Measure of loss in breach of warranty claim

The case of Ageas (UK) Limited v Kwik-Fit (GB) Limited and AIG Europe Limited [2014] EWHC 2178 (QB) centred on the correct approach to valuing the loss suffered by a party who buys a business in reliance on warranties that are subsequently found to have been breached.

The ruling will be of interest to all parties involved in mergers and acquisitions and also to insurers who underwrite warranty and indemnity (W&I) cover. This type of cover has become increasingly common in recent years with the result that insurers, rather than the transacting parties, will often bear the majority of the risk of warranties being breached.

BACKGROUND

In August 2010, Ageas agreed to purchase the entire share capital of Kwik-Fit's subsidiary, Kwik-Fit Insurance Services Limited (KFIS). KFIS was an insurance broker offering various types of motor and household insurance to Kwik-Fit's customers. KFIS placed these policies with a number of different insurers.

The agreed purchase price of £214.75 million was based on Ageas' calculation of the future value of KFIS' revenue streams using a discounted cash flow analysis. This is a fairly common type of model based upon the past performance of the business and various projections and assumptions about future performance. Ageas' valuation therefore relied upon KFIS' published accounts and Kwik-Fit warranted that these accounts were true, fair, accurate and compliant with applicable accounting standards. Kwik-Fit's liability for breach of warranty was capped at £5 million and Ageas took out a W&I policy underwritten by AIG to cover any losses in excess of £5 million that it may suffer as a result of breach of warranty.

In reality there were errors in KFIS' accounts which led to a significant over-valuation of the business by Ageas. KFIS' business model involved it paying the entire premium due on policies at inception but allowing policyholders to pay by instalments throughout the year of cover. KFIS entered into a financing arrangement with Barclays Bank to cover its cash-flow position. There was an inherent risk of policyholders failing to keep up their premium instalments after KFIS had paid the premium in full. KFIS' accounts wrongly allocated this bad debt risk to Barclays rather than to the company itself. This resulted in an over-statement of KFIS' revenues during the years covered by the accounts.

Ageas brought an action against Kwik-Fit for breach of warranty and against AIG on the basis that the loss claimed would exceed the £5 million cap on Kwik-Fit's liability.

DECISION

By the conclusion of the trial in 2014 the only point in issue was how Ageas' loss flowing from the breach of warranty should be calculated. It was accepted that the loss exceeded £5 million on any view and so Kwik-Fit had no financial interest in the outcome.

Ageas and AIG agreed that the starting point was to compare the agreed value of the shares in KFIS as warranted (i.e. the price Ageas paid) with the true value of the shares. Ageas argued that this should be calculated by re-running the discounted cash flow analysis it had undertaken using the corrected accounts for the period up to the point of sale. This would lead to a loss of £17.635 million (£12.635 million net of Kwik-Fit's payment). AIG argued that the Court should also, with the benefit of hindsight, look at the financial performance of KFIS in the period after the transaction. The actual bad debts in the period between the transaction and trial were lower than those in the period covered by the accounts. Accordingly, using this information would lead to a smaller loss of £8.792 million (£3.792 net of Kwik-Fit's payment). There appears to have been little dispute between the parties as to the calculation of these figures. The issue was simply one of principle as to whether or not the Court should consider performance after the transaction.

Mr Justice Popplewell affirmed the compensatory principle, namely that damages for breach of contract should, so far as is possible, put the claimant in the position he would have been in had the breach not occurred. In the context of a breach of warranty as to the accuracy of financial information, this will usually mean assessing what price the claimant would have paid if he had known the true position prior to sale (i.e. Ageas' position). Popplewell J accepted that in some cases it may be appropriate to look at the financial performance of the target company post-acquisition but only where it was necessary to do so in order to give effect to the compensatory principle. The party seeking this departure from the normal rule would need to justify it on the particular facts of the case.

In this case, Popplewell J was not persuaded by AIG's argument that ignoring the actual performance of KFIS after the transaction would result in an unjust windfall for Ageas (i.e. that it would benefit from an assumption in its modelling (namely that levels of bad debt pre-acquisition would continue post-acquisition) being wrong). Popplewell J noted that the contract had allocated all of the risk of KFIS's future performance to Ageas. It would have been open to the parties to agree some form of price adjustment mechanism based on future performance but they chose not to.  Ageas therefore bore the risk that the business would perform less well and had a right to the benefit of any improvement. The Court would not disturb this contractual allocation of risk.

Ageas therefore recovered in full its claim for £17.635 million from Kwik Fit and AIG.

COMMENT

The judgment affirms important legal principles that will be of interest to commercial parties and to W&I insurers. Where a Court is required to assess damages for breach of contract by reference to the value of a company at the date of breach it will only take account of the performance of the company after the breach where this is shown to be necessary to give effect to the compensatory principle. In all other cases, the Court will assess only the value of the company as it would have been calculated at the time if accurate information had been available.

The calculation of damages in cases of this kind is inherently difficult, relying as it does on consideration of sometimes complex financial information as well as modelling based on assumptions and projections. This confirmation of the applicable legal principles is therefore helpful.