Recent developments in liability in private M&A deals: Episode IA

In this episode of our series of articles on liability in private M&A deals, we discuss the recent decision of the Court of Appeal of England and Wales in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWCA Civ 1284. This overturned the High Court of England and Wales’ decision in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch) discussed in Episode I of our series of articles on liability in private M&A deals.

In brief

• The Court of Appeal of England and Wales recently handed down its decision in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWCA Civ 1284. This overturned the High Court of England and Wales’ decision in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch) discussed in Episode I of our series of articles on liability in private M&A deals.
• The Court of Appeal disagreed with the High Court’s decision that the sellers of an IT consultancy company had breached a contractual warranty in a sale and purchase agreement (SPA) that there had not been a material adverse change in the prospects of the company.
• The Court of Appeal found that the High Court applied the wrong test in determining whether there had in fact been a material adverse change in the company’s prospects. The Court of Appeal also found that the buyer did not provide a valid claims notice as required under the SPA, and accordingly, was not willing to remit the matter to a re-trial on the basis the buyer was subsequently out of time to bring a new warranty claim.
• Although a decision of the High Court of England and Wales, the case provides useful commentary on the approach of the English and Welsh courts to the interpretation of warranties referrable to a ‘material adverse change’ and the ‘prospects’ of a business in a SPA. It also illustrates the importance of complying with the claims notice provisions in a SPA when warranty claims arise.
• Following the High Court of Australia’s recent dismissal of the special leave application in Viterra Malt Pty Ltd & Ors. v Cargill Australia Ltd & Anor [2023] HCASL 165, Episode II of our series of articles on liability in private M&A deals in early 2024 will discuss the long-running Viterra v Cargill litigation and its impact on private M&A deals.

Background

As discussed in Episode I of our series of articles on liability in private M&A deals, the Decision Inc v Garbett proceedings concerned the sale of Copperman Consulting Ltd, an IT consultancy business that specialised in the design of enterprise performance management software to Decision Inc Holdings Proprietary Limited.

Prior to signing, and as part of due diligence prior to entry into the SPA, the sellers disclosed the target company’s financial information up until July 2018. However, shortly after the SPA was entered into, the buyer was then provided with the company’s accounts for the two months preceding signing, where it was revealed that turnover had dropped to £269,999 in August (where it was predicted to be £629,804) and £283,360 in September (where it was predicted to be £626,969).

In light of the significant drop in the company’s turnover, the buyer commenced proceedings against the sellers for breach of two warranties under the SPA, being that:

• “Since the Accounts Date … there has been no material adverse change in the turnover, … or prospects of the Company”; and
• “All financial and other records of the company … do not contain any material inaccuracies or discrepancies”.

Decision at first instance

Please refer to our article “Recent developments in liability in private M&A deals: Episode I” for a detailed discussion of the High Court of England and Wales’ decision at first instance in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588.

By way of recap, Gleeson J of the High Court rejected two claims by the buyer that there had been breaches of the records warranty in the SPA, and the warranty in the SPA that there had been no “material adverse change in the turnover” of the target. Gleeson J was of the view that:

• the relevant documents on which the claimants relied were not “records” and were not inaccurate in any case; and
• although there had been a significant drop in turnover figures particularly on a month-by-month basis, this was not large enough for a conclusion to be made that there had been a fundamental change in the nature of the revenue flows into the company.

Gleeson J, however, found in favour of the buyer in relation to its claim that there had been a “material adverse change to the prospects” of the target and that the sellers had breached the relevant warranty in this respect in the SPA. Gleeson J concluded that the defendants were liable to pay the Buyer £1.31 million in damages.

Material adverse change in prospects

In coming to His Honour’s conclusion, Gleeson J adopted a three-step approach to assessing a material adverse change in a company’s “prospects”, namely:

1. identifying the baseline figure (i.e. what the expected or forecast level of the relevant factor was at the time of the contract);
2. the actual figure (i.e. the actual position as at the date of the contract); and
3. the difference between the baseline and the actual figure to determine whether that difference is so greater as to be material.

In summary, Gleeson J held that the target would generate around £1m EBITDA in 2018 and possibly a little more in 2019 but that the actual expected profit was £0.3m, that being “what a reasonable hypothetical seller in the position of the Defendants would have known to be the true expected prospects of the Company for the year 2018”. The judge therefore held that there had been a “material adverse change in the prospects of the Company” and a breach of warranty.

The claims notice

The sellers had also argued at first instance that the buyer’s claims notice giving notice of the relevant warranty claims was invalid on the because it did not specify in respect of each of the relevant breaches, the quantum of damages sought in respect of the breach. The relevant provision in the SPA had provided that the defendants should not be liable for a “Claim” unless given notice in writing “summarising the nature of the Claim (in so far as it is known to the Buyer) and, as far as is reasonably practicable, the amount claimed.”

In the circumstances of the case, Gleeson J considered it was not possible for the claimants to allocate different values to the different breaches because the breaches were intertwined. His Honour held that the reason that the claimants gave only a single figure for the cumulative impact of the breaches was because that was the best they could do, and that must mean that their estimate was “reasonable”. The notice therefore satisfied the requirements of the SPA.

Decision in the Court of Appeal

On appeal by the sellers, the Court of Appeal was asked to consider, among other things, whether Gleeson J’s interpretation of and approach to the “prospects” warranty was wrong and whether the claims notice gave adequate notice of a claim for the breach of warranty. The Court of Appeal found in favour of the sellers and dismissed the buyer’s claims.

Given the claim for breach of the “material adverse change in turnover” warranty was dismissed at first instance, this was not considered on appeal.

No breach of warranty regarding material adverse change in prospects

The Court of Appeal considered that the judge at first instance had applied the wrong test in determining whether there had been a material adverse change in the target company’s prospects. Specifically, the Court of Appeal held that Gleeson J should not have determined the target company’s actual position as at the date on which the parties signed the SPA. Rather, the correct approach “had to be to assess the Company’s “prospects as at 31 December 2017 [the relevant accounts date] and to compare them with the prospects in October 2018 [the date the SPA was signed]”. This was because, as noted above, the warranty in the SPA provided that “Since the Accounts Date … there has been no material adverse change in the … prospects of the Company”.

The Court of Appeal gave four reasons:

• Date: based on the wording of the warranty, for a breach to be established, the company’s prospects must have worsened from the “Accounts Date”, being 31 December 2017. Accordingly, it was necessary to evaluate the Company’s prospects as at 31 December 2017 with the Company’s prospects in October 2018 when the SPA was signed and the relevant completion date occurred. Gleeson J did not do this. Rather, Gleeson J had assessed the “actual” position in October 2018 but contrasted that with the “expectation which a reasonable buyer would have had” rather than the position as at 31 December 2017.
• Comparison: a comparison needed to be conducted between the same thing (i.e. prospects) on different dates and not a comparison of different things (i.e. Gleeson J’s conception of “the expectation that a reasonable buyer would have had” versus the “actual” position) on the same date. The warranty was concerned with what the company’s prospects were in fact (at two points in time), not with what a buyer would have expected them to be.
• Assessment period: Gleeson J compared the forecast for the company’s prospects for the financial year 2018 with the earnings before interest, taxes, depreciation and amortisation (EBITDA) that a reasonable buyer might have expected for that year. The Court of Appeal held that Gleeson J had assessed whether the warranty had been breached by reference to what had already happened, not how the target company might fare in the coming period. The Court highlighted that “prospects” is forward-looking and that “the concern must surely be with what might happen after the relevant date”. However, the judge at first instance had focused on EBITDA for 2018 even though more than nine months of the year had passed by the time the SPA completed.
• “Prospects”: Gleeson J had equated “prospects” with EBITDA. However, in the context of the SPA, the term “prospects” did not simply refer to EBITDA and on its plain and natural reading, appeared to connote “chance or opportunities for success” in a more general sense. It was noted that:

“The meaning to be attributed to “prospects” may, of course, be affected by the context in which the word is used and, where used contractually, could potentially vary from one contract to another. In the context of the SPA, “prospects” is not easy to construe. I have not, however, been persuaded that it simply refers to EBITDA. Had the parties had EBITDA in mind, they could have been expected to use the term: after all, EBITDA features elsewhere in the SPA in a number of places.”

Claims notice

The Court of Appeal also found, contrary to Gleeson J’s decision at first instance, that the buyer’s claims notice was invalid. As noted above, the SPA had provided that the sellers would not be liable for a claim unless given notice in writing “summarising the nature of the Claim (in so far as it is known to the Buyer) and, as far as is reasonably practicable, the amount claimed”.

The Court of Appeal held that the notice was defective because it failed to give the “amount claimed” for breach of the warranty. The Court rejected the judge’s finding at first instance that it would not have been possible for the buyer to allocate different values to the different breaches. Instead, the Court of Appeal opined that:

“… it was not reasonably open to the Judge to find either that it was “not possible” to give an amount claimed for breach of the Prospects Warranty or that it was not “reasonably practicable” to do so. Common sense suggests that it was not impossible to work out how much was claimed. While the damages sought might have overlapped with those claimed for other alleged breaches of warranty, there was surely no bar to assessing what the damages would be if no other breach of warranty were alleged or made out. In fact, the Judge himself undertook such an exercise in the Judgement.”

The Court of Appeal also held that the correct view was that the SPA “required the claimants to state the “amount claimed in respect of each breach of warranty alleged, not just an omnibus figure, as far as reasonably practicable”. There was commercial logic in this approach to the extent that “a recipient may wish to settle a stronger claim but fight a weaker one”. Accordingly, the Court of Appeal held that:

“In all the circumstances, it appears … that, for the claimants to be entitled to pursue a claim for breach of the Prospects Warranty, the Notice had to include the “amount claimed” in respect of that breach and that the fact that it did not do so meant that the defendants could not be held liable for any such breach.”

The Court of Appeal declined to set the case for re-trial on the basis that the breach of warranty claims had failed because the claims notice did not comply with the requirements under the SPA and any new claim would therefore be out of time.

Commentary

While the Decision Inc. litigation relates to the courts of England and Wales, the Court of Appeal’s judgment provides useful commentary on the approach of the English and Welsh courts to the interpretation of warranties referrable to a “material adverse change” and a company’s “prospects” in a SPA. While it will always be warranty and fact specific, the Court of Appeal’s decision to dismiss the buyer’s claims for breach of a “no material adverse change in prospects” warranty demonstrates the potential difficulties in establishing a breach of these kinds of warranty provisions. It also illustrates the importance of complying with the claims notice provisions in a SPA when warranty claims arise.

As discussed in Episode I of our series of articles on liability in private M&A deals, in an Australian context, it is also important to note that statutory remedies can radically alter the deal between seller and buyer in private M&A deals. As previously noted, the Victorian Court of Appeal this year upheld various claims for misleading and deceptive conduct under the Australian Consumer Law in the context of a private M&A deal in the Cargill v Viterra matter. Subsequently, the High Court of Australia has recently dismissed the special leave application stemming from this litigation in Viterra Malt Pty Ltd & Ors. v Cargill Australia Ltd & Anor [2023] HCASL 165.

The next episode of our series of articles on liability in private M&A deals in early 2024 will discuss the long-running Cargill v Viterra litigation and the implications for liability in private M&A transactions.