeopardise the ability to recover additional loss under a warranty claim
- damages for a breach of warranty in respect of one-off items of expense may be assessed on a cost of cure basis, giving a pound for pound adjustment, rather than a more complicated assessment of the loss in value of the shares. This suggests that arguing for an indemnity basis of damages for such items will not always offer any additional protection in practice
- damages are generally assessed at the point of breach of warranty and as a general rule a subsequent recovery of value will be disregarded
The Hut Group also considers other issues, including the process for notification of warranty claims and the effect of fraud.
Both cases relate to the sale and purchase of the entire issued share capital of a company. In Augean this was a waste management business. The purchase price comprised cash paid at completion, a cash retention payable later and an earn-out. One of the claims brought by the buyer related to a breach of the accounts warranties in the sale agreement.
The Hut Group related to the sale and purchase of an online sports nutrition business. The sellers sold the target for cash and also a minority shareholding in the buyer. The buyer brought a claim for breach of warranty relating to the target’s management accounts and the sellers counter-claimed for fraudulent breach of the accounting warranties given to them in relation to the minority shareholding.
The two cases show that calculation of damages for breach of warranty is likely to vary depending on whether the claimant has acquired a majority or minority shareholding (and the basis on which the parties valued the target). In both cases – where the buyers had acquired 100% of the target company – the correct method for calculating damages was held to be the difference between a multiple of EBITDA calculated as if the warranties were true (a ‘warranty true’ basis) versus a multiple of EBITDA based on the target as it actually was (a ‘warranty false’ basis). In both cases, the EBITDA on a ‘warranty false’ basis was smaller, but the multiplier remained the same. In The Hut Group it was argued that, when calculating the ‘warranty false’ value, a reduced multiplier should apply (hence enhancing the difference between ‘warranty true’ and ‘warranty false’). The court did not reject this in principle, but disallowed it on the facts, finding that a reasonable buyer and seller would not have revisited the multiple as well as the EBITDA. A reduction in the multiplier was not addressed inAugean.
In The Hut Group, the sellers’ counterclaim related to their minority (about 12%) shareholding in the buyer. Because of this, the judge decided that the correct measure of damages should be based on a discounted cash flow basis. The judge followed the established contractual principle that damages are generally to be calculated as at the point of breach, but added that damages can be forward-looking and can take into account the claimant’s expectations. The fact that, at the time of the sale, the sellers had a clear expectation that the buyer would be involved in an IPO, and that this would result in a windfall increase in the sellers’ shareholding in the buyer, was taken into account in calculating the ‘warranty true’ value. But the fact that the IPO might still happen in the future and the price of the shares might recover was not taken into account in calculating the ‘warranty false’ value.
In Augean the amount and type of waste stock on site at the target gave rise to a number of allegations of breach of warranty. The disclosure letter included a statement that the cost of treating waste stock had not been included in the accounts and that it was estimated to be £25,000. The completion accounts subsequently included a provision for waste stock of just under £75,000. The buyer confirmed that the completion statement was agreed without amendment and gave a statement that ‘at today’s date there are no known matters which we believe give rise to a claim under the Warranties’. The actual cost of treating the waste stock was higher than had been estimated in either the disclosure letter or the completion accounts, so the buyer brought a claim for breach of the accounts warranty. The judge found that, at the point the completion accounts were agreed, the buyer clearly did not think that there was a material difference between the estimate given for waste stock in the disclosure letter and the provision in the completion accounts, and that this weighed evidentially against the buyer in its attempt to maintain a claim for breach of the accounts warranty. This suggests that a buyer should take great care to reserve its rights when agreeing completion accounts if it is expecting to bring a warranty claim in the future that relates to the relevant item.
In both cases, where breach of warranty was proven, the judge calculated damages in respect of one-off items on a ‘cost-of-cure’ basis – i.e. a pound-for-pound recovery – even though the claim was for breach of warranty rather than an indemnity claim. This illustrates that, in practice, all is not necessarily lost as far as the buyer is concerned if the share purchase agreement does not provide expressly for recovery for breach of warranty on an indemnity basis, since the same pound-for-pound calculation might be applied by the court, provided it is reasonable and proportionate to do so.
In The Hut Group, the sale agreement provided that warranty claims must be notified within 20 days of the party ‘becoming aware of the matter’. When did awareness occur? The judge said that, to make commercial sense of the agreement, time started to run only once the buyer had enough information to realise that there was a proper basis for putting a claim forward – in this case, that point was not reached until the buyer had had initial advice from forensic accountants. Nevertheless, the case highlights the risk to the buyer of specifying such a short period for notification, as it can be difficult to review and consider a potential claim within that period.
The sellers tried to argue that the notice of claim did not meet the requirement in the sale agreement to specify the nature of the claim in reasonable detail and the amount claimed. The judge considered the notice to contain all that was practicable at that early stage by way of quantification, and commented that not much was required by way of description. Much depends on the wording of the agreement, however – in other cases, would-be claimants have been barred from bringing warranty claims because they have not meticulously complied with notification provisions.
In The Hut Group the sale agreement contained a financial cap on the buyer’s liability to the sellers but (as is standard) provided that the cap would not apply in cases of fraud. The sellers argued that the accounts warranties relating to the buyer were untrue and were based on fraud. It was accepted by both sides that the buyer’s financial controller had manipulated the buyer’s accounts, but the buyer argued that the financial controller’s fraud was not attributable to the buyer: he was not senior enough.
But the judge decided that, although the financial controller was not a director, he was involved in the deal and had personally provided information relating to the accounts warranties. The fact that he was not ‘front facing’ was irrelevant. His fraud was the buyer’s fraud and the cap did not apply.
Agreements often provide that the awareness of the parties is to be fixed by reference to the knowledge of named individuals – for example, where warranties are qualified as being given ‘so far as the seller is aware’ or the buyer affirms that it is not aware of any grounds for a future warranty claim. The case is a salutary reminder that provisions like this will not necessarily have any bearing on whether fraud can be attributed to a party (and it is doubtful whether the parties could effectively pre-ordain whose awareness is to count where fraud is in issue).
These cases are helpful as reminders of the basic principles which underpin damages for breach of warranties, and offer some useful pointers for the negotiation of M&A transactions and the avoidance of pitfalls.