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

In Episode I of our series of articles on liability in private M&A deals, we discuss the recent High Court of England and Wales decision regarding claims for breach of contractual warranties in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch).  

In brief 

• The England and Wales High Court has recently handed down its decision in Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch)¹ (Decision Inc v Garbett) which concerned claims from the buyer of an IT consultancy business for breach of contractual warranties in a sale and purchase agreement.
• The buyer claimed that the sellers had breached contractual warranties that:
  • there had been no material adverse change in the turnover or prospects of the company at the time the contract became effective; and
  • the records of the company were accurate.
• As we discuss below, the buyer was successful in its claim for breach of the material adverse change warranty regarding the prospects of the business, but the remaining warranty claims failed.
• Although a decision of the England and Wales High Court, the case illustrates that contractual warranties in a sale agreement remain an important part of a private M&A process. However, in an Australian context, it is also important to note the key role that statutory remedies can play in the deal between buyer and seller.
• Stay tuned for Episode II of our series of articles on liability in private M&A deals for a discussion of the long running litigation in Viterra Malt Pty Ltd v Cargill Australia Ltd [2023] VSCA 157 (Cargill v Viterra)² in this regard.

Background 

Decision Inc Holdings Proprietary Ltd (Buyer) and the target company, Copperman Consulting Ltd (Company) were both IT consultancy businesses that specialised in the design of enterprise performance management software.

On 8 October 2018, the Buyer and sellers executed a sale and purchase agreement (SPA) to acquire all the shares in the Company. The SPA took effect on 12 October 2018.

Prior to signing, and as part of due diligence prior to entry into the SPA, the sellers disclosed the Company’s financial information up until July 2018. 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, financial position or prospects of the Company”;³ and
• “All financial and other records of the company … do not contain any material inaccuracies or discrepancies”.⁴

The sellers denied the claims and argued that the facts on which the Buyer sought to rely were known to the Buyer as at the time they entered into the SPA and consequently, that the Buyer was prevented from suing by virtue of the terms under the SPA. Alternatively, the sellers argued that they had a countervailing claim in damages for a breach of that warranty which should be set off against any award. The sellers also contended that the Buyer had failed to give valid notice of their claim in accordance with the SPA.

The Court's decision 

Claim for breach of “records” warranty

The Buyer argued that “records” for the purposes of the records warranty in the SPA included:

• the forecast profit and loss account for FY2018;
• schedules setting out the sales pipelines for FY2018; and
• schedules of invoices purportedly raised in July and August 2018.

Gleeson J, citing the observations in Macquarie Internationale Investments Ltd v Glencore UK Ltd [2010] 1 BCLC 238,⁵ held that the term “record” included a company’s books and records of everyday transactions and that this was distinct from any analysis prepared in reference to them.⁶

His Honour noted that if the term “records” included every document created by a business in the course of its operations, the relevant warranty would be akin to a warranty of the accuracy of every communication made pursuant to the negotiation of the SPA, whether relating to the past, the future or hypothetical states not in existence (such as “pro forma” accounts) which could not be correct.⁷

His Honour held that:

• all documents produced by a company in respect of its business are not “records”;
• the term “records” itself implies a retrospective element;
• it was hard to see how any statement about a future transaction into which a company intended to enter could be classed as a “record” in the ordinary sense of the word (which was consistent with use of the term elsewhere in the SPA which applied the term to documents recording what had already happened); and
• a financial projection in relation to the expected future profitability of a company cannot, on this basis, constitute a “record” of the company.⁸

His Honour concluded that the relevant forecasts and pipelines were not “records” of the company for the purpose of the warranty. In addition, the invoice schedules disclosed were created from records but were not records themselves. As such, the claim for breach of the records warranty failed.

Gleeson J noted that even if he was wrong that the documents concerned were not “records”, there would still not have been a breach of the warranty which related to the accuracy of the relevant records. His Honour noted that:

“The question of whether a record is accurate does not turn on what the record contains, but on whether it is an accurate record of the thing that it purports to record. If a director were to tell a series of lies to a board meeting, and the board minutes were to faithfully record what he said, the board minutes would not be an inaccurate record, even though the statements which they recorded would be inaccurate. Applying this principle to this case, in order to argue that the pipeline documents were inaccurate records, it would be necessary for the claimants to show that they did not accurately record the beliefs of the defendants.”⁹

In the case, his Honour was of the view that what had been written in relation to the relevant matters concerning the pipelines and forecasts was an accurate record of what the relevant seller believed the position to be no matter how implausible the beliefs of the defendants may have been at the time when the document was put together.

Claim for breach of “material adverse changes” warranty

The Court noted that to establish a breach of a warranty that there had been a material adverse change in the turnover of the company or its prospects, the following three things needed to be determined:

• a “baseline” figure – i.e. what the expected or forecast level of the relevant factor at the time of the contract;
• the “actual” figure – i.e. what the actual position was as at the date of the contract; and
• the difference between the baseline and the actual figure and whether that difference was so great as to be material.¹⁰

In relation to whether a change is “material”, Gleeson J considered that the correct test was whether a change is so significant that the other party, had they known of the change, would not have entered into the transaction at all, or would have entered into it on significantly different terms, referring to Group Hotelero Urvasco SA v Carey Value Added SL [2013] EWHC 1039.¹¹ His Honour held that such an enquiry was objective and the actual states of mind of the parties was not admissible.

Gleeson J referred to the well-known Delaware case of IBP Inc v Tyson Foods Inc (2001) 789 A.2d 14 (2001), noting that, in that case, it was observed that a “material adverse effect” event in a corporate sale and purchase agreement is to be “best read as a backstop protecting the acquiror from the occurrence of unknown events that substantially threaten the overall earnings potential of the target in a durationally significant manner”.¹² Gleeson J cited Vice-Chancellor Strine’s comments that:

“A short-term hiccup in earnings should not suffice; rather the Material Adverse Effect should be material when viewed from the longer-term perspective of a reasonable acquiror.”¹³

The question of how big a disruption has to be before it is more than a “mere hiccup” is dependent on the business model of the company concerned (noting, for certain business structures, even a short interruption in revenues can be material, depending on the circumstances). However, the use of the term “materially” should not be informed by any accounting concepts of “materiality” given the two perform different functions. The correct test for the purposes of a contractual term of the relevant kind was that “a breach is material if, had it been known to the other party in advance, the other party would either have declined to proceed with the transaction at all, or agreed to proceed only after a renegotiation of the financial terms”.¹⁴ His Honour noted that determining this “… is a matter of evidence, and cannot be reduced to a mathematical expression”.¹⁵

Turnover

In relation to the claim regarding turnover, Gleeson J considered that the question to be asked was whether the deterioration in the turnover of the company between 31 July (which was the last date from which the claimants had financial information) and 12 October 2018 (the Effective Date) was materially adverse. In particular, it needed to be answered whether the turnover figures for the months of August and September were so far away from the long-run average for the company that a hypothetical reasonable seller would have concluded that there had been a fundamental change in the nature of the revenue flows into the company.¹⁶ His Honour noted that:

“It is entirely clear from the evidence that it [the Buyer] was not engaged in any form of financial speculation – its aim was to develop a UK business, and it regarded the acquisition of the Company as a step towards that aim. Viewed from that perspective, a shortfall in two months’ turnover cannot, of itself, constitute any sort of material change.”¹⁷

Gleeson J concluded that although there was a significant drop in turnover figures (turnover in August and September was £269,999 and £283,360, compared to the predicted amounts of £629,804 and £626,969) particularly when considered on a month-by-month basis, these were not large enough for a seller to have concluded that there was such a fundamental change. As such, the Court concluded that the claimants had failed to establish there had been a breach of the material adverse change warranty relating to turnover.¹⁸

Prospects

On the issue of whether there had been a breach of the warranty relating to material adverse change in the prospects of the Company, Gleeson J found in favour of the Buyer.

In relation to the meaning of prospects, Gleeson J noted that he thought there was “some truth” that this meant:

• the Company’s chances of being successful in the future (as argued by the defendants); or
• the future profitability of the company (as argued by the claimants).¹⁹

However, the term needed to be considered in the context of the transaction, and the overriding primary factor for the Buyer in its pursuit of the transaction was future gross profit.²⁰

His Honour was of the view that the baseline estimate from which the assessment of material adverse change was to start was the expectation that the Company would generate around £1m EBITDA in 2018, and possibly a little more in 2019.²¹ The evidence suggested that three out of the four potential mandates of the business in the relevant period did not give a reasonable prospect of revenue in that year and that the fourth would generate significantly less. The actual expected profit was therefore £300,000 as at the Effective Date (which indicated that the Company, in aggregate would be loss making in the second half of the year), and Gleeson J considered that constituted a material adverse change in the prospects of the Company as at the Effective Date.²²

Knowledge

Turning to whether any defences applied, Gleeson J noted that the deemed disclosures for the purpose of the warranties in the SPA included matters disclosed in the Disclosure Letter. However, Gleeson J noted that the claimants could nevertheless not disregard actual knowledge of information which they had by reason of it having been provided to them by the defendants.²³ That being said, the seller could not raise defences of knowledge based on information which was not directly provided to the Buyer, but which the Buyer might or ought to have inferred.

In the circumstances, the Court was satisfied that the claimants did not have actual knowledge of the fact that the prospects of the company had materially and adversely changed as at the Effective Date, but that any constructive knowledge which they might be found to have had would be irrelevant.

The claims notice

Typical of sale agreements of this nature, the SPA in Decision Inc v Garbett also provided the following:

“The Sellers shall not be liable for a Claim unless 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, has been given by or on behalf of the Buyer to the Sellers … on or before the expiry of the period of 24 months commencing on the First Completion Date.”²⁴

It was argued by the defendants that, although the notice in relation to the claims for breach of warranties was given within time, it did not specify in respect of each of the relevant breaches, the quantum of damages sought in respect of the breach and liability for the relevant breaches of warranties was therefore excluded.²⁵

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. The Court 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”.²⁶ The notice therefore satisfied the requirements of the SPA.

Damages 

In relation to damages, the Court held that damages in contract are intended to place a claimant in the same position as they would have been if the contract had been performed. Gleeson J further held that as applied to sale shares, the general rule to be applied was the difference between the value of the share as warranted and the true value of the shares.

The Court noted some useful principles citing the decision in The Hut Group Ltd v Nobahar-Cookson [2014] EWHC 3842 (QB)²⁷ as set out below:

• valuation involves an assessment of the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and a willing seller in an arm’s length transaction;
• there is no one methodology to be applied in a valuation;
• models used by valuation experts should be considered as a tool with the output to be assessed in light of all the circumstances and common sense;
• the valuation methodology actually used by the parties to the transaction is not determinative of how valuation out to be carried out for the purpose, however can be relied upon as evidence of the as warranted value and might give guidance as to an appropriate approach to assessing actual value; and
• it is for the plaintiff to prove both the fact of the loss and the quantum of the damage.²⁸

The figure to be used in calculating the “as warranted” value was to be the figure reflecting the actual expectations that reasonable parties would have had.²⁹ The “actual valuation” was the valuation which a valuer would have arrived at if, on the Effective Date, they had conducted a valuation of the Company in the knowledge of its true position and prospects.³⁰ Damages were ultimately assessed by the Court for the relevant breaches to be £1.31m.³¹

Commentary 

Although a decision of the England and Wales High Court, the decision in Decision Inc v Garbett illustrates that contractual warranties in a sale agreement remain an important part of a private M&A process. In Decision Inc v Garbett, the claims concerned were purely for breaches of contractual warranties, although the judge noted that, in the absence of the provisions of the sale contract, the circumstances would give rise to a straightforward case in misrepresentation.

In an Australian context, it is also important to note that statutory remedies can also radically alter the deal between seller and buyer in private M&A deals. In particular, the Victorian Court of Appeal in Cargill v Viterra recently upheld a number of claims for misleading and deceptive conduct under the Australian Consumer Law in the context of a private M&A deal (noting Viterra has sought special leave to appeal to the High Court of Australia). As such, a holistic approach to a sale process is needed to manage liability.

Stay tuned for our next article on liability in private M&A deals for a more detailed discussion on the Cargill v Viterra litigation and the implications for liability in private M&A transactions.

1. Decision Inc Holdings Proprietary Ltd v Garbett [2023] EWHC 588 (Ch) (Decision Inc v Garbett).
2. Viterra Malt Pty Ltd v Cargill Australia Ltd [2023] VSCA 157 (Cargill v Viterra).
3. Decision Inc v Garbett [12].
4. Ibid.
5. Macquarie Internationale Investments Ltd v Glencore UK Ltd [2010] 1 BCLC 238.
6. Decision Inc v Garbett [90].
7. Ibid [91].
8. Ibid [92].
9. Ibid [94].
10. Ibid [101]–[103].
11. BP Inc v Tyson Foods Inc (2001) 789 A.2d 14 (IBP v Tyson Foods).
12. Decision Inc v Garbett [108].
13. Decision Inc v Garbett [109] citing IBP v Tyson Foods, 67–68.
14. Ibid [112].
15. Ibid [112].
16. Ibid [123].
17. Ibid [110].
18. Ibid.
19. Ibid [125]-[126].
20. Ibid [126].
21. Ibid [155].
22. For a detailed discussion on material adverse change conditions and decisions concerning them, see Tony Damian and Andrew Rich, Schemes, Takeovers and Himalayan Peaks (Ross Parsons, The University of Sydney, 4^th ed, 2021) [5.3.3].
23. Decision Inc v Garbett [163].
24. Ibid [186].
25. Ibid [192].
26. Ibid [193].
27. The Hut Group Ltd v Nobahar-Cookson [2014] EWHC 3842 (QB) (Hut Group).
28. Decision Inc v Garbett [200] citing Hut Group [180(2)]–[180(4)] (Blair J).
29. Ibid [204].
30. Ibid [206].
31. Ibid [231].